Springtime for Banks

James Kwak | Feb 21, 2009
Less than a week after pulling off the media coup of publishing his universal credit insurance proposal in both the FT and the WSJ on the same day, Ricardo Caballero has a new proposal for solving the banking crisis, this one in tomorrow’s Washington Post.He should go back to the last one.Here’s the new proposal: “The government pledges to buy up to twice the number of bank shares currently available, at twice some recent average price, in five years.” According to Caballero, this will have the following effects:

Because bank stocks immediately become more valuable, it has a wealth effect that pushes up the value of all assets.
Banks will be able to raise private capital, because they can issue additional shares equal to all of their outstanding shares, and these shares will have a price floor.
Because this will have a stimulative effect and will solve the bank capital problem, the economy and the banking sector will go back to normal, and five years from now the government won’t actually have to buy any shares, because they will be trading above the government-guaranteed price floor.
Let’s start with the most important issue: fixing the banking sector. Caballero’s credit insurance plan would solve this goal, because it involves cheap government insurance for all bank assets. This proposal, by contrast, is a private sector recapitalization plan. Essentially, each bank would be able to raise new capital (by selling shares) equal in value to twice its current market capitalization, because those shares are guaranteed. For Citigroup, that would be about $20 billion. Does anyone think that would be enough to lift the clouds hanging over Citi? JPMorgan, by contrast, could raise about $150 billion. But there’s nothing saying that they have to, and bank managers who think that twice their current share price is still undervalued will have no new incentive to raise capital.

This is especially true because of the perverse incentives this plan creates, which make it especially hard to understand. This plan creates a government guarantee on the stock price. In other words, it says, “No matter how stupid you are, what ridiculous risks you take, and how bad your bank is, we will buy your stock at an artificially inflated level.” Is this really the way to create a healthy banking system? I understand why people are afraid of government control over banks, but this seems at least as bad to me, since it creates an obvious incentive to take excessive risks. In addition, this takes away the usual incentive for raising capital: the need to maintain capital adequacy levels. Now that the government has guaranteed that shareholders will not lose their capital, no matter what, why raise more and split the upside with new investors?

What about the stimulative effect on the economy? Basically bank stocks would double in value overnight. Now, the S&P 500 Financial Sector Index is down about 80% from the summer of 2007; banking stocks are probably down a little more, say 85%, and insurance stocks down a little less. So the day after this plan is announced, your bank stocks - by now a small part of most portfolios - are down only 70% instead of 85%. While this might have some wealth effect, I think it would be relatively small; among other reasons, stock holdings and retirement accounts have a relatively small impact on consumption, compared to wages, dividend and interest income, or even home values (because they can be used for home equity lines). And I don’t see how it could turn around the economy.

Besides, if the idea is to stimulate the economy by making people feel wealthier, the simplest and fairest way to do this is through a tax cut. But the problem with tax cuts right now is that most of the tax cuts will simply be saved. This should be even more true of the Caballero plan, which just makes your banking stocks double in value. And if we are looking for creative ways to make people feel wealthier, what about a government guarantee to buy your house, in five years, for whatever you paid for it? (That was a rhetorical question.)

But, Caballero says, the great thing about his plan is that it is free. Because the plan will turn around the economy and return the banks to normal, the government will never actually have to buy the shares. This is wishful thinking in its most pure form. Yes, it is possible that if we fix the banking system, the economy will turn around, and most of these troubled assets will return to something like their current book values. But in that case, every proposal anyone has offered will turn out to be free. Caballero’s credit insurance plan will cost nothing, because the government will never have to cover any losses. Paulson’s plan to buy toxic assets will cost nothing, because those assets can then be sold for more than the government paid. The nationalize-reprivatize plan will cost nothing, again because the the government can sell the bad assets at a profit. Buiter’s and Romer’s “good bank” plan will cost nothing, because the good banks will be worth more than the capital it takes to set them up. A government recapitalization plan - say, for example, the government buys, at twice the current price, a number of shares equal to the current shares outstanding, will cost nothing, because the government’s new shares will be worth more than it paid for them. (This is similar to Caballero’s plan, except we know that the banks will actually raise capital, and the taxpayer gets the upside as well as the downside.)

But as Martin Wolf put it in a post I’ve recommended before and recommend again, “the heart of the matter . . . is whether, in the presence of such uncertainty, it can be right to base policy on hoping for the best.” That question answers itself.

Covered by a few extra dirhams

By Safura Rahimi on Saturday, February 14, 2009

With the financial crisis touching an increasing number of lives in the UAE, credit cardholders have been left wondering how to tackle their bulging balances.

