The case for government takeover of banks receiving bailout

In a previous post, I opined that the best TARP plan is the one calls for the government acquiring active stakes in the banks, in exchange for taking bad assets out of their books. Nationalizing the banks completely is a move that the government has been reluctant to take. Policy makers believe that government will never be as good as the market in allocating capital, a principal function of the banks. That’s true, but we may have to make an exception this time around, given the market environment we currently have.

When the crisis has been contained and people are investing again, then the banks that are able to raise private capital can get out of outright government ownership. But for now, my instinct tells me that government ownership of banks makes a lot of sense. Here are some reasons why:

1. The Government already guarantees most bank loans, deposits, and assets anyway. Remember the Citibank deal? Government has nationalized the bank, but in return for a guarantee amount that would otherwise have necessitated a full takeover, government acts as a backstop to the bank’s liabilities. Should Citibank’s assets continue to decline, the government will end up paying much of the bank’s liabilities. Government would have to put up the funds, either depleting Treasury funds, or printing more money.

Financial markets have come to expect the Fed to come and bail out troubled large financial firms institutions, with the rationale that there are firms too big to fail. With the financial markets more inter-connected than ever, there is widespread belief that a failure by a large counter-party is bound to spread to the rest of the financial system, and hence, widespread sentiment that prudent policy dictates lifelines be extended during times of trouble for said privileged firms.

The practice of bailing out institutions in financial distress creates the moral hazard that these firms will continue to take ever-larger risks in the future. This has created a breakdown in market discipline, as market participants take on larger and riskier bets, with the expectation of benefiting from the higher potential up-side, while being bailed out by taxpayer money in the event of a down-side. Government takeover will teach these banks that in the future, untamed risky behaviour can have bad consequences, and government bailouts come at a price.

2. Banks are inherently risky, and the current crisis of confidence is not helping any. So here we are, with giant, inter-connected banks loaded with toxic securities, and no willing market to buy them out. No bank would of course unload them at firesale prices, and no body knows how much of these toxic securities are in each bank’s books. A consequence of course, is the loss of credibility of banks among each other. No bank will lend to another bank that can, at an instant, need to liquidate at firesale prices, and default on its borrowings as a result.

Asymmetrical information abounds in most financial transactions. This creates an imbalance of power in transactions, which have great potential to go awry. Because of increased economic concentration among financial institutions, and asymmetrical information, there are now, more than ever, greater opportunities for moral hazard. Market actors have lately been acting with impunity, with the expectation of relatively low downside due to societal bailouts of failure. This was the case in many of the recent financial transactions that have recently undermined the capital markets. This is a principal reason the financial crisis has reached epic proportions.

Government takeover will help stabilize the financial markets, as bank equity will no longer be driven by risk-averse private sector speculators. It will help shore up waning confidence among counterparties, depositors, and creditors, who need to know that they are dealing with a stable entity that is not out to unload questionable risk on to unsuspecting parties.

3. Banks are still populated by risk-chasing, bonus-obsessed me-first capitalists. This cultural mindset is deep-set, and comes from more than quarter century of unrelenting encouragement of cowboy risk-taking by ‘big swinging dick’ traders and bankers. This needs to change, and may only come under government ownership.

Wall Street still believes, often rightfully, but many more times not, that its biggest assets are the ones who go down the elevator every evening. As a result, many firms are always apprehensive that, if unhappy, their biggest producers could leave any time to go to the first competitor willing to pay more. So, in the midst of a big recession, when the rest of the economy goes down the toilet, while bank after bank requests, and receives, a government bailout, financial firms are still handing out generous bonuses. Even the very same firms who have received the bailouts!

4. Pursuit of profit sometimes goes in the way of banks’ ultimate goal – facilitating trade. A private, for-profit company’s objective is first and foremost to make a profit. If the company’s shareholders are of the shareholder value maximization school, they will want to maximize profits first and foremost. Any gains in monopolistic power that translate into greater economies of scale can therefore lead to greater opportunities for these same players to further increase their gains over competitors.

In frantic efforts to chase after profit during the boom, banks continually undermined their own lending standards. More and more aggressive practices emerged, as bankers tried to outdo one another in landing the transactions that seemed theirs for the taking. All were done to keep the juicy profits flowing to their own institution. It was always easy to justify that, since every other financial institution was doing the same, keeping their banks out of the game would only make their own shareholders unhappy, and encourage their more ambitious employees to jump ship, and do the same scams elsewhere. As one famously put it, when the music started, you had to dance.

Remember the proverbial “the bank gives an umbrella to you when you don’t need it and takes it away when you need it”? Well, now, to keep their financial institutions viable, particularly in a declining economic environment as this one, bankers have had to pull the plug on their crucial lending activities at the worst possible time, when borrowing firms need money to remain viable themselves.

To keep the corporate market afloat, the Fed has now been buying commercial papers itself. It is jumping into the market because banks have been hoarding capital, and have been reluctant to lend money out at any cost. It is guaranteeing all inter-bank lending, also with the aim of jumpstarting a non-existent inter-bank credit market.

It’s becoming more evident that the US Treasury’s capital infusion into the banks is unsuccessful in jumpstarting lending. Lenders have been pulling back on credit lines for businesses, mortgages, home equity loans and credit card offers, and analysts have said that this was unlikely to be reversed by the government’s money. Outright government ownership would now seem much more effective in getting credit flowing again, given the reality we are seeing.

5. It is getting harder to regulate banks, who are always a step ahead in arbitraging regulation. Ideally, the banks remain private institutions, regulated with great scrutiny by the Fed. But to be able to this monitoring adequately, the Fed will have to drastically increase its personnel. It needs to do so to beef up its expertise in watching over securities firms, whose activities have been becoming more complicated, thanks largely to the accelerating pace of financial innovation. Actively regulating the new and much-broader activities, especially of the financial supermarket firms, will only increase the federal budget, and yet, in my opinion, bankers who still wish to circumvert the Fed’s policies and regulations will always be one step ahead of the regulator.

Government ownership of banks will put a momentary brake on unbridled financial innovation, limit the need for more expert bank auditors who at the end of the day can do nothing more than arms length examinations, and, with a first-hand view of banks, get the government up to speed on what the financial market has been up to these past few years.