Comment: '30s Agency, Not RTC, May Point Way for Japanese Rescue

Amid the second-guessing on the Japanese banking system's problems, it is useful to recall that banking uncomfortably combines the public's desire for effectively riskless deposits with the role of deposits in funding a business that is inherently quite risky.

All banking is subject to recurring losses greater than anyone ever imagines.

Since a combination of riskless deposits with a risky business is impossible, governments that pursue it are periodically put in the difficult position of transferring losses from the banks to the public and resources from the public to the banks.

The most striking case of this difficult position at present is in Japan. As Japanese central bankers, regulators, politicians, and managers struggle with it - and others around the world would like to be helpful - does the U.S. experience offer useful parallels that should be considered?

Many seem to think the obvious model is the Resolution Trust Corp., and there are numerous references to "Japan's version of the RTC."

But is the RTC the right model? Is this decade the right period in which to look for parallels - or should we be looking at the 1930s instead?

Well before the problems of the Japanese banking system attracted general press coverage, The Economist magazine presciently commented, "Did the Japanese banks in their first decade of financial dominance make the same mistakes the American banks did in the first decade of theirs, the 1920s? They did."

Indeed, the shift from euphoria to a simultaneous bursting of large stock market and real estate bubbles, losses on international investments, and runs on financial institutions in Japan is markedly similar to the 1920s in the United States. Our 1930s are also being echoed in very low Japanese interest rates that fail to solve the problem, and the onset of a liquidity trap.

If the correct historical analogue is the 1930s, a much better model than the RTC is the Reconstruction Finance Corp., or RFC, which was one of the more powerful and effective agencies created to cope with the financial crisis of that time.

When banking losses have been so great as to run through bank capital, when waiting and hoping have not succeeded, when the future is uncertain and therefore risk premiums are very high, banks need more equity capital, not more debt, however cheaply priced.

Consider the instruments available to a government to address a banking crisis:

First, there is delay in recognizing losses while issuing assurances. Then there is the central bank as lender of last resort, which is by definition short-term debt, not equity. Third, there is an RTC, a master liquidator that shifts assets and liabilities around the financial system while transferring government funds to depositors.

But in a 1930s-style situation, something different and better is needed: a massive provider of new equity capital, an RFC.

It is little recognized today what a huge operation the RFC was. Its investments in U.S. companies, mostly financial institutions, totaled $50 billion. In 1995 dollars, this would be more than $500 billion, dwarfing the funding of the RTC.

The most important element of RFC operations was a fundamental change made in the Hoover administration's original design by the Roosevelt administration to address the nationwide banking collapse in 1933: authority for the RFC to invest in preferred stock, that is, equity capital.

More than 6,000 financial institutions, including many of the principal banks of the day, got RFC investments. The basic pattern of the agency's operations, as described by its head, Jesse Jones, in his instructive memoir, "Fifty Billion Dollars: My Thirteen Years With the RFC," consisted of four principal steps:

*Write off bad loans to realistic economic values, and consequently write off book equity.

*Judge the character and capacity of management and make any appropriate management change.

*Based on realistic asset values and capable management, invest in new equity for the bank in the form of redeemable, dividend-paying preferred stock.

*Collect dividends and ultimately the par value of the preferred stock, as the bank returns to profitability and recapitalizes in the private market.

This proved a very successful model.

The Japanese public displays great resistance to spending tax funds on a bank industry bailout. On the RFC model, however, the public, instead of only providing subsidies, makes equity investments with an expected return.

Indeed, one important improvement on the RFC model should be giving the public more upside potential. The government's preferred stock should be combined with warrants on the common shares of the recapitalized banks. As the Chrysler Corp. recovery demonstrated, this structure offers attractive outcomes to all concerned.

The economic historian Charles Kindelberger has observed that, in the last four centuries, banking crises occur on average once every 10 years.

The worst cases involve severe asset deflation and destruction of banking system capital. Such crises require the emergency provision of new equity as a bridge to private recapitalization - the RFC strategy. This is fundamentally different from the RTC concept of a master liquidator.

It therefore appears that Japan may wish to consider the RFC, not the RTC, as the most relevant model U.S. experience has to offer.

Mr. Pollock is president and chief executive of the Chicago Home Loan Bank.

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