Why bank nationalization is a last resort

by on January 20, 2009 at 8:06 am in Economics | Permalink

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.

1 MichaelB January 20, 2009 at 8:21 am

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.

2 Jason January 20, 2009 at 8:28 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.

3 asiequana January 20, 2009 at 8:56 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.

4 Craig January 20, 2009 at 10:13 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.

5 mds January 20, 2009 at 12:06 pm

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.

6 Yancey Ward January 20, 2009 at 3:26 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?

7 ggalNV January 20, 2009 at 5:57 pm

I am new at this so excuse the beginner question. What happens to the stockholders shares in a company when it becomes nationalized?

8 pireader January 20, 2009 at 6:53 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.

9 Walt French January 20, 2009 at 8:00 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.

10 Superheater January 20, 2009 at 10:35 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.

11 aaron January 20, 2009 at 11:55 pm

Totally off topic, but has anyone looked at reparations as fiscal stimulus?

12 Massimo GIANNINI - M.G. January 21, 2009 at 8:09 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…

13 JohnKav January 22, 2009 at 1:57 am

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?

14 jc January 25, 2009 at 11:25 am

Tyler

Everyone is assuming that tangible equity is the same as balance sheet equity. They aren’t the same thing. While C has tangible equity of about 1.6:1 balance sheet equity is much higher.

The government can’t simply nationalize a bank because market cap is very low. Sure the market cap is a signal what the market thinks is the value of the equity however bank assets are in such a state of flux that it really is impossible to figure where things stand at present. Why the hurry to take over these banks anyway?

15 Navaid February 3, 2009 at 4:03 pm

Nationalization is a bad thing. History has proven over and over again that government cannot run industry. Folks like Greenspan (oh isn’t that the Fed) allowed this mess to occur … do we really feel that suddenly the Fed will do a better job just because they now own the bank?

In addition, a lot of us are owners of banks as part of our retirement savings … do you think I want my savings to be wiped out in the hopes that as a taxpayer I will receive the windfalls of government’s great management in the future?? Sorry, I’ll take my chances and say no nationalization it does not work … I do not want to get screwed as a shareholder in my 401k and then get shafted as a taxpayer when the government bungles things up.

16 John February 20, 2009 at 12:53 pm

Our quality of life would go down if we privatize.

the government caused this problem:

the feds go through bank books checking for discrimination on loans. So the easy way out is the Clinton administration push for freddy and fanny to buy and package mortgages into bonds, a crazy dollar amount of risky loans of individual home ownership (5-7 trillion I heard) with the goal of banks not running out of their own capital.

Then the bubble starts… Now the bubble ends because it was never sustainable, it was very similar to a ponzi scheme, then it runs out when home values exceeded incomes levels. Now people are as the government said “underwater,” people transfer or lose jobs, and there house are at the peak and can’t be sold starting 2-3 years ago. then the rollercoaster starts it decent. Meanwile those profits are eaten up in expenses at all this big banks.. wamu still couldnt set aside enough capital for the losses.

Now it takes a slow writedown…

the bond holders of these mortgages can sue against the loan modification but that would be stupid, they should hold out for the longer term adjustment of this housing scam, they will recoup more cents on the dollar when it deflates down to a normal supply and demand…

nationalization doesn’t solve the problem, it replaces management with government… post office is a good example of government run business… it just puts another burden on the taxpayer.

we need smaller government, were they spend more time putting stop gaps in place (i.e. banning interest only loans, adjustable rates, require substantial money down) then spending and controlling everything…

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