In this guest post Ricardo J. Caballero, the Ford International Professor of Economics at MIT, offers an alternative scenario for banks that fail Treasury’s stress tests.

A central aspect of the Obama administration’s financial stabilization plan is to stress test the major banks and to recapitalize the ones that do not fare well. Analysts’ responses to this plan have been lukewarm at best. Some claim that the aggregate scenarios used for the tests are too rosy. Other analysts think this to be a creeping nationalization policy. Either way, the news for the stock market is awful and, as a result, we have observed massive wealth destruction since the plan’s announcement. Rather than help to contain fear, uncertainty has now risen to a new level, further complicating the financial health of the very institutions that were supposed to be stabilized under the plan.

I argue here that these perception problems can be solved by more directly addressing the core fear issue. This requires a clear policy principle: Whatever we do, financial institutions should not be left holding the downward aggregate risk.

Under this basic principle, the stress test policy would be slightly modified as follows: Each bank would be subject to stress tests as planned (I would advise giving some weight to even more extreme aggregate scenarios than those that have been proposed). In this case, however, the result of the stress test should not be used to determine how much more capital the bank may need in an extreme scenario. Instead, it would be used to determine how much insurance the bank needs to buy from the government to protect itself against these scenarios.

The immediate impact of such an apparently small modification would be to narrow the risks perceived by banks and their stakeholders. This would encourage banks to lend because the insurance policy would replace the need for massive self-insurance induced hoarding. It would also encourage private recapitalization. By insulating the financial system as much as possible from the downward risk of the current macroeconomic environment, the policy would break this deadly downward spiral where a worsening macroeconomic environment weakens financial institutions, which in turn further weaken the macroeconomic environment, and so on. With this principle firmly in place, survival risk would be extensively reduced allowing investors to make their decisions based on the long-term prospects of the particular institutions. Without this, investors and banks will remain mired in uncertainty and fear, relegating the natural forces of recovery (and there are many of them) to the sidelines.

A key dimension of the policy principle is to think not only about the particular institution in trouble but about the systemic implications of the policy. For example, some could argue that one way of breaking the perverse feedback between the health of a financial institution and the macroeconomic environment is to nationalize the bank (which means almost by definition, that the full insurance for the losses rests upon the taxpayer). However, while this would indeed work for an individual bank, it would exacerbate, rather than reduce, the aggregate risk faced by non-nationalized institutions because now, a negative macroeconomic shock would make it more likely that they too would be nationalized. It is important not to fall into a fallacy composition where what is good for one institution in isolation may be just the opposite for the system as a whole. In other words, the principle goal should be the removal of the aggregate downward risk not only from individual financial institutions but from the leveraged institutions as a whole.

Who should pay for this insurance? Those most directly protected by the policy. Certainly the shareholders are first in line, but there is no reason to stop here. All preferred shares and debt that are being discounted by uncertainty should also contribute, perhaps by retaining some of the interest payments to service the insurance policy. The government should charge fairly for this insurance, using the same probabilities it assigns to the different scenarios used in the stress tests, and it should mandate that the banks acquire this insurance once they have converged on the particulars of the stress test.

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Talk about nationalizing some of the nation’s biggest banks is all the rage these days. Shares of major financial institutions tumbled further Friday as the chatter continued. The White House’s statement of support for private ownership — “a privately held banking system regulated by the government is what this country should have,” Obama’s spokesman put it — helped a bit, but not enough.

The government taking over a bank presents plenty of problems. Among the challenges, Federal Reserve Chairman Ben Bernanke said this week, is “that you tend to lose the franchise value, that the counterparties and others don’t want to deal with you because they don’t know your future.”

But if it’s necessary, how should it be done? Sweden is often seen as a model of bank nationalization that worked following its boom in real estate and consumer debt. Of course, the concept is always easier when you only have a few banks to worry about, rather than the 8,400 in the U.S. to sort through. (The count is 25 if you just consider the giant banks to probe, as U.S. regulators are preparing to do now.)

The Federal Reserve Bank of Cleveland has assessed the Swedish experience, in a 2007 paper and a commentary this month by two of the bank’s economists.

“Most of the criticisms that can be leveled at the Swedish crisis resolution are easy to make in hindsight,” write researchers O. Emre Ergungor and Kent Cherny. “Facing the prospect of imminent systemic collapse, incentive-skewing actions like blanket guarantees and liquidity provision can seem like surefire ways to restore confidence and avoid meltdown.”

(Blanket guarantees? Extensive liquidity provision? “Oops,” the American people might say after the U.S. government’s moves on that front last fall.)

The Cleveland Fed staffers, in a commentary this month, walk through the Swedish experience of the early 1990s and cite four key principles necessary in resolving troubled financial institutions:

1. Transparency. Fully disclosing banks’ losses “clears the uncertainty surrounding the institutions and makes it possible for the viable institutions to raise new funds.”

For the U.S., of course, the extent of banks’ losses is the big mystery. The government at least appears headed down that road, for its own analysis, by starting stress-testing of major banks to assess how they would fare in a weakening economy.

