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US Economist James Galbraith: Financial Crisis Caused by a 'Culture of Complicity'

While the world talks about new ways to save struggling banks, there are a handful of economists who think some banks shouldn't be saved at all. American economist James Galbraith told Manager Magazin that it might make more sense to break them up and start over.

Manager Magazin: Professor Galbraith, you suggest that banks that suffer from bad assets should simply be declared insolvent, instead of rescuing them with taxpayers' money. Why?

What should be done with the world's ailing banks?
REUTERS

What should be done with the world's ailing banks?

James Galbraith: We need a correct assessment of the degree of losses suffered by a bank which is functionally insolvent. But as long as the old management is in place, there are no incentives to cooperate in the evaluation you need to make. That's the first problem.

The second problem is: When a bank is insolvent, the incentives for normal banking practice disappear. They become perverse. The incumbent management has good reason to gamble excessively and to make capital losses. This is because it appears that the regulators could soon close down the bank.

Beyond that, if the situation for the bank is truly hopeless or if the management is truly corrupt, then the incentive is to loot the institution, to take as much money out of it -- e.g. in the shape of bonuses and dividends -- before the true state of the books is discovered.

Manager Magazin: Is this something we are witnessing right now?

Galbraith: Certainly those incentives are in place. In a situation when a bank has suffered losses sufficient to impair its capital, you need to have regulatory supervision in place.

This does not mean that you necessarily close the bank. The way it usually works in the USA is that a bank is closed on Friday and re-opened on Monday under a new name, with a new leadership and with a team of examiners who are going through the books, trying to sort the good business loans and personal loans from those which are hopeless. Then you isolate the hopeless stuff, you force a write down of the equity and the subordinated debts of the people who put in risk capital -- so they have to take their losses as they should. And then you break up the bank into pieces which have a better prospect to gain viability soon. That's a process of re-organization and re-capitalization.

Manager Magazin: The change of management, as we have seen in Germany with Hypo Real Estate bank, is probably the most important step.

Galbraith: A change of management is essential, because firstly, the incumbents are responsible, whether they were culpable or not, and secondly, you need new people who are in line with the public purpose of this re-organization. It's the same principle in the navy: When a ship runs aground, the captain is removed, no matter if he caused the accident or not. No one would think it's a good idea to have the subsequent investigation headed by the ones who are to be investigated.

Manager Magazin: What you suggest is hard for two groups of people: for the management in place and for the shareholders of the bank.

Galbraith: Why worry? The shareholders have already lost most of their capital. In the case of Citigroup, it was traded at $55 (€41) per share a year ago and it's now at $3.58. That's approximately a 95 percent loss. And the remaining 5 percent exists in the books only because of the expectation that the government would bail them out. So, even this poor market capitalization is only nominal. Everybody understands that the bank in fact is insolvent.

Another question is: Who are the shareholders? Who holds shares at that price? A good deal of them could be people who bought their Citi shares at $5 or $4. Clearly, they are gambling on the bailout. There's nothing wrong with them doing this. But they have no claim on public support.

Manager Magazin: What about the management?

Galbraith: The managers are in their positions on behalf of the shareholders who gave them great powers and, of course, like to see them perform well. When they do, they are very well off. Most of them have been in place for a couple of years, and they have earned very much in recent years, in some cases bonuses of $20 million.

Again: When the bank runs aground, there have to be consequences. The management has no claim on sympathy. They won't be poor. They have enough to send their kids to college. Some of them may have to sell some houses or boats. This is not a sad thing -- this is called the capitalist system. Well, it used to be called the capitalist system. Do we still have a capitalist system somewhere? China, maybe? (laughs) It's certainly a life change for them, but there's no human tragedy involved in changing the management of an insolvent bank.

Manager Magazin: In your scenario, the deposits must be guaranteed by the state.

Galbraith: Yes, that's absolutely essential. The standard practice in this case is to establish a deep insolvency insurance fund. This follows the principle that the ordinary depositor is not responsible for the problems of the bank because it's unreasonable to expect ordinary depositors to be monitoring the performance of the management. It's that simple: If the depositors feel that there's something wrong with the way the bank is run, they just leave, and that causes a systemic problem very quickly. And that's also the reason why you try as hard as possible to keep this ordinary business going after declaring a bank insolvent.

Manager Magazin: The most prominent example of a German bank facing a possible breakdown is an institution named Hypo Real Estate ...

Galbraith: (laughs) Why am I not surprised to hear that?

Manager Magazin: Yes, their core business is rather obvious ... they are in a liquidity crisis, some of their problems stem from asset backed securities from the US. The government has already put some €100 billion into preventing the bank from collapsing. What's your recommendation for the future of such a bank?

Galbraith: I sincerely hope the bank management conducted some due diligence with the products they bought. And if they relied on agency ratings, they should have asked whether the agencies were working on their behalf. But I am very sure that, again, the answer is 'no'. The rating agencies made a mess by rating asset backed securities with AAA, so we're seeing a failure of due diligence at every stage. And a deep fraudulence at every stage. When a rating agency certifies that a security is AAA, it is making a claim about the quality of that security. It cannot make this claim unless it has closely looked at this security...

Manager Magazin: One would think.

Galbraith: One would think. The representation of such a quality of this security without examination is fraud. Perhaps Hypo Real Estate has legal recourse to these rating agencies for having relied on their fraudulent ratings.

Actually I doubt that, as there was some hidden understanding between such banks and rating agencies. The language they used reveals a different story than the one bank managers are selling to the public these days. "Liars' loans," "toxic waste," or my favorite: "neutron loans" -- loans that destroy the people but leave the buildings intact. These were the words to describe these loans and they were used by the people who were working in this industry. They reveal a culture of fraudulence on a massive scale. And of course governments now have to come to recognize that these are things they have to deal with.

Manager Magazin: So in your view, the talk about systemic failures is aiming to hide the real crimes that are actually involved?

Galbraith: There was clearly a systemic failure. But that does not mean there was no criminal energy around. The language one uses to describe these things is very important. I tend to stay away from neutral terms like "systemic failure" or "bubble," because these terms imply the innocence of the people involved -- and I can't see that.

Manager Magazin: What was it, then?

Galbraith: The reality of the financial crisis is that it was caused by a culture of complicity. That makes it so difficult for people to come to grips with it, especially for people who were involved, who were denying it themselves and who were partially aware of the extent of the damage. Probably many of them thought they would get away with it and now they realize that they have created an enormous slump.

Manager Magazin: Back to the consequences you suggest, declaring the banks insolvent and just saving the loans. What about the domino effect that could result, damaging systemically relevant banks?

Galbraith: The domino effect will happen anyway. The question politicians have to deal with is: Do they want to have the effect now or do they want to have to deal with these problems for another decade? They should be warned: The longer this goes on, the bigger the losses are. That's the lesson to be learned from the Japanese experience. There are moments where the state has to assert its autonomy. If, in the case of Hypo Real Estate, one assumes that the functioning of this bank for the entire system is necessary, then it's about time to make these bankers work for the public rather than having the public work for the bankers.

Interview conducted by Matthias Kaufmann

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