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Taboo of nationalisation

• Evan Davis | Small Change |
• 17 Mar 08, 03:09 PM

Is it a good time to nationalise the banks?

The taboo of nationalising a bank – evident in the government’s reluctance to accept that option for Northern Rock – may have to be overcome in the next few years.

This is one lesson to draw from previous banking crises. The for example, is generally regarded as well handled. And the solution there was to take ownership of the failing banks, to strip out the bad assets and to put them into separate well-funded asset management companies whose only job was to extract as much value from them as possible.

Once that had been done, new “cleaned up” banks could be re-established and operate again very quickly. It worked for them, although it was helped by buoyant economic conditions.

But it tells us that a successful resolution of a bank crisis can involve governments or central banks owning more of their banking systems than they would probably like.

The relevance of this argument today is that the banking crisis we are now in is one in which the banks’ own capital has been eroded by losses they have incurred on their past decisions.

The banks' capital is best viewed as a relatively small rock, on which the rest of their activities sit. Before they can borrow and lend £12, they need £1 of their own capital to serve as a kind of safety cushion. That capital is one thing that makes it safer to lend your money to a bank, than it is for you to lend directly to the bank’s borrowers.

It is no wonder that bank capital is regulated. When borrowing and lending is profitable, it is tempting for banks to scale up their operations and to borrow and lend too much in relation to their capital, in effect reducing the effectiveness of the potential capital cushion.

The problem for all of us is that when bank capital is eroded, the banks’ lending has to be curtailed, with broad economic consequences. Whatever the central bank rate of interest, or whatever the credit-worthiness of potential borrowers, banks are constrained from lending and sometimes have to call in loans that have already been made.

We want banks to lend responsibly, but we don’t want them to curtail lending too far.

So the goal has to somehow be to get more capital into the banks.

That’s not about us putting deposits into banks, or central banks lending money to banks… it is about extra money finding its way into the banks, to rebuild the capital rock on which successful banking depends.

Who can invest new money in banking right now?

The most obvious candidates around the world are the sovereign wealth funds sitting on large amounts of spare cash.

But in the absence of clear information about how much the banks are worth, the funds may be reluctant to throw more money in.

(The experience of may put other investors off. As China’s biggest brokerage firm, it promised last October to invest $1bn in Bear Stearns in return for 6% of the company, a price that looks high given the news that has occurred since.)

If wealthy foreigners are not going to inject capital into the banks, and if the crisis is as bad as some suggest, the best candidate to inject capital might instead be our own governments.

It’s not quite bailing the banks out, and it would not be aimed at rescuing the shareholders – the new money would go in, and in return the state would obviously have to take a stake in the banks future profits. The existing shareholders would lose some of their share.

These kinds of solutions are not infrequently adopted, but normally occur when the banks have run out of money. But does it have to be a 100% stake in a bank? And does it have to wait until the bank is in dire trouble?

Ultimately the solution to the problems of the banks is clear: the full scale of losses incurred in the bad lending of recent years has to be recognised; the failing assets written off without a fire sale of assets; and for the banks to be recapitalised and re-launched from a healthy base.

Taxpayers might object to their money being sent in to support banks, but it is probably money well spent if it supports the economy generally, and stops the rot quickly.

In fact, there is one final lesson to be drawn from history, from the , which was less well-handled than Sweden’s.

As problems unfurled in the early 90s, the public objected to the idea of helping banks and only one trillion yen of support was mobilised. By the end of the decade, as the crisis worsened, more like 6o trillion had to be found.

These things can get very out of hand.

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