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Why bank nationalization is a last resort
Banks don't function well at low levels of capitalization, so there is a strong and understandable tendency to want to "do something." Everyone says nationalization is not intended as a long-term solution but the question is whether government ownership will succeed in building up a greater capital cushion for the banks. If the environment for banking is not favorable, it won't and banks will have to stay nationalized.
How many years of profits are needed to create the cushion of capital which is required for re-privatization? And how many years of government ownership will be needed to generate that many years of profits? Will banks owned by the government be allowed to pursue profits, rather than lending to troubled industries in the districts of influential Congressmen? Or will government just stick money in the bank and hope they have thereby created a sound enterprise?
You might take the line: "Government is bad at running bail-outs, but it sure is good at running banks," but of course that's a tough sell.
Those are the questions you should be asking. Admittedly the alternatives to nationalization don't currently look so great either.
Kevin Drum adds some good points. Felix Salmon offers ongoing coverage.
Posted by Tyler Cowen on January 20, 2009 at 08:06 AM in Economics | Permalink
Comments
Why not nationalize in order to facilitate an orderly winding up of the banks operations? If they have insufficient capital now, the can effectively go through a slow-motion bankruptcy. There is no need to re-privatize the banks as such, they can be wound up and what useful assets they do have sold. There are plenty of smaller banks that are apparently in a solid financial, and who would value adding accounts/clients/branches/etc.
After all, the goal is the preservation of a functional banking system, right? We don't want Citibank to collapse suddenly because it might cause severe systematic problems for the entire system.... but we have no special concern for the survival of Citibank (or any other particular bank) beyond that.
Posted by: MichaelB at Jan 20, 2009 8:21:00 AM
The basic problem, throughout the run-up to the crisis and even now, has been the reluctance of financial institutions to acknowledge their losses. In this crisis they had an excuse: they had concealed much, maybe most, of their losses from everyone - themselves included - in slices of sold-on risk. But even outsiders could see the general size and shape of probable losses more than a year ago. The lesson for future regulators ( a lesson repeated after most bank crises) is that regulators need to be prepared to force banks to acknowlege losses early.
If banks had acknowledged the real likely extent of probable losses in the third quarter of 2007, shareholders would have felt they were being wiped out. However, shareholders would have been better off than they are now; and the market would have supplied the missing capital (as it did supply it for Goldman Sachs and Barclays).
That is about how to avoid future nationalisations. In the mess we are now in; the USA is lucky in having a good way of dealing with bust banks. It is called the FDIC. Is there any better optiion than using it?
Posted by: D iversity at Jan 20, 2009 8:28:01 AM
How many years of profits are needed to create the cushion of capital which is required for re-privatization?
But the banks we are talking about can't make a profit, so what does it matter? They were only able to grow as large as they did because they assumed people would never walk away from homes, home prices would never go down, little due diligence was needed, and that even if there were problems their insurance would take care of it. None of which has turned out to be true.
Posted by: Jason at Jan 20, 2009 8:28:02 AM
Oh Tyler, you overstate the case. We did successfully - albeit not optimally, I admit - bail out the S&Ls.
This is something grownups can do; as you noted the other day, Sweden managed it. Do you believe America is just dumber than Sweden? If they can do it, why can't we, Tyler?
Posted by: StreetWalker at Jan 20, 2009 8:40:19 AM
The solution isn't so hard and nationalization need not be more than a transitional phase. The heavily regulated banking industry pre-1970 worked pretty well, with some tweaks. Just limit banks to taking in deposits and lending it out. I don't see why we can't just go back to that. To parse Buffett - banking needs to be simple enough that an idiot can run it because someday one will. I am generally pro-free markets but they are not a solution to every ill. Even penicillin has a limit as to what it can cure.
The free market for banking products in the end didn't really provide much in the way of innovation. If you look at the banking industry over the complete time line since deregulation began it is nothing more than a history of innovations that were supposed to allow people and companies to take on more debt without necessarily incurring more risk. If the best the banking industry can come up with over three decades is junk bonds, CDOs, swaps and subprime mortgages then the trade off certainly isn't worth it. It may be time for the industry and investors to accept the fact that it is not possible to get more return for the same amount of risk.
Posted by: asiequana at Jan 20, 2009 8:56:08 AM
I have many questions about the current state of banking starting with this:
Why would it not be better to kill all the very weak banks and pump the money into the strongest banks? Would the strongest banks (with the fed monetary expansion) then be able to make up for the lost money creation of the killed banks?
Posted by: Floccina at Jan 20, 2009 9:09:34 AM
The unspoken assumption in this conversation is that nationalization is better than bank failures and that regulatory schemes are the best way to protect investors and depositors. In both cases (nationalization and regulation), the premise should be challenged. Because with each, the government establishes a set of incentives that too often deter management from operating in the best interest of stakeholders or at best occludes what should be a much clearer picture. Some banks were forced to take money they didn't want in order to restore a false sense of confidence to the entire system. Well, the entire system isn't sound. So, why not let those that know how take whatever viable assets remain and manage them properly rather than the slow bleed of continued mismanagement, disclosure and restructuring?
