Monday, February 16, 2009

U.S. Banking Crisis: Should Banks Be Nationalized?

Nationalizing banks has been required at times throughout economic history. I accept that to a point. 

Some think nationalizing banks makes sense right now.

Nationalize the Banks! We're all Swedes Now

Well, in a different context, maybe, but not this time.

Why? Here's a couple of reasons:

1) Scale - It's one thing for a government -- even one as large as the U.S -- to take over banks with just $ 10-20 billion in assets but there is more than $ 7 TRILLION in our top four banks. This New York Times article suggests the FDIC is struggling to manage just $ 15 billion of bank assets.

The government lacks the capability, resources, and incentives to fix and operate these rather large and complex institutions.

2) Disincentives - The disincentives that nationalization (and the threat itself) creates for fresh capital is very real. It would likely chill the capital formation that's needed on a big scale. In fact, it just might divert equity capital away from the U.S. banking system for years to come. Those who think that's not a big deal should feel free to nationalize away. I'm not in that camp. My view is it would be terribly damaging to the private equity capital formation process for banks. That just makes the system inherently weaker than it needs to be.

I'm certainly okay with some intervention, but any intervention should encourage private equity capital formation and enhance liquidity. There's a sensible way to go about this short of nationalizing the banks.

Keep in mind that some of the reasonably well-behaved banks prior to the crisis are now, through financial contagion, getting into trouble because other institutions behaved badly and the related systemic issues (i.e. excessive leverage, insufficient liquidity, derivatives, mark to market, among others things).

The question I have is this: 

Why is it a good idea to wipe out the common stockholders of a well-run bank that got into trouble because of the excessive risk taking by others and systemic flaws? How do you suppose those with risk capital around the world would view future investments in U.S. banks if that happens?

A better capitalized/less leveraged banking system needs as much equity capital from private sources as possible. Well, wiping out equity in a cavalier manner (and I think nationalizing banks across the board qualifies) just makes equity harder and more costly to raise in the future.

Inevitably, a poorly run bank will produce big losses for its common stockholders. That's a perfectly appropriate outcome. It's when a good bank is taken down by the behavior of others -- or due to any systemic meltdown -- where the line must be drawn.
(Who behaved well and who did not might not be clear-cut but it's far from impossible to judge.)

If we're not careful the current serious but now fixable problem will get to the point that nationalization becomes the only reasonable option. The consequences and costs of nationalization are not small and need to be considered carefully. We'd benefit greatly at this time from fewer provocative statements regarding nationalization. Such a serious fork in the road deserves thoughtful commentary. Expertise, visibility, and influence should be put to productive use. Let's at least try to make sure the emergency doesn't become so great that nationalization becomes inevitable. This, to me, would be a terrible and unnecessary outcome. The experts -- some who are frequently visible on popular media outlets -- will have been "right" about the need to nationalize. The fact it could have been avoided -- beyond the possible lessons learned -- will then be irrelevant.

Statements like the "system is close to being insolvent" and calls to nationalize banks are feeding the fire that's already been set. The window has not closed but some seem convinced it has. Many banks are not anywhere near insolvent today on an economic basis. Some are under terrific stress, no doubt, yet still have enough earning power to repair their balance sheets over time. So it's far from hopeless. Bank balance sheets shouldn't necessarily look great during a financial crisis. Some do have balance sheets that appear, at least for now, insolvent on an accounting basis and maybe even on an economic basis. For these banks the picture is not a good one. Intervention is inevitable. Up to a point, regulatory forbearance can be wise for those banks that have, on a normalized basis, sufficiently good assets and earnings capacity; it can be wise when economic activity is temporarily reduced and no one's in the mood to buy assets. During a crisis market prices may not reflect underlying economic value. This could make bank balance sheets appear temporarily weaker than they really are depending on the accounting rules in place.

What is your car worth if you have to sell it in the next fifteen minutes? How about if you have a year to sell it? Two materially different prices. Forced selling can lead to a temporary mispricing of assets compared to underlying value.

Shore up the banks through capital raising (where possible, at fair equity prices not temporary market meltdown prices) then monitor behavior closely. Deal with the failing institutions decisively. Otherwise, allow the banks to earn their way back to full strength as long as they have the capacity to do so. Plenty of banks are capable of this if given some time.

Early intervention is often the right call when it comes to stabilizing a financial system. Yet patience and regulatory forbearance can also make sense for those banks that are economically sound but temporarily under pressure. The right call varies depending on the institution and the circumstances.

Private capital needs to believe that equity won't be wiped out in an arbitrary manner. Otherwise, equity capital will become too costly and too difficult to come by.

In any case, decisive action is needed sooner than later.

Nationalizing the banks won't do the trick.

Economic dynamism will be lost.

To at least reduce the likelihood and scale of a future financial crisis, much more capital and liquidity should be required.

There'll surely be another financial crisis, but we can still work to delay the inevitable and mitigate the effects.


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