Time to Nationalize Struggling Banks?

In the U.S., former Fed chairman Alan Greenspan has unexpectedly
joined a list of notable financial experts who believe some banks may
have to be nationalized temporarily. Additional surprising converts
include prominent Republican politicians such as Sen. Lindsey Graham of
South Carolina and former presidential candidate John McCain.

Many Wharton faculty also agree. Among them is Wharton finance professor Franklin Allen,
who argues that a temporary nationalization of the affected banks is
the only way to remove the top executives who helped trigger the
financial crisis, while ensuring that the interests of taxpayers are
valued over those of stockholders and bondholders. This is not
something the government should be doing in the long run, says Allen.
The banks should be nationalized for however long it takes for things
to get back to normal. I would imagine that would be less than three to
five years. Like other advocates of bank nationalization under the
current circumstances, he points to the example of Sweden, which
nationalized its banks during a crisis in the early 1990s and for the
most part privatized them again once they had been stabilized.

The U.S. is not the only Western economic power in which recent talk
of bank nationalization abounds. Ireland nationalized Anglo Irish Bank
in January and has spent some $9 billion to recapitalize Bank of
Ireland and Allied Irish Banks. In Berlin this week, the government
said it would prefer to take a majority stake in Germany's struggling
Hypo Real Estate Holding rather than nationalize the property lender.
Nationalization is only an option after attempts to take a majority
stake have failed, a government spokesman said. Everybody agrees that
nationalization can only be a measure of last resort if it's necessary
for the stabilization of financial markets and other, less severe
solutions have been exhausted.

There has also been speculation -- frequently denied by U.K. Prime
Minister Gordon Brown -- that the British government aims to
nationalize Lloyds Banking Group or Royal Bank of Scotland (RBS), in
which it holds stakes of 43% and 70% respectively. Just a year ago, the
U.K. nationalized Northern Rock, one of the first banks to suffer
catastrophic losses from its exposure to securitized subprime mortgages
in the U.S.

European experiments with bank nationalization have essentially treated
it as a temporary measure, to be reversed when the financial system
returns to normal. In contrast, Asian countries such as India and China
have adopted a different nationalization model -- which has had results
that are often negative. As governments in the U.S. and Europe ponder
their own rescue strategies for banks, these experiences could serve as
cautionary tales of the risks involved in nationalization.

Fear of Bureaucracies

One reason that bank nationalization has been the subject of more
talk than action is the central role that banks play in free-market
economies. Critics say that nationalized banks can quickly devolve into
inept bureaucracies, prone to politics and other pitfalls.

Nationalized banks do not generally perform as well as privatized
banks because they have much more complex objectives -- employment,
subsidies to a particular sector or politician -- and because they
generally have much looser corporate governance, says Wharton finance
professor Richard J. Herring, co-director of the Wharton Financial Institutions Center.  Employees are generally civil servants and the board is generally packed with political appointees. 

Even so, Herring agrees that the current crisis in the American
banking system is so severe that a temporary nationalization of some
banks -- serving as a kind of a bridge until new buyers can be located
-- is probably necessary. Such a framework provides officials and
potential buyers with the time and opportunity to undertake due
diligence to make an optimal disposition of a failed bank. I am puzzled
about why the Treasury is so reluctant to use it.

The reason may lie in politics, and the aversion even among more
liberal public officials to take steps that could be criticized as
appearing socialist. One of those hesitant politicians appears to be
President Barack Obama, who recently told ABC News he is wary of the
Swedish model of bank nationalization because of the sheer size of
America's banking industry. The scale of the U.S. economy and the
capital markets [is] so vast, and ... the problems in terms of managing
and overseeing anything of that scale, would be so complex, Obama
said, that it would not make sense. And we also have different
traditions in this country.

But many experts predict that the current crisis may trump
tradition. Two large American banks are especially at risk: Citigroup,
which received a $300 billion federal aid package -- mostly in the form
of loan guarantees late last year -- and Bank of America, the
beneficiary of a similar $120 billion program earlier this year. Many
experts believe the two bailouts, despite the massive amounts of money
involved, did little to take the banks away from the edge of
insolvency, and the federal government can take little further action
without becoming the majority stakeholder. They note that Washington is
already seeking to impose strict controls without ownership, such as
the limits on executive pay that Congress included in the recent
economic stimulus bill.

A leading advocate of bank nationalization is New York University (NYU) economist Nouriel Roubini, who recently co-authored a Washington Post
op-ed on the topic with NYU colleague Matthew Richardson. They wrote
that it may sound somewhat blasphemous for economists who believe in
a free-market system to advocate a bank takeover by Washington, but
they saw no alternative after they estimated that looming losses by
U.S. banks amounted to a staggering $1.8 trillion, which is more than
their $1.4 trillion net worth. It's critical, they wrote, that the
Treasury Department determine which banks are actually insolvent, take
them over, and separate out the so-called toxic assets so that the
remaining healthy assets can be sold quickly to private investors while
the bad loans are disposed of in due time. We have used all our
bullets, and the boogeyman is still coming, they write. Let's pull
out the bazooka and be done with it.

