The current formula being used to resuscitate troubled being banks seems instead to be hastening their demise.

Present bailout policy identifies troubled banks as those with insufficient capital to absorb expected credit losses. A bank with a Tier 1 capital ratio of less than 4% is considered troubled and must raise its ratio.

The Fed needs to develop a mechanism by which large banks are exempted from capital ratio considerations. These banks must then be encouraged to expand rather than shrink their balance sheets.

Expansion must, of course, involve the acquisition of well-performing assets.

The Usual Scenario

Under today's regulatory system, however, just the opposite occurs. Since troubled banks are generally unable to obtain fresh capital from the market, either through the sale of equity or preferred stock, they are urged to improve capital ratios by selling assets.

Two types of assets are typically sold: subsidiaries and loan assets. In the sale of both subsidiaries and loan assets, the market is willing to buy only those assets and subsidiaries that perform well.

Accordingly, the troubled bank is able to sell only the good subsidiaries and good loans, while keeping the weak-performing subsidiaries and poor quality loans. This course of action temporarily strengthens the capital account, but substantially weakens income streams.

Makings of a 'Bad Bank'

As a consequence, banks become top-heavy in terms of costs. Furthermore, the concentration of bad loans remaining on the balance sheet increases. In effect, the makings of a "bad bank" are set in place.

As long as credit quality in the economy is a whole continues to decline, charges for credit writeoffs and restructurings start to overpower earnings.

Adding to this, troubled banks find that noninterest income shrinks as their trading lines are cut and their ability to participate in market-related activity is diminished. To a growing extent, successful participation in the foreign exchange, swaps, and securities markets is largely a function of credit rating.

Accordingly, banks with deteriorating credit perceptions realize a further decline in income as trading revenues decline.

Cost of Funds Rises

Of even greater significance, noninsuranced funding sources, such as commercial paper and interbank deposits, become dysfunctional - and the troubled bank's overall cost of funds rises.

Eventually, negative perceptions of a troubled bank's balance sheet are reflected in fee income from such noncredit functions as clearing and custody.

And at a certain point, the "bad bank," stripped of its quality income sources and chasing deteriorating asset quality, attempts to build capital internally. This generally involves the suspension of its dividend.

This sequence is more or less what took place at the Texas banks in the late 1980s and the Bank of New England in 1990.

The principle of downsizing through asset sales is based on the successful experience of Bank of America in the mid-1980s. It worked for Bank of America because, unlike banks today, Bank of America was not chasing a moving credit quality target.

When Bank of America's restructuring took place, credit quality in California was relatively stable or improving and the economic environment supported its recovery efforts. This is not the case today in most of the United States.

Increasing the Income Streams

Therefore, the solution is in bank expansion through the acquisition of well-performing assets. Under such a scenario, credit losses and restructuring charges would be offset by growing, rather than declining, income streams - and the concentration of bad debts in the balance sheet will diminish.

As such a process unfolds, strong supervision would be required to force the institution to restructure its cost base and improve cost/income ratios, because unless costs can be reduced and efficiency improved, the entire rationale for such a strategy would be rendered invalid.

As institutional investors recognize the potential for additional earnings and incrementally higher return-on-equity, they might be willing to buy into higher income levels through equity or preferred stock.

Eventually, capital levels could be restored and the quality perception of the bank's balance sheet would improve, allowing it to grow its market-related activities and improve funding costs.

Of course, it might be said that such a regimen would reward inept management, but that should not be the issue.

The aim must be to avert systemic disruptions, preserve the stability of America's big banks, and minimize bailout costs to the taxpayer.

The crisis that started in the early 1980s has been a fiasco for bankers, regulators, investors, and taxpayers alike. It is time regulators acknowledge that market forces alone might not be sufficient to turn the situation around for some large banks.

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