It seems credit shield policies – temporary protection plans available on most credit cards – promise to offer a respite. The scheme, which can be activated when applying for a credit card, claims to provide cardholders with the security of knowing they are covered against outstanding credit card balances in case of an inability to pay.

In other words, the bank or insurer will shell out the money to pay the monthly credit card installments in case you get sacked for reasons such as business closure or company layoffs, but not poor performance.

Some will even cover monthly card payments for up to 12 months, or until the customer finds a new job.

But despite the different variations of the scheme offered by UAE banks, reaping the benefits of credit shield is not always simple.

Variations Galore

Some banks don't offer credit cover for at least 30 days after the cardholder reports involuntary job loss. Others only cover outstanding payments if the customer was laid off at least three months after the credit shield activation. And you most likely won't see a dirham if you've only activated the credit shield on your card after being fired from your job.

So the message from banks is, plan ahead. "Activating credit shield post a loss of job is like buying an insurance policy today to cover for yesterday's loss, which is not allowed in any part of the world, as insurance is taken to indemnify one against an unforeseen event," says Zeeshan Saleem, Head of Credit Cards at Barclays.

Saleem says it is simple to claim insurance if you're a customer already enrolled for credit shield and have lost a job. "Insured individual needs to submit a few documents like a notice of termination from the employer, copy of passport with visa page, and copy of the labour contract from the employer to verify the period of employment contract," he says. "The claim can be made only if the credit shield insurance is active or applied for by the customer."

The turnaround time to claim the insurance is about two to three weeks depending on the type of claim. Once approved, the insurance company pays the card's outstanding balance.

The Devil in the Details

Although the programme does offer peace of mind particularly in today's uncertain job market, it's important to read the fine print of your credit shield coverage.

To make a claim, Citibank says cardholders must have been employed for 12 continuous months with the same employer during the 24-month period before the claim date.

The bank also rejects claims from job losses due to misconduct, and from cardholders over the age of 65 from date of unemployment.

"We view Credit Shield as a valuable product that can further protect customers, especially in times like these.

Our approach has been to offer the product to customers in a very transparent way and let them decide on its value to them at certain price points," says William Keliehor, Citi Credit Cards Head for Middle East, Africa and Pakistan.

The credit shield payments stop when the cardholder resumes work or when the maximum benefit payment term of three monthly installments has been reached for any one claim, or six monthly installments in total for several Involuntary Loss of Employment (ILOE) claims during the period of coverage.

While Citibank cardholders insured with credit shield would have their monthly installments covered for each month they remained unemployed, the bank said a claim is turned down if the customer is sacked within the first month after activation of the policy.

"The waiting period is calculated from the first day of ILOE commencement. No benefit is paid for the first 30 days," the bank says. That means if a customer presents a redundancy letter in February, his credit shield, if approved, will cover the monthly due amounts starting from the end of March.

At Mashreq, customers can apply for a claim against credit shield cover immediately but the bank said benefits for involuntary loss of employment are only paid if the customer was laid off at least three months after the credit shield activation.

"However, if the customer has had the policy cover for more than 90 days and has just become unemployed, he can immediately apply for a claim. Hence, it is advisable to sign up for credit shield even if one's job is secure today to cover any eventuality in the future," says Vimal Kumar, Cards Business Head at Mashreq.

Mashreq's credit shield fees are charged on the card's billing date and costs 0.65 per cent of the outstanding balance. "In the current economic environment, it is extremely prudent to cover as much of one's liability arising out of unforeseen circumstances."

The feature gives customers peace of mind to use the credit card freely, without worrying about any unforeseen events in the future, he adds.

In the case of insured cardholders who have recently been sacked from their jobs, Kumar says 10 per cent of the outstanding balance on the card is subject to a maximum coverage of Dh2,500 for Classic and Gold cards and Dh4,000 in the case of Platinum cardholders.

Customers must notify the bank in writing no later than 30 days from the unemployment date to claim the coverage, as well as complete the standard claim form and submit the required documents. Kumar said credit shield will activate within 10-30 days and the amount will be credited to the cardholder's credit card account.

No Job Loss Cover

However, not all banks that offer credit shield cover job layoffs. Emirates NBD offers an 'ultra' credit shield scheme on its credit cards but it does not protect customers against involuntary layoffs. The bank declined to respond to queries from Emirates Business.

HSBC's optional Credit Cover – charged at 0.2 per cent of the cardholder's monthly outstanding – is insurance that protects outstanding balances against death or permanent total disability. However, the bank said it does not cover loss of employment at this point in time.