With regard to comparisons to Sweden, even if positive outcome correlations can be established between it and other Scandinavian responses in the 1990s, the GDP of New Jersey is larger. I guess the reasoning here goes, because I rode my wooden rocking horse as a child, I know I can land an Airbus safely over water after its engines enjoy some foie gras on takeoff.
Posted by: Craig at Jan 20, 2009 10:13:28 AM
I would like to see us force the sick banks to raise money or go into government-sponsored insolvency. That way, we could quickly wipe out the shareholders (and perhaps some management) at the truly insolvent banks, recapitalize them without excessive moral hazard (we'll just have to accept that we've introduced some debt-market moral hazard), and send them on their way. The government should clear the decks and not operate the banks for longer than is necessary to accomplish that.
The alternative seems to be zombie banks pretending to be solvent for X years until they finally work through things on their own, which may be a slightly more efficient use of capital but takes too long and introduces too much overall economic uncertainty for my preference.
Posted by: Greg at Jan 20, 2009 11:07:07 AM
With regard to comparisons to Sweden, even if positive outcome correlations can be established between it and other Scandinavian responses in the 1990s, the GDP of New Jersey is larger.
Craig, two things:
(1) Could you elaborate on the "even if"? The Swedish banking rescue was successful. This is not some fanciful hypothetical.
(2) What does the size of a country's GDP have to do with the feasibility of a bank nationalization? Please show your work pinpointing the precise elements of the Swedish approach that would not scale to a much larger and richer country.
Posted by: mds at Jan 20, 2009 12:06:02 PM
What is the difference between "nationalization" and FDIC "purchase and assumption?"
Isn't it normal for the FDIC to take bad assets off the books?
What is wrong with Zingales' proposal that those holding bank
debt can be made into the new stockholders?
Perhaps I am making some error, but it looks to me that if FDIC makes 10% of the debt holders into equity holders, the other 90% of debt holders are "assumed" and the 10% get equity equal in value to their debt. The old stockholders are wiped out and FDIC (ie, taxpayers) covers the losses. The
reorganized bank has 10% capital and all good assets. Ready
to roll.
If the "problem" is that the chance of being given risky equity in place of debt will make people less likely to hold bank debt, then a larger fraction of debt can be assumed. Paradoxically, the smaller remainder getting equity will receive equity worth more than the debt. The cost, of course, is a bigger bill to the tazpayer.
On the other hand, if the "problem" is that those lending to these banks should not have done so, various debt holders, uninsured depositors and the like, should take a loss, then fewer of them can be assumed. More debt can be shifted to equity. The bailout cost will be less, and in the limit, there is no cost to the taxpayer.
Posted by: Bill woolsey at Jan 20, 2009 12:38:03 PM
If you don't use government takeovers to close down the bad banks, how do you prevent these banks with repaired balance sheets from weakening the others through unfair competition?
Posted by: Yancey Ward at Jan 20, 2009 3:26:36 PM
The last I heard, Banks need people to save to accumulate capital. Short cutting the process to have consumers spend without capital accumulation is simply not sustainable as consumer confidence will remain unaffected. We need to do something to stimulate capital accumulation. A 5 year tax holiday on interest income might help stimulate capital accumulation. This would boost savings returns immediately by over 30%. Instead of investing in zero coupon treasuries, there may be an incentive to make deposits into institutions that are in the business of lending money. Congress is good at spending money, not saving or investing money or running businesses. Nationalization is not the answer, it would only be a reprieve.
Posted by: Scott at Jan 20, 2009 5:48:26 PM
I am new at this so excuse the beginner question. What happens to the stockholders shares in a company when it becomes nationalized?
Posted by: ggalNV at Jan 20, 2009 5:57:58 PM
Professor Cowen --
The Treasury can nationalize and re-capitalize an insolvent bank more-or-less overnight.
The only reasons to hold a nationalized bank in public ownership for a while before IPOing it would be:
(1) to give the new management team time to demonstrate competence
(2) to wait for capital-market valuations to improve (if you believe they're depressed today), so the government earns more from the sale.
Why do you believe that the banks must spend years accumulating a large pool of retained earnings before the IPO?
Posted by: pireader at Jan 20, 2009 6:32:10 PM
Professor Cowen --
You seem to think that a nationalized bank must spend years generating a pool of retained earnings as capital before it can be privatized. But the Treasury can nationalize and re-capitalize an insolvent bank almost overnight. It simply takes the toxic assets off the bank's books; and replaces them with enough Treasury securities to more-than-cover the bank's obligations. Voila, a solvent, well-capitalized bank.
Of course, the Treasury might then elect to hold the bank's equity for a while, in hopes of getting a better price when they sell it off.
Posted by: pireader at Jan 20, 2009 6:53:36 PM
Apologies for the double post
Posted by: pireader at Jan 20, 2009 7:45:32 PM
What happens to the stockholders shares in a company when it becomes nationalized?
The FDIC offers the shareholders $0.00 per share for all the shares, take it or take it. Some will be unhappy, believing that if they could have just held on a bit more, ... Most will recognize the deal as more than fair. Banking regulations more than provide the legal backing for the taking.
