The post was co-authored by Simon Johnson and James Kwak.
When the stress tests were first announced on February 10, bank stocks went into a slide (the S&P 500 Financial Sector Index fell from 133.13 on February 9 to 96.18 two weeks later), in part on fears that the stress tests would be a prelude to “nationalization” of the banks. This week, it has emerged that several large banks will require tens of billions of dollars of new capital, most notably Bank of America. They could obtain that capital by exchanging common shares for the preferred shares that Treasury now holds, an accounting trick that boosts tangible common equity without providing the banks any new cash. Such a conversion would greatly increase the government’s stake in certain banks, perhaps even above the 50% level, yet the markets seem relatively unconcerned this week, with the S&P 500 Financial Sector Index at 168.14 and rising.
What happened?
Back in February, America was mired in a public debate over the word “nationalization” and what it meant for our banking system, with contributions by Nobel Laureates Paul Krugman and Joseph Stiglitz, former and current Fed officials Alan Greenspan, Alan Blinder, and Thomas Hoenig, and administration figures Timothy Geithner, Larry Summers, and even Barack (”Sweden had like five banks“) Obama, among others. On a substantive level, the debate was over whether large and arguably insolvent banks should be allowed to fail and go into government conservatorship, as happens routinely with small insolvent banks. Opponents of this view who wanted to keep the banks afloat in their current form, including the current administration, beat off this challenge by calling it nationalization (more precisely, by demonizing government control of banks). Perversely, however, what we got instead was increasing co-dependency between the government and the large banks, as well as increasing influence of the government over the banks, and vice-versa. And according to the market, the banks should be quite happy with this outcome.
As a starting point for thinking about this issue, there are good reasons to be skeptical about nationalization, meaning indefinite state ownership of the banking system.
Government ownership of banks or any other company can go badly wrong. Anyone growing up in the United Kingdom during the 1960s and 1970s experienced first-hand the problems that occur when the government runs major industrial and infrastructure companies – particularly when they have powerful unions. Margaret Thatcher came to power in 1979 in part because the state-run parts of the U.K. economy were not doing well, and the wave of deregulation that she started (and the financial boom it triggered) was a reaction to that context.
Similarly, people working in Eastern Europe and the former Soviet Union in the 1990s got a close-up view of wasteful and unproductive state ownership at work. Privatization was not handled well in some situations, particularly when it led to the emergence of powerful oligarchs. But the state had been a dreadful owner in almost every respect – quality of service in stores, productivity in manufacturing companies, resource management in oil and gas companies, and massive pollution by energy and transportation systems.
All of these nationalized industries had something in common. When companies did badly, the losses were borne by the state. As a result, there was little incentive for company managers to improve their performance. Some years they would get lucky and even make a profit – but at those moments, most of the benefits would go to the insiders, in higher wages, bigger perks and the like.
Direct state ownership of industry has proved disappointing almost everywhere. It turns out to be an arrangement in which a small group of people – whoever has power at or around the state enterprise – get the upside, while society as a whole gets all the downside. There is a prominent role for government in the modern economy: setting rules, enforcing contracts, supporting longer-term research and development, and trying hard to continually upgrade education. But managing banks is not part of that package, primarily because politicians should be kept away from credit. Once the allocation of loans becomes politicized, you get all kinds of pathologies and, most likely, more inflation as the central bank loses the ability to cut back on credit.
However, this does not mean that the state has no role to play in the banking system.
In every developed country, the financial industry is closely monitored and regulated - on paper at least - because of its crucial role in the economy. That regulation has two major objectives that almost no one disagrees with. The first is protecting depositors. There is no simpler scam than accepting deposits, paying them out to bank insiders (or “investing” them in insiders’ money-losing projects), and then going bankrupt. Even in the absence of fraud, mismanagement can lead to the same result. If people do not trust banks to hold their money, they will hold onto cash instead - increasing the cost of everyday life, and starving the economy of credit.
The second, related objective is preventing bank failures, when they do occur, from causing major damage to other institutions. At any moment, a reasonably complex bank will own a diverse portfolio of assets, owe money in different forms to many different investors, and have open trading positions with many counterparties. Unwinding these relationships through a traditional bankruptcy process could cut off liquidity to other financial institutions and cause a ripple effect of successive failures.
In the U.S., the solution to this problem was defined in the Great Depression and has never been seriously questioned. Deposits are guaranteed by the Federal Deposit Insurance Corporation (FDIC), which receives insurance premiums from banks. In return, federal and state regulators have the right to monitor banks in order to minimize the losses that the FDIC could suffer. This is analogous to a workers’ compensation insurer auditing its customers’ workplaces to make sure they meet prescribed safety guidelines.
