You may recall in my last blog posting ‘The Wolf is at the Door – if he huffs and he puffs can he blow the bank down?’ we started to explore the scenario of hikes in interest rate and the impact upon commercial lending books.

The blog seems to have resonated with a number of you judging by the  comments I received over the past couple of last week.

As a follow on, I wanted to share some of the comments with the wider community.

One reader told me “I reckon you hit it spot on. The elephant in the room is interest rates.”  Ok now you can see why for this week’s title I chose “Dumbo” and we all know that he could fly, even if it was with the help of a ‘magical feather’  

Anyway the reader went on to state, “The key thing is what the central banks did over the last two years. The standard remedy for loan losses hitting banks’ balance sheet in a downturn is to steepen the yield curve as fast as possible to make (big, capital markets dependent) banking more profitable, allowing banks to build the necessary capital buffers.” Though, the same logic may not hold true for savings bank, rather it may make them less profitable because there might be a floor for saving rates. But then again, who cares, if these banks are sufficiently small some kind of a consolidation process will clean that mess up at some point. Won’t it?

I am not suggesting that banks veer away from crisis management by thinking too much about the distant future. However, if one were to proceed this way, then there are two main challenges.

The first is a practical issue. For instance, if a big mess is hidden inside these small banks, it would require years of mopping up the vomit of yesteryears’ party.  No sane banker would actually buy such a small bank, would they?

So, this leaves two awful choices: building a bad bank for all those dud loans or letting them live on like zombies. In a world of fiscal constraints, the second choice looks the more likely option, albeit an unpalatable one.

The second issue is linked to the original cause of the problem. If we’re talking about some normal recession, the dud loans can’t be this bad, and the odd zombie bank won’t hurt anyone. If, however, we come out of a ‘super-dooper-cycle’, things look altogether different.

The problem in the first place is low interest rates that fuelled some sort of bubble. And now we’re back again in a mode where we need yet another dose of this medicine to keep the (now really big) zombies afloat, unless we want to turn them into even bigger zombies.

Realistically, if rates stay low for a considerable amount of time, it would mean growth prospects remain subdued, as well. If everyone saves (instead of investing or consuming) to re-build their private and/or corporate balance sheets, well there you are, growth will remain low, potentially even turning into a deflationary spiral (which makes things hardly better for the zombies). At the end of such a process, balance sheets are strong again and the zombies are hopefully unwound, but that is a huge job that takes time.

There’s your house of stone – at the cost of deflation, joblessness and hysteresis. 

There is only one alternative to this: rapid economic growth coupled to a clear process of fiscal consolidation, preferably through budget cuts, but most likely through higher taxes. Only this will help to keep rates in check and build the fiscal credibility for the inevitable: building a proper bad bank without upsetting the bond markets too much.

The reader went on to state that “the second thing that needs urgent attention is righting the wrongs of monetary policy. We have played the game of clearing up a mess by creating a new one once too often. The ideology behind it is in the sticky prices engrained in most macro models.”

The assumption is that central bankers can only control and target sticky prices, whereas market-determined prices are out of bound. So, why control them? They do what they want anyway. This prevents incorporating credit into macro models. Yet, the perennial debate is to actually control asset prices, too, since they represent future consumption. Given the research needed for this and the cycles in which must-read-books for central bankers come out of Princeton University Press (the last was 2004’s “Interest and Prices” by Michael Woodford, the predecessor was Don Patinkin’s book from the 1970s), do we have to wait another 30 years?

Some interesting views and hopefully you can see why I felt the need to share…..

I would love to hear your views.