How to Clean Up a Bank

This post draws heavily on MPettis:

How to Clean Up a Banking Crisis

Reduce accumulation of NPLs by keeping borrowing rates low. Low borrowing costs make it easier for struggling businesses to roll over the debt, and effectively reduce the real value of debt payments. Remember that if you reduce the coupon payment on a loan, it is economically the same thing as forgiving part of the principle amount. By lowering rates, central banks able to transfer part of the principle cost onto the banks that made the loans and so obtain debt forgiveness for the borrowers. But while this helped the borrowers, it did not of course help the banks – unless the banks themselves were able to push the cost onto depositors, which of course they did by repressing deposit rates. Households pay for this in the form of low returns on their savings. (appendix 1 - alternative investment opportunities are also affected when savings rates are held too low).

Direct equity injection, when financed by government borrowing at low (suppressed) interest rates is also passing the cost to savers. If other banks provide the financing, then suppressed lending and suppressed deposit rates have the same effect as above.

Lending Spread - provide the banks a wide spread between lending and deposit rates that allows them to rebuild their capital through profitability. This is a second "tax" on households
(the first is through deposit rates) that subsidizes profitability of the banks.

These three mechanisms are how households and other savers clean up banking problems. The bailout implicitly required that bank depositors subsidize the cleaning up of the banking industry. This in effect represented a large transfer of income from the household sector to the banks, to government and to businesses, equal annually to several percentage points.

How much does it cost?