Under this system, if a bank is at risk of failure, the regulator can demand that it increase its capital. If it cannot find additional capital, or if it is insolvent, the FDIC will take over the bank. Most often the bank’s assets (loans, securities, buildings, customer base, deposit accounts, etc.) are transferred to another bank, insured deposits are protected, losses to uninsured deposits are minimized, and operations continue nearly seamlessly. By most accounts, this process runs very smoothly. And it happens regularly - 25 times in 2008, and 29 times through April this year.
Even when the FDIC has to operate a bank for some time before it can find an acquirer or wind it down, we never talk about the FDIC “nationalizing” a bank. An FDIC intervention is typically called a conservatorship or a receivership, depending on whether the bank will be liquidated or not. Although insured depositors are protected, uninsured creditors such as bondholders are not; how much they get depends on what the FDIC can sell the assets for. And shareholders are almost entirely wiped out.
Although this process includes a period of government control, there’s a good reason why no one calls it nationalization: the process preserves the incentives of free market capitalism. Shareholders, who took the most risk for the highest expected returns, lose their money. Bondholders, who took some risk for modest expected returns, lose some of their money. Managers lose their jobs. Healthier, better-run banks claim the assets, grow, and make more money.
The recent nationalization debate has this precisely backwards.
The problems of the banking sector are clear, although reasonable people may disagree about their magnitude. America’s biggest banks suffered massive financial losses due to bad loans and worse risk management, while reducing their capital to the legal minimum and then lobbying Washington to reduce that minimum. The crisis began with unexpected losses on complex securities, but has since spread to every type of financial asset, as the deepening recession undermines the ability of all types of borrowers to repay their loans. The IMF has boosted its estimate of aggregate losses by financial institutions to $4.1 trillion, only a fraction of which has been written down on balance sheets.
As a result, some of our largest banks are either insolvent - their assets are worth less than their liabilities - or are short on capital, and confidence in them has been preserved solely by the government’s willingness to provide capital injections, loans, and debt guarantees as necessary to keep them in operation.
In most countries, the course of action would be clear. The government would take over banks, remove “bad assets” from their balance sheets, inject fresh capital, and put them bank into the private sector. This is essentially what the FDIC does when it takes over a bank. There is some debate about whether the government currently has the power to do this for bank holding companies - Tim Geithner says no, Thomas Hoenig says yes - but if not, this is certainly something the Obama administration could press for.
In fact, this is usually the approach suggested by the U.S., both directly and through its influence at the IMF. For example, the U.S. repeatedly and publicly pressed Japan to do exactly this during the 1990s.
If the government were to implement this type of policy, the recent stress tests would be a reasonable first step. The stress tests would determine which banks were failing, and then they would be put into conservatorship. This is what investors were afraid of in February, because when a bank goes into conservatorship, its common shareholders are effectively wiped out - which, again, is what is supposed to happen in a free market system when companies mismanage themselves into the ground.
Since February, however, the government has clearly communicated that it has no such intentions, for example in Geithner’s insistence that “the vast majority of banks have more capital than they need to be considered well capitalized by their regulators.” Even as the capital shortfall numbers have leaked out over the past few days, the government has emphasized that no banks will actually be allowed to fail, or even be allowed to be put into a conservatorship; instead, they will first attempt to raise capital from the private sector, and failing that they can convert their TARP preferred stock into common stock. Even if this results in significant government ownership, there is no evidence that shareholders or creditors will be forced to take losses. As rfreud said in a comment here, “The stress tests results are confidence-building in that they signal the low likelihood of nationalization or seizure. Reform at the moment seems a distant prospect.”
The strategy, in short, is to continue to prop up our existing large banks in place (no such consideration has been granted to small banks) through a lengthening list of bailout measures. Why?
One reason is that taking over banks has somehow been redefined as “nationalization,” with the images it conjures up of forced confiscation of property. Yet there are no guns involved here. Ordinarily, when an investor puts a large amount of new capital into a bank, it gets some measure of control in return. Yet Treasury has bent over backward to minimize its voting shares, beginning with the initial round of recapitalizations and continuing through the latest Citigroup bailout in February.
Perhaps after fighting off charges of “socialism” from the McCain campaign, the Obama administration is wary of any steps that could be described as nationalization. And so instead of insisting on its well-understood duty to shut down failing banks for the public good, it has tied its hands by taking this option off the table.
But what are we getting instead? Increasing government support for the financial system, and increasing government influence over the flow of credit - or nationalization by another name.
Instead of the government taking over and sorting out banks transparently, the big banks are receiving massive government support:
- $700 billion in Troubled Asset Relief Program (TARP) money is flowing to no fewer than eleven separate programs, as documented by the TARP Special Inspector General, including preferred share purchases, asset guarantees, purchases of asset-backed securities, and subsidized purchases of toxic assets.
- The Federal Reserve has committed trillions of dollars to lend against and purchase securities of all kinds from the banking sector.
- The FDIC is guaranteeing hundreds of billions of dollars of newly issued bank debt, and is set to guarantee loans to private investors to buy loans from banks under the Public-Private Investment Program (PPIP).
