James Galbraith on Bank Stress Tests

Al Jazeera: Earlier, I spoke with progressive American economist James Galbraith, and I asked him to explain why some banks still need more capital after receiving billions in government bailouts.

James Galbraith: I think this is expected.  If the test did not show that they needed capital, nobody would believe them.  At the same time, they don’t show that they need so much capital as to pose threat to the system.  So, we got a result which is just about where I’m sure the treasury wanted it to be.  And that itself tells you that perhaps it’s not a completely accurate reflection of the true condition of the banks.

Al Jazeera: . . . How would you basically define the banking system right now? Would you say that they’re recovering?

James Galbraith: I would say they’re still in need of rigorous examination of the quality of the underlying assets.  And until we have that, we won’t know whether they are going to recover or not.  Clearly, the economy has moved along a bit.  We’re coming to the end of an inventory cycle, we should see some bottoming out and some improvement in the months ahead, and the banks will reflect that.  But the real question is whether the assets that they hold, all of those toxic assets, are so riddled with fraud and corruption that they cannot recover or whether they are not and therefore may.  Until the assets are examined, stress tests are not gonna give a definitive answer about that.

Al Jazeera: And a lot of this assumes that the economy will continue to improve.  What if that doesn’t happen?

James Galbraith: Oh, then the bets are off.  My understanding is that the stress test was based upon fairly mild economic assumptions, and if things got much worse, then, of course, even the stress test would show a substantially greater need for capital.

Al Jazeera: There’s already strong public opposition to more money for the banks.  How does the administration address that? It’s essentially a political issue.

James Galbraith: Well, no, it’s essentially a regulatory issue.  There’s been a political refusal to do what the law and regulatory practice would normally dictate, namely when a bank is in trouble, at risk of becoming insolvent, let alone actually insolvent, then, send in a team of regulators, replace the management, do a clean audit, and reorganize the institution.  That’s what the Federal Deposit Insurance Corporation is set up to do.  Banks accept deposit insurance on condition that they are prepared to have that happen if they start getting too close to the line.  But the administration has been unwilling to do that with the very largest banks.  And that’s partly a question of the political power that the banks have and partly a question of a strategic decision, which I think is very wrongheaded, about the importance of these particular institutions to the financial sector and the economy going forward.

Al Jazeera: And given public opinion right now, do you think that, going ahead, the administration will tighten up its control over that?

James Galbraith: Well, that all depends on circumstances, but I think the options are narrowing if this particular way of papering over the problem doesn’t work, then, the right thing to do, which should have been done in fact last September, will become basically the only remaining option, the only remaining credible option.

Al Jazeera: What would the right thing be?

James Galbraith: That would be take the banks into what is called pass-through receivership, replace the management.  You end up wiping out the equity, subordinated debt, the capital that’s at risk.  You guarantee the deposits, so the institutions continue to function.  And you have a clean audit, so you can determine just what needs to be done to restructure, or sell, or break up, or merge as the case may be, each particular institution.  And that is the way that you resolve, that they do resolve, are now resolving, banks like IndyMac.  They’ve simply been very reluctant to use that power, those procedures, on the very largest banks.

This interview was brought online by Al Jazeera on 7 May 2009.  The above is a partial transcript of the interview.