No Quick Fix for Banks

March 14, 2009 Updated: March 14, 2009

During the first months of this year, 17 banks closed their doors, representing nearly a quarter of the 69 bank failures since 2000, according to the most recent FDIC bank failure list. This list includes only commercial banks and savings institutions insured by the FDIC.

Options are few for the remaining banks that may find themselves in difficult situations. Each option is fraught with peril and has voices fighting for and against it.

Pro-Nationalization Voices

Senate Committee Chairman Christopher Dodd suggested temporarily nationalizing banks last month and the press had a field day, especially since it took little time for bank stocks to take a nosedive.

Most politicians and influential people favor temporary nationalization, according to financial expert and radio commentator Barry L. Ritholtz.

Joining the call for nationalization include Alan Greenspan, former Federal Reserve chairman, Sen. Lindsey Graham, former presidential candidate John McCain, TARP oversight panel member Elizabeth Warren, and House Speaker Nancy Pelosi.
Ritholtz suggests getting rid of the greedy polluters and those who caused the banking crisis can only be achieved through nationalization.

“The dilly dallying around with these horrific banks and their grossly incompetent management must come to an end…Temporary nationalization and pre-packaged chapter 11 reorganization is the fastest most effective way to deal with what ails the [financial] sector: toxic assets and not enough cash,” he wrote on his blog.

There is no other choice but to temporarily nationalize, say professors at the University of Pennsylvania, given that the multi-million-rescue effort has so far failed and left banks clamoring for more government handouts.

What stops the recovery of the distressed banking system is not the money the government handed out, but that the “current bank rescue plans 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,” the professors argue.

Banks, unless bound by contractual agreement, will not get rid of toxic assets if prices are below the expected value. On the other hand, if prices are above the expected value, the banks and its owners receive an undeserved bounty—after all, the banks were at the root of the financial dilemma, argues New York-based think tank McKinsey in its article “A better way to fix the banks.” McKinsey suggests that the government set a true market value, terms and discount based on true market forces for the assets instead of using outdated models that were part of the inapt handling of loan packages.

Warnings Against Nationalization

“People who should know better have been speculating publicly that the government might need to nationalize our largest banks. This irresponsible chatter is causing tremendous turmoil in financial markets,” William M. Isaac, former FDIC chairman, suggested in a recent opinion letter to the Wall Street Journal.

Independently owned banks play an important role in a competitive environment, while government-owned banks become unyielding bureaucracies, are subject to political manipulation, are often run by inept managers, political appointees, lack initiative and foresight, and are not driven by competitive objectives.

“Nationalized banks do not generally perform as well as privatized banks because they have more complex objectives—employment, subsidies to a particular sector or politician—and because they generally have much looser corporate governances,” Richard J. Herring, co-director at the Wharton School of the University of Pennsylvania, said in the KW article.
Experts point to India for what can go wrong with nationalizing an entire banking system. The Indian government had to recapitalize a number of banks periodically. Most recently, India approached the World Bank for a $4.2 million loan for another recapitalization of its banks.

The Bridge Banks Compromise

Richard Herring, professor at UPenn, warns in the KW article “Economists to Obama: Get the Government out of the Banking Business” against full takeover of banks, although his voice has not riled against “the government to temporarily intervene through a vehicle called “bridge banks.” This type of method generally is authorized for two years and could be extended another two years.

A bridge bank is a bank formed to assume the deposits and secured liabilities of an insolvent bank. The FDIC can operate a failed bank for up to three years until a buyer can be found by using a bridge bank.