2. Political and financial independence. “If a government agency holds the purse strings, it can dictate policy and can also impede the process if emergency funding is needed,” they write.

Here, escaping political involvement entirely is a lost cause at this point. The Federal Reserve — an independent agency — oversees the major banks and is intimately involved, but the Obama administration is running the show

3. Maintenance of market discipline Investors must pay the price for missing signs of trouble, they say. “As past historical examples demonstrate, the stability of financial markets after crises largely depends on the incentive framework that is left in place.”

This is where the “blanket guarantees of uninsured depositors” comes into play to skew market discipline. It’s a form of the moral hazard argument — one that’s very much being discussed amid the U.S. response, though moral hazard of course has taken a back seat at times.

4. Restoration of credit flows Getting credit moving through the economy again, they acknowledge, is “a difficult task, given that the economic fallout from a crisis (such as rising unemployment) actually erodes credit quality further.”

With all the talk in Washington about getting banks to lend, that problem surely will stay front and center. But it’s likely to take years to work out.

Read the Cleveland Fed’s full commentary here. — Sudeep Reddy

By Ricardo J. Caballero

The basic principles underlying Secretary Geithner’s sketch of a financial stabilization plan are the right ones: To stabilize the financial system without nationalization; to jump start frozen financial markets by reducing the perceived tail risk from private investments; and to reduce the risk, especially systemic risk, being held by banks and other leveraged financial institutions. Politics require that a “good deal for the taxpayers” is added to these principles, but the truth is that the best deal for the taxpayers, once one considers the endogenous response of the economy, is anything that works to stabilize the financial system, almost regardless of how many short-term transfers the financial institutions may receive.

It is true that the recent announcements are lacking specific details, and perhaps revealed that the Treasury’s economic team overestimated people’s ability to distill the good news in an abstract message of principles when in panic mode. But there is good news in them, as they reflect a much deeper understanding of the fundamental uncertainty problem ravaging insurance and credit markets than commentators and politicians have. It is time for all of us to focus on facilitating their difficult task and to try to fill some of the gaps.

My preferred (part of a) solution is to provide universal insurance for the assets that are currently clogging the balance sheets of banks and other financial institutions. There are two issues often raised in the context of an insurance arrangement of this kind: How to determine the fair price of insurance in an environment where there are no sensible market prices? And, how to prevent financial institutions from selectively insuring their worst assets without disclosing them as such?

Fortunately, once the policy decision is made that these key systemic institutions will survive no matter what, these problems have a relatively easy solution. The great advantage of dealing with long-lived institutions holding a large number of assets is that there is no need to resolve the thorny issue of the insurance price and the quality of the assets right now. We can wait for the passage of time and a return to normality to determine whether their assets were worse than the representative asset in the corresponding asset class. Concretely, I would suggest that:

A key aspect of this insurance arrangement is that it is aimed mainly at removing the aggregate risk from the balance sheet of financial institutions, although it does so asset-class by asset-class, so it considers the different portfolio composition of different financial institutions. Moreover, since these institutions have a large number of assets within each asset-class, one can rely on the law of large numbers to net out idiosyncratic accidents.

One potential criticism to this mechanism is that it does not resolve an adverse selection problem faced by potential equity investors: Since banks that choose to lie now will be eventually punished retroactively, then how can investors be reassured that the bank they are choosing to recapitalize is not lying? My reaction to this valid concern is twofold: First, my sense is that at this point in time the main risks are aggregate rather than of this kind. Thus, if enough aggregate uncertainty is removed from their balance sheets, the banks will not need, for the time being, much new capital. Second, the aggregate insurance arrangement need not work in isolation, but it can be implemented very quickly and be used as a stopgap. It can then be followed by the much slower process of getting onto the books of the banks to build more public trust. Moreover, by proceeding in this sequence, the stress tests do not put the burden of further negative aggregate shocks on the banks balance sheets, and hence further reduce the need for nationalizations and other remedies that have brought great distress to equity markets and taxpayers wealth in recent days.

I view this insurance proposal as complementary to and in the spirit of Secretary Geithner’s two-step proposal. On one hand, the former appears to have two advantages over the latter: First, it is simpler and faster to implement since it is done in one step, instead of having to go through a bad bank and then enticing the private sector to buy these assets. My sense is that the non-banks private sector will require more insurance than the banks themselves, since they will be exposed to an additional layer of adverse selection as they will be buying assets from the banks. Second, it immediately raises the tangible capital of the distressed financial institutions, without further need for capital injections. On the other hand, the two-step approach also has two advantages over the single-step insurance proposal: It addresses, more directly, the illiquidity problem in underlying asset markets, and it provides a channel to inject resources into the harder-to-get-to shadow financial system.

Clearly, there is no single dominant strategy to deal with the current crisis, but whatever we do, it is central that we focus on the whole system and on the role played by uncertainty. Standard recipes used to deal with isolated problems in a bank or two can easily backfire. Nationalizations and related measures are fine solutions in partial equilibrium, but they are recipes for disaster in an environment where systemic risk and uncertainty are at the core of the problem.

Mr. Caballero is the Ford International Professor of Economics at MIT