Once the Feds own the bank, they can do with it whatever they like. They can take some of the assets, sell off branches, whatever. Step 1, they take for themselves the sludge (yes, smart because they want to...) Step 2, offer it up for sale to other investors who are qualified to run banks, typically another bank. Often, they will offer it as little more than a zero-value deal: the bank will owe depositors just almost as much as the bank will make on the loans it still has on its books.
If it were to be Citi they took over, I'd assume the "Citi" name itself would be valuable, and part of the sale. All the former shareholders could say they owned it back when, without realizing that the Board of Directors that THEY elected ran their ownership into the ground.
I'm surprised that so few "Corporate Governance" discussions have popped up; instead greedy, overpaid managers and indifferent regulators are blamed. Yes, regulators were supposed to be the guardrails here, but the guys telling the chauffeur where to drive were the Boards, often totally taken as patsies by management who wanted the thrill ride of a Quick Killing.
But that might be uncomfortably close to shareholders having to blame themselves as they casually returned their proxies in favor of whatever Management proposed.
Posted by: Walt French at Jan 20, 2009 8:00:34 PM
I've been reading "the coming battle" and I don't know much about economics but it sounds like a
"private" bank system is horrible and detrimental to a nation especially if the stockholders are from a nation we are at war with.....ex: the war of 1812 when "the united states bank" wouldn't loan money to Jefferson to fund the war because it's stock holders were from Britain
so Jefferson was forced to have congress issue the money and that was key to us winning the war.
Posted by: louis s at Jan 20, 2009 9:41:31 PM
The heavily regulated banking industry pre-1970 worked pretty well, with some tweaks. Just limit banks to taking in deposits and lending it out. I don't see why we can't just go back to that.
It did? It was inefficient-to try to go back to it is to forget life has changed in 40 years. you can't just click your heels three times and go back, toto, no matter how economically atavistic you are-besides-much of what we have is a reaction to blither like the CRA and that won't go away.
Posted by: Superheater at Jan 20, 2009 10:35:04 PM
What happens to the stockholders shares in a company when it becomes nationalized?
It depends on how badly the government wants to seize the property or 'not overpay for worthless assets' (the quoted phrase was actually crafted for TARP)
Read up on the nationalization of railroads in WWI. it was widely assumed that the railroads were inefficient and disorderly and the government could make everything right. The truth is that they were being systematically starved by the ridiculous rate regulation of the ICC at the behest of the grange. The government created the USRA (United States Railroad Administration). A good account the ICC's "efforts" is "Enterprise Denied" by Albro Martin. (its out of print, unfortunately)
The bureaucrats in DC offices thought they were smarter about locomotive design than the master mechanics of railroads and attempted to standardize designs. What they didn't consider is that since the 1860's railroads designed their locomotives and they were built to specifications for a reason. Steam locomotives were such special purpose machines they were often designed not for a specific railroad, but a SPECIFIC GRADE of a specific division. They produce near peak power in a very narrow speed range. Successful design depended on intimate familiarity with the operating practices of the division. After the end of nationalization, the railroads returned to specifying their designs until the diesel-electric era.
Interestingly, re-regulating railroads is a big policy objective of the Democrats, despite the fact that the 108 year reign of error of the ICC was finally ended in 1995 with Bill Clinton's signature. The chemical industry is behind the push to re-regulate this time, not the grange.
Posted by: Superheater at Jan 20, 2009 11:15:44 PM
Totally off topic, but has anyone looked at reparations as fiscal stimulus?
Posted by: aaron at Jan 20, 2009 11:55:49 PM
aaron,
I think you meant "fiscal stimulus as reparations."
My position on reparations is this: Name a price where they will STFU.
I won't force anyone else to pay it, but I'd be willing to pledge some amount if they will STFU.
Posted by: Andrew at Jan 21, 2009 5:35:01 AM
So you call Plank N° 5 of The Communist Manifesto written by Karl Marx in 1848 "Centralization of credit in the hands of the state, by means of a national bank with State capital and an exclusive monopoly", a last resort?
I would call it beach resort for bankers and central bankers who screwed it up!
Perhaps we can discuss centralization and exclusive monopoly levels...but it appears that Marx was eventually right...
Posted by: Massimo GIANNINI - M.G. at Jan 21, 2009 8:09:39 AM
Maybe if we brought back the "Usary Laws" where interests rates were capped we wouldn't be in the mess we are today. States used to regulate the max interest rate anyone could charge. The "national" lenders were limited to twice that amount (go figure). The number one concern today according to a poll I just read is credit card debt. With the paultry 1-2% interest we get at the bank, wouldn't it be nice to know that they could only lend money at 5 or 6%?
Posted by: Joe at Jan 21, 2009 6:54:44 PM
Are there any details with regard to what toxic assets are actually on these balance sheets? Are they mostly CDO's, synthetic CDO's, CDS's, liquidity puts, ABS's? With regard to CDO's, is the CDO itself considered a toxic asset and a candidate to be put in some "bad bank", or just a particular tranche of the CDO?
Posted by: JohnKav at Jan 22, 2009 1:57:02 AM