That once-radical position is finding some support. According to
Allen, the biggest problem with the current bank rescue plans is that
they have not removed the executives who caused the crisis, and have
allowed them to continue to collect large salaries, bonuses and other
perks despite taxpayer outrage. We've got all this money invested and
no control over what they're doing at all, Allen notes. The classic
example is what happened with the bonuses at Merrill Lynch, which gets
dealt to Bank of America and says that they need $20 billion. The
government says 'yes,' and then they turn around and hand out $4
billion in bonuses.

Cleaning House

Like other proponents of bank nationalization, Allen argues that the
successful experience of Sweden in the early 1990s should be an example
to American officials. At that time, the Scandinavian nation faced a
crisis that was strikingly similar to our own: Banks that had been
largely unregulated by the government over the prior decade suffered
large losses in the collapse of a real estate bubble.

Swedish officials insisted that the banks write down their losses,
which wiped out shareholder value. The government then recapitalized
some banks in return for an ownership stake. It also created an agency
to sell the bad loans. The spending involved was significant -- more
than $18 billion in today's dollars in a nation much smaller than the
United States -- but Sweden earned a significant portion of that money
back through the sale of the assets, and even today it still owns
nearly 20% of the Scandinavian banking giant Nordea.

In Sweden they went in and fired all the senior management, Allen
notes. The shareholders got nothing, but [the government] put the
banks back in good shape -- it was a better way to proceed. Allen and
other experts note that Sweden's comprehensive approach was much more
successful than Japan's woeful performance during its so-called Lost
Decade of the 1990s, when the government's intervention to help out
banks was seen as too piecemeal and not dramatic enough to end a
prolonged slump.

Wharton finance professor Itay Goldstein
has concerns about bank nationalization in the U.S. Still, he adds, the
initial stage of the federal rescue plan showed how hard it is to
attack the problems at U.S. banks without the kind of large-scale
coordination that comes from a central government. He said that
individual banks are reluctant to make loans during the current crisis
-- even after the initial cash infusion from Washington -- because they
worry that borrowers will default as the economy drifts deeper in
recession.

There's also a coordination problem, he says. If you feel that
banks are not seeing the full picture of their impact on the economy as
a whole ... taking over the banks could be justified. The costs are
huge -- it is almost impossible for the government to take over so many
big banks and actually control them. I don't know if the government has
the personnel for that.

While we're not happy with the CEOs of the banks, I don't think
many people want the government and a bureaucracy running the banks,
says Wharton finance professor Jeremy J. Siegel.
You could get rid of all these CEOs and say that you're going to get a
new board, but there's a feeling that you want to keep [the banks] in
the private sector.

Siegel believes the Obama administration should continue along its
current path, which aims to separate the banks' good assets from their
toxic holdings, even though he acknowledges that developing such a plan
is difficult. He also argues that any additional infusions of taxpayer
money should ensure that the banks' bondholders take a haircut in
addition to the losses already felt by stockholders who have watched
the value of their shares plummet.

Allen says the current response to the economic crisis has been
characterized partly by the amount of coordination involving Western
governments. He notes that the U.K. has been reluctant to go the full
nationalization route because of lessons that it learned during the
1970s, but he expects that stance to change soon. They were
reluctant, he says, but now they already own 70% of RBS, so I think
they'll do it. From the late 1960s through the early 1980s, the
British government nationalized nearly a dozen industries, including
auto manufacturers, utilities, transportation and aerospace firms. Many
of them have since returned to private control.

Mexico also managed what is generally viewed as a successful,
temporary nationalization of much of its banking system following the
peso crisis of the 1990s. But critics of bank nationalization contend
that while this radical solution may look like a speedy panacea for the
financial crisis in the U.S., history has not been kind to most efforts
-- especially a wave of such efforts by socialist-leaning governments
in Europe and elsewhere in the generation following World War II. Many
of these efforts failed for the same reasons -- lack of competition led
to inefficient bureaucracies as well as corruption and bad decisions
based more upon politics than upon sound business practices.

A Cautionary Tale from India

Bank nationalization has had a long history in India, though it was
more a matter of political ideology at first as India pursued
socialist-leaning policies after gaining independence from Britain in
1947. This bank nationalization was intended to be permanent -- not
part of a temporary rescue -- thus there are limited parallels to what
occurred in India and what is now being contemplated in the U.S. Still,
it's worth noting the effects of bank nationalization on another large
country.

In 1955, India created the State Bank of India (SBI) to take over
the Imperial Bank of India, which accounted for some 25% of the Indian
banking system. Large-scale nationalization took place in 1969, when 14
major commercial banks were taken over by the Congress government led
by Indira Gandhi. Another seven were nationalized in 1980. This
increased the share of public sector banks in total deposits to 92%.

