Asset Management Company to the rescue….maybe?

The Asset Management Company Bill has been passed by the Senate with the aim of solving the current banking crisis. So what will the AMC do? It will effectively by up the bad loans from banks thereby cleaning up the banks balance sheets therefore fixing the banks and allowing them to resume lending. At least in theory. Will it work?

One of the suspected reasons why lending has allegedly dried up is due to these toxic assets on the banks’ balance sheets and it does make sense that removing this burden should put banks in a better position which should allow them to boost  lending.

There is another long-term implication of having a company which will essentially buy up bad debts. It is safe to assume that the banks go to this perilous position by making very risky decisions which turned out bad (margin loans and over exposure to the oil sector). The main disincentive for banks against excessive risk taking or making bad decisions is the possibility of these risks turning bad and the losses that go with it. However if you throw in a way for banks to sell these potential losses then they have nothing to lose from making bad decisions. It’s a win – win situation. If the decision turns out to be good they gain the extra benefits and if it turns out bad they sell it to the AMC. Either way the incentive is take on more risk. What this means is that we should expect the banks to make even worse decisions in the future because the penalty for making these worse decisions is even less than it is today.

This would be fine if the AMC was some foreign entity or a black hole where all the losses could be dumped. But it is not. The AMC is simply the government. That means the banks are essentially transferring their losses to the government.

The AMC, while maybe fixing the problem today, creates a structural problem. There is no penalty for making bad decisions. It is for this reason I suspect many other central banks opted for simple cash injections as opposed to actually buying up these assets or setting up institutions to continually buy up these bad assets.

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