Nationalisation as a solution to the banking crisis

Nationalization seems to suggest that we are abandoning the principles of markets. However, if done in an orderly fashion, we can bring the banking system back to reasonable health and restore confidence.

These are the steps that should be followed in nationalization. First, a quick review of every major and mid level bank must be made to determine the extent of their exposure to these assets. Second, the ones that are otherwise healthy must be saved, while the ones which are irredeemable must be allowed to fail. Third, the fundamentally healthy but impaired banks (those which don’t need capital can exist as it is) should be placed under a conservatorship (like Freddie and Fannie). Fourth, their entire equity must be wiped out, managements fired, and no golden parachutes must be given. This takes care of one form of moral hazard. Fifth, debt holders, other than senior most debt holders, must be forced to take a haircut, as there is no rationale for the tax payer to fund bond holders. Sixth, managers may be incentivized to lend according to long term profitability. Seventh, the bad assets are now moved to an RTC like bank where debt is paid down and the assets are gradually sold to private investors. Finally, when the books are sufficiently cleaned up and markets stabilize the banks can once more be available for public ownership.

What are the advantages of nationalization? The most obvious advantage is that uncertainty in the markets is removed once and for all. Rather than lurching from one bailout to another, and markets worrying about creeping nationalization, a bold solution like this would signal a bottom. Another advantage is that banks can begin to lend again. The problem with equity stakes without control was that managers and shareholders, worried about their future would rather use the money to pay their salaries and repair their balance sheet, resulting in a hobbling bank which does not take risk. At the same time moral hazard is vastly reduced when exiting managers are punished for reckless lending and hence future excessive risk taking is minimized. The greatest advantage though is that the problem of valuing assets is no more a necessity. Since both the “good” bank and “bad” bank are under government control, the asset valuation does not matter, as it merely involves transfer of assets from one part to another part of the same owner. This could be done at historical cost or zero value or any other value as there is essentially no difference. The “bad” bank collects all the cash flows associated with the assets and if no market develops, then it holds the assets to maturity. The “good” bank can be privatized when conditions improve. The cost of nationalization has been shown to have a lesser final fiscal cost than this stage wise bleeding. As an example of its actual implementation, we need not look further than Sweden which in 1993 did the same thing. The overall cost to the government was minimal. Finally, the reason debt holders have to pay a price is because there is no reason for risky debt investors to be rewarded while stock holders suffer. The tax payer should not subsidize them (senior debt holders may need to be accommodated for fear of greater contagion while junior debt holders’ rationale for investing itself is that they sought more risk and hence where paid a higher rate).

The arguments against nationalization exist. The major reason is the mistrust that government cannot run efficient operations and would be prone to political pressures. By appointing commercially oriented managers, this problem can be reduced. Further, it can be argued that state control may become permanent. Finally, a very credible argument exists to make a distinction between the Nordic experience in the 1990’s and the US. The US banking system is much larger than the Swedish system and both the costs and time required are higher and chances of a successful withdrawal at a later stage by the government are likely to be lower. The linkages in global finance may also cause issues on valuation of assets unlike in the 1990’s when most of the assets in Sweden where regionally owned. However, none of these reasons are sufficient to continue with status quo. The costs are too high, and a bold initiative is a must. Nationalization and nimble restructuring is the quickest and cleanest end to the mess we are in right now.