Several reasons accounted for these takeovers. Many of the banks had
been set up by large industrial houses and functioned as appendages of
these groups. Discretionary norms were ignored while lending to their
parents and a very real danger existed that some of them would
collapse. In 1993, when the Reserve Bank of India permitted private
banks to be launched, it noted that the new bank should not be
promoted by a large industrial house.

In addition, with its socialist inclinations, the government
believed that the best way to help the farmers and the poor was through
directed lending. A priority sector was created for such loans.
Ministers organized loan melas (or fairs) in which money was
distributed without the necessary security or expectations of
repayment. Not surprisingly, the banking system was soon reeling under
bad loans. Several banks nearly went under and had to be rescued
through capital infusions by the government.

Since the reform process started in India in 1991, there have been
no new nationalizations. There have been some rescues, however. New
private bank Global Trust fudged figures and ended with a negative net
worth. It was taken over by Oriental Bank of Commerce in an
RBI-orchestrated shotgun marriage.

What has nationalization achieved in India? It has prevented some
bank collapses, and it has created a secure and trusted institution: In
the current crisis, depositors have pulled out of Citibank and ICICI
Bank to put their money into state-owned banks. It has helped bank
penetration in rural areas: India has a Composite Index of Financial
Inclusion of 48, versus 42 for China. These banks -- particularly the
largest, SBI -- have bucked global industry trends in the current
slowdown.

Yet there has been a downside to nationalization. Some banks have
had to be recapitalized for their populist lending. The World Bank has
been asked for a loan of $4.2 billion for this purpose. State ownership
has created lethargic organizations, where creativity and innovation is
frowned upon and customer service suffers. Several of these banks are
now publicly listed -- a fallout of liberalization. But the government
still holds majority stakes and it is only recently that the culture in
these organizations has started changing. Competition does not exist,
in effect.

Chinese Banks: The Opposite Direction

China, where so many companies, including banks, have been
government owned, is now leaning in the opposite direction -- partial
privatization is now a goal.

Since the current administration came to power in China in 2003,
policy towards state-owned banks has changed drastically, and reform of
their shareholder structure (or privatization) has begun. The first
step was a massive injection of state funds: The banks' non-performing
(NPL) loan ratio was widely believed to have stood at 40% or more, but
the central government had written off almost all of their bad loans by
the end of 2003. A sell-off to foreign strategic investors (mainly
international financial institutions) followed, with a 20% cap placed
on single foreign ownership and a 25% ceiling on cumulative foreign
ownership of individual banks introduced before the banks were floated
at home and abroad.

But banking privatization remains highly controversial in China.
Fierce debates have raged among academics, particularly regarding
pricing of shares sold to foreign investors, and the favoritism shown
them over domestic investors. However, China's authorities have pushed
forward resolutely with reform. By the end of 2007, China had 24 banks
with more than 30 foreign strategic investors sitting on their boards.
Over one-sixth of the Chinese banking system is now foreign controlled.

Despite the debate on valuation and fairness in the privatization
process, an improvement in China's banking industry appears evident.
Following their partial privatization, banks have introduced governance
structures to transform themselves into modern financial institutions,
and the NPL ratio has fallen from 30% a few years ago to single digits
today. Some observers also comment that the banking environment in
China has changed radically over the past 10 years, with better
regulation and supervision, better macroeconomic policy making, better
internal controls and better borrowers.

Due to its limited exposure to the international capital market,
Chinese banks have not been impacted severely by the recent global
crisis. In early February China's big commercial banks, the Industrial
and Commercial Bank of China, China Construction Bank, and Bank of
China (ICBC, CCB and BOC) ranked as the top three banks globally by
market share.

On June 17, 2005, the announcement that Bank of America (BoA) would
purchase a 9% stake in China Construction Bank for $3 billion -- the
most expensive banking acquisition in China's history -- made headlines
throughout the global financial media. Jonathan Anderson, chief
economist at UBS Asia, commented at the time that it was a win-win
strategy for both parties. He was right. On January 7 of this year,
Bank of America, under financial strain, sold 5.6 billion Hong
Kong-listed shares in CCB at a fixed price of HK$3.92, reducing its
stake in the Chinese bank from 19.1% to 16.6%. BoA made a profit of
around US$1.1 billion from the sale based on the price of the shares at
the time of CCB's IPO, according to the Financial Times.

On the other hand, although Chinese banks have performed strongly in
recent years, their ability to manage risk has not been tested, notes
Qian Jun, a finance professor at Boston College. Most of the Chinese
banks haven't really experienced any true financial crisis, so they
have not been tested in the areas of risk management and balancing
between financial innovations and generating profits, he says.

As the experiences of these countries indicate, bank nationalization
is hardly a silver bullet that can solve banking problems forever. As
consensus grows among U.S. and European economists in favor of
nationalization, it may help them to keep these risks in mind.