Why the banking sector is hard to fix

Here is my latest column, excerpt:

The second set of solutions involves taking control of insolvent banks, either by nationalizing them or declaring them bankrupt. In the past, the Federal Deposit Insurance Corporation has used the model of rapidly shuttering failed banks, and it has usually worked.

Many
analysts cite Swedish bank nationalization, from the early 1990s, as a
model, because the Swedes later reprivatized these banks and resumed
economic growth.

But Sweden nationalized only two banks. And the
Swedish banks were much smaller and easier to run than the largest
United States bank holding companies, which combine a wide range of
complex international businesses, commercial paper operations, derivatives trading and counterparty commitments.

It
is quite possible that the reputation of a nationalized bank would be
so impaired that it would incur even greater losses as its web of
commercial dealings collapsed. These far-reaching commitments are a
reason that the F.D.I.C. model of rapid shutdowns cannot be applied so
easily here.

The most obvious problem with nationalization is the
risk of contagion. If the government wipes out equity holders at some
banks, why would investors want to put money into healthier but still
marginal institutions? A small number of planned nationalizations could
thus lead to a much larger number of undesired nationalizations.

On top of that, the government doesn’t have the expertise to run large bank holding companies like Citigroup.
There is the danger that caretaker managers, with bureaucratic
incentives, will never return the banks to profitability. And
restrictions on executive pay, already enacted into law, will make it hard to hire the necessary talent.

In
the meantime, there would be increasing pressure to politicize lending
decisions – for instance, by requiring loans to the ailing automobile
industry. Talk of taxpayers capturing an “upside” is probably
unrealistic.

The plight of the American International Group,
the giant insurer, provides a cautionary tale. The government has
already effectively nationalized A.I.G., but after a government
commitment of $150 billion, the company’s losses continue to mount, and
there is no simple way to either manage it or split it up. If the
government cannot run that bailout very well, how can it run major
banks and nurse them back to profitability?

Nationalization
also puts bank debts on the balance sheet of the government without
restoring bank solvency. Once the government takes over, it is hard to
reorganize the debts of these companies without damaging the
government’s own creditworthiness and spreading the insolvency to bank
creditors. Yet if the banks are insolvent, paying off the creditors may
cost trillions.

It is becoming increasingly clear that the question is not whether to nationalize but rather whether we can afford to make whole long-term bank creditors.  Megan McArdle has some thoughts.  How much do we gain by transferring the losses away from banks and toward Europeans, insurance companies, and pension funds?  If the worst-case scenarios really are true — and they may be — that is the next question on tap.  It is of course a very ugly question.

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