Cash up front please June 22, 2009 at 4:35 pm

The Telegraph reports an idea of Paul Tucker’s: making the banks pay to clean up their own mess:

The banking industry could be told in advance that, if ever there was another crisis, the ultimate cost would come from banks themselves. In the midst of a crisis, that would not be possible. A government would have to pump in new equity. But when the dust had settled and the government had sold its shares, the loss (if any) could be calculated – and then collected from the industry via a levy.

This isn’t a bad idea. But there is a better one. Make them pay before the crisis.

There are various ways to do this. One is to take cash from the banks, via a beefed up version of the way the FDIC works. In order to be a financial institution, you need an annually renewable license, and the license should be expensive.

A more intriguing one, though, is to make the banks hand over each year not cash, but one year call options on their stock. The regulator would then hedge these options. The bank’s shareholders would only be diluted if the stock went up, sugaring the pill for them, while the hedging process would ensure the regulator made money whether the stock went up or down. Indeed, as the position is long gamma, a big fall would be particularly profitable to the hedging strategy.

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