Tough love is the best regime for failed banks

Following is a letter sent to the Editor of the Financial Times:

Dear Sir,

John Kay is right to outline cases where companies cannot be allowed to close ("Tough love is the best regime for failed banks" Financial Times, September 25, 2007), while maintaining the discipline that the market brings to companies which is for them to fail.

His concept of having an Administrator take over the business needs to be extended to cover the recent experience which we have seen with Northern Rock.

It is unreasonable to expect that normal depositors have the responsibility to monitor and control the banks which hold their deposits, both through lack of information and also a lack of expertise. Normal depositors have a right expect that, if an institution has the correct licenses to operate in place, their savings should be safe. This is why it is right and proper that there is some form of deposit insurance to protect smaller depositors.

The way to minimize moral hazard is through putting the careers of senior bank management and shareholders´ capital on the line.

When things go well, senior bank managers are well paid and career progression continues apace. When bank management does not do so well and loses the confidence of the markets, this management needs to be held to account and that means that they lose the right to work in the industry.

In that case, interim managers can be seconded from other banks to take the reins until a solution is found, whether that be closing the bank, a sale or a relaunch. At that time, the interim managers can stay or return to their jobs, as they and new shareholders see fit.

This solution means that the loss when a bank gets into difficulty is set firmly where it belongs, with managers and with the shareholders of the bank, who would lose their capital. That should go a long way to minimizing whatever moral hazard may arise from introducing some form of deposit insurance.

Onésimo Alvarez-Moro

See article:
The British government, planning to privatise water utilities, was forced to recognise that these could not be like other businesses. If a hairdresser, or a burger bar or even a car plant failed, the shop or factory would close. But if a privately owned water company failed, it would not be enough to post a notice on the reservoirs and sewage treatment works telling potential customers to contact the liquidator. Even if the flow of cash to the business ran dry, the taps must not.

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