The Banking System: The Issue of Trust

Paul Kedrosky writes:

"People keep talking about the perils of nationalizing the banking system. Newsflash: There currently is no banking system, if by that you mean a network of organizations lending to one another and to quality companies in a predictable way. (Look at the spread on today's IBM issue for an example.) Instead, there are a bunch of paralyzed deposit-hoarding institutions stuck in a game theory experiment that no-one understands or can exit.

The solution to a systemic breakdown in tightly-coupled systems is to uncouple the systems, build in slack, and break the feedback mechanisms -- and not necessarily in that order. In this context you can do that most directly by either recapitalizing a select set of banks immediately, or by letting banks fail and consolidate. Either way, you end up with uncoupling and the eventually reappearance of trust, whether through a government backstop or through defaults and collapse. I tend toward the former approach, but I fully understand its risks and the attractiveness of the latter to some people.

Either way, trying to fix things on the fly, without breaking the feedback mechanisms, and without introducing slack to protect a fragile and badly damaged system from the next inevitable lurch, is stupid, destructive and childish."

The Banking System, Nationalization and Slack

This summarizes a crucial issue, but I strongly favor the less costly and more equitable proposal set forth by Luigi Zingales.