The Case For and Against Bank Nationalization

[RedEarth]

Matthew Richardson
Professor Richardson is a contributor to the NYU Stern School of Business project, “Restoring Financial Stability: How to Repair a Failed System”, John Wiley & Sons, March, 2009

| Feb 26, 2009

Secretary Geithner’s financial plan calls for stress tests at the large complex financial institutions (LCFIs). These tests are due to start this week. They will involve estimates on the eventual losses due to default on a wide variety of assets.


Economic analysts have already performed such a test at the aggregate level. It was not a pretty picture. For example, Goldman Sachs looked at the U.S. banking sector’s holdings of the current “toxic” pool of assets, such as option ARM residential mortgages, subprime residential mortgages, Alt-A residential mortgages, credit card debt, second liens/home equity loans, consumer auto loans, and commercial real estate. Expected losses come in at around $900 billion. These losses give the banking sector very little wiggle room. Therefore, there is the real possibility that some LCFIs are bankrupt - the face value of the liabilities exceed the current value of their assets.

I. Insolvent Financial Institutions

If a bank is insolvent, there are three general ways to attack the problem.

The first is unbridled free market capitalism. I am sympathetic to this view. I wish we somehow could figure out a way to let the market work and let these institutions fend for themselves. Shareholders, creditors and counterparties knew the risks they were getting into. After all, why is some debt secured, why do we have collateralized lending, why do riskier assets deserve larger haircuts, etc…? But when Lehman Brothers went down, we looked into the abyss. This would be the equivalent of nuclear armageddon for the financial system.

The second is to provide government aid to the insolvent bank, to in effect throw good money after bad. This is sanctioning private profit taking with socialized risk. Since October of this past year, the government has followed this strategy. Let the banks plod along, throwing money here and there to keep them afloat, at usually way below market prices at a high cost to taxpayers.

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III. Concluding Remark

We are definitely caught between a rock and a hard place. But the question is what can we do if a major bank is insolvent? Sometimes the best way to repair a severely dilapidated house is to knock it down and rebuild it. Ironically, the best hope of maintaining a private banking system may be to nationalize some of its banks. Yes, it is risky. It could go wrong. But it is the surest path to avoid a “lost decade” like Japan.

IV. Case Study: Sweden<1>

Sweden has been cited frequently as a model of “nationalization”. While this is probably an exaggeration, the Swedish model is in many ways a model in terms of the principles it puts forth to handle a financial crisis. Putting aside the obvious fact that Sweden’s economy is much smaller and its financial institutions much less complex, it is a useful exercise to describe some basic facts.

The distribution of assets within the Swedish and U.S. banking system were similar. For example, while Sweden had 500 or so banks, 90% of the assets were concentrated in just six. In the U.S., while there are over 7,500 institutions, the majority of assets are concentrated in the top 15 or so.

Sweden’s credit and real estate boom in the late 1980’s closely mirror the U.S.’s similar boom prior to the current crisis. There was even a similar shadow banking system that developed during these periods – in Sweden, unregulated companies that financed their operations via commercial paper whereas in the U.S., unregulated special purpose vehicles (SPVs) via asset-backed commercial paper (ABCP). When the bubble began to burst, there was also sudden collapses in these markets as a few of these companies and SPVs began to fail.<2> Ultimately, the funding came back to the banks, causing them to have large exposure to the real estate market.

As conditions eroded in 1991, the Swedish government forced banks to writedown their losses and required them to raise more capital, otherwise to be restructured by the government. Of the six largest banks, three – Forsta Sparbanken, Nordbanken and Gota Bank - failed the test. One received funding and the other two, Nordbanken and Gota bank, ended up being nationalized.

These latter two banks had their assets separated into good banks and bad banks. The good banks ended up merging a year later and were sold off to the private sector. The poorly performing loans were placed in the bad banks, respectively named Securum and Retrieva. These banks were managed by asset management companies who were hired to divest the assets of these banks in an orderly manner. (It took around four years.)

The main lessons from Sweden are relevant, however, for the current crisis:

Decisive action in terms of evaluating the solvency of the financial institutions.
Some form of “nationalization” of the insolvent firms.
Separation of these insolvent firms into good and bad ones with the idea of reprivatizing them.
The management of the process was delegated to professionals, as opposed to government regulators.
The issue of course is whether the complexity of the institutions affect how these principles should be applied in the current crisis. Complexity alone does not nullify these principles.

Richardson is a contributor to the NYU Stern School of Business project, “Restoring Financial Stability: How to Repair a Failed System”, John Wiley & Sons, March, 2009.

http://www.rgemonitor.com/roubini-monitor/255740/the_case_for_and_against_bank_nationalization