In exchange, the government is deciding how credit is allocated in the economy, albeit on the wholesale rather than the retail level. In addition to direct loans to automakers, programs such as the Term Asset-Backed Securities Loan Facility are effectively distributing money to support specific types of lending (credit cards, auto loans, etc.), and the Fed is purchasing over $1 trillion of mortgage-backed securities in order to push mortgage rates down to historically low levels.
In addition, there is anecdotal evidence that the government, while renouncing official control of any banks, has intervened in management decisions for some of the weaker players. According to Bank of America CEO Ken Lewis, he was threatened with removal if he failed to complete the acquisition of Merrill Lynch. And unnamed sources recently reported that federal regulators are considering removing Vikram Pandit from Citigroup.
In short, relationships between the government and the large banks have never been closer, with large amounts of money flowing in one direction, and complete co-dependency going in both directions. Those relationships are not entirely friendly, which is not surprising. In any crisis when public resources are called on to bail out the private sector, not all of the oligarchs will survive; Bear Stearns and Lehman have already vanished. But the winners - which should include Jamie Dimon of JPMorgan Chase and Lloyd Blankfein of Goldman - will emerge even more powerful and influential than before.
In rejecting “nationalization” (regulatory takeover and conservatorship), the government has not ensured a private, properly functioning banking system. Instead, it has muddled into a broken-down, undercapitalized system that is nominally in private hands, but is able to tap the state for apparently limitless support. And to date, that support has flowed on one-sided terms, with the taxpayer accepting downside risk but limited upside potential. No wonder bank shareholders are comfortable with this outcome.
As a result, the banks have largely preserved their existing management teams and bonus plans: on Wall Street, first-quarter accruals for bonuses returned to the levels of the glory years of 2006 and 2007. Creditors and counterparties have been kept whole, most notably through the AIG bailout. And shareholders have seen their share prices supported by the promise of sustained government support. The incentives we have ended up with are more similar to those of a nationalized system than those of a free market. Instead of state-owned coal mines run for the benefit of miners (the U.K. in the 1970s) or state-owned oil and gas companies run for the benefit of bureaucrats (the Soviet Union in the 1980s), we have state-backed banks in the U.S. run for the benefit of bankers and their creditors.
The smart economists in the Obama administration must know what is going on. But having insisted that large bank takeovers are tantamount to nationalization and therefore off the table, the administration is betting that the financial system will repair itself - or “earn their way out,” as StatsGuy put it.
This is possible. With the competition in both investment banking (Bear Stearns, Lehman) and mortgage lending (most of the specialist mortgage lenders) gone, the survivors all enjoy larger market shares and higher prices, contributing to their somewhat healthy profits in the first quarter. Even the large banks that receive the lowest grades in the stress tests will be given relatively cheap capital by the government; Treasury will use its resulting stakes to apply behind-the-scenes pressure to the banks (more government influence), but without taking decisive steps to clean up bank balance sheets. Instead, it will hope that the PPIP will do the trick, using cheap government financing.
But success is by no means certain. And we cannot know for how long the government will have to continue propping up weaker banks, at growing taxpayer cost, while they absorb funds that could otherwise help the economic recovery.
In the end, when a financial system is dominated by banks that are too big to fail - and they do fail - the only options are an FDIC-style takeover or the kind of public-private co-dependency that we see today. As far as the current crisis is concerned, the die is cast and the big banks won.
For the future, however, the question is how to avoid a situation where banks cannot be made to fail gracefully without creating systemic risk. As a starting point, we believe that banks that are too big to fail are too big to exist. Only then will we be able to maintain the incentives necessary to manage risk, punish failure, and reward success.
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“But it isn’t clear that Chinese policy makers really ever thought out the end-game (i.e. their exit strategy from the dollar trap), despite their reputation for thinking about the long-term.”
It’s a well-deserved reputation. Comparatively. Here’s the answer:
“The goal should be the creation of a more balanced relationship – one where the US doesn’t require so much Chinese financing and China doesn’t need so much US demand – not a return to the old unbalanced relationship.”
It’s simply a matter of working out the details. China understands that it’s connected to us. And, just as we try and influence them through our statements ( On human rights, for example ), they try and influence us in the same way.I suppose they take the idea of a partnership more seriously.
Whatever the press said, Geithner as the one person calling for a total guarantee. China surely knows this. That’s what they wanted and expected. As you say:
“The sources of pressure for change are increasingly obvious. Even in China. That’s good. But transitions aren’t easy. Deficits – even shrinking deficits – have to be financed. And financing an orderly (think gradual) adjustment poses particular challenges.*** For everyone.”
I believe that the US and China know where they want to go, it’s really a matter of the actions and compromises necessary to get there. In other words, China has a plan, but we have a say in how that plan works out.
To me, what’s interesting is how they’re reacting to getting, more or less, what they want. I guess that they don’t trust democracy, while they’re pretty sure that they’re in control of their responses.