Thursday, 19 February 2009

A true capitalist solution to the banking crisis

In an interview in the London Financial Times, former Federal Reserve Chairman Alan Greenspan has made a stunning turnaround: he now believes that a temporary nationalisation of significant portions of the US banking sector is required.

Well, one could be sarcastic about those words coming from a man whose near-religious beliefs in the self-regulating forces of capitalism led him to introduce still more lax standards of regulation and work for the same to happen across the world. But strangely enough, aged 83, he appears to be faster on the button than many of his younger students.

Of course what leads Greenspan to this 180 degree turn is that despite mind-numbing amounts having already been thrown at banks have not had the desired effect. Bank lending remains seriously constrained, the banks are notoriously unwilling to come out and be honest about the correct amount of losses, and, most provoking of all, bankers appear to believe they still deserve bonuses. Even if the funds come from the tax payers.

Banks have no incentive to be honest
The key here is that the banks are still not honest about the real amount of losses. There are probably two reasons for that. One is that they do not know, since now where the economic downturn is hitting the loan books, it is a difficult call to guess delinquency rates in the near future. Except of course that credit losses will begin to mount in the coming months. The other is that there is a stand-off between the banking sector and the US lawmakers. By proxy, the outcome of this standoff will probably set the standard for what will happen elsewhere.

Banks of course hope to receive a maximum amount of cash while to the fullest extent trying to avoid limitations to their activities. Lawmakers have been struggling to find various models to avoid that banks receiving cash injections spend the received money in unwanted ways. Hence the suggestions that in order to receive more money, the banks should comply with certain rules.

This situation is not to be understood in the terms of bankers being immoral (which may indeed be the case), but in terms of banks being competitive entities trying to maximise their long term survival and profits. Their strategies are obviously determined by the existing playing field. In this case the playing field is determined by the models for rescue being discussed.

Getting out of the pinch
Being a bit crude, there are three ways out of the current stalemate. Two are being mulled over again and again in these weeks all over the world. One is to create a government-sponsored bad bank which will buy the bad assets off the banks, who after this cleaning will have much healthier balance sheets and hence can go back to their intended activity, namely taking deposits and giving credits. Another is to recapitalise the banks and issue a guarantee for their bad assets.

In both cases the banks will have an interest in receiving a maximum amount of money for their bad assets, as this will position them favourably for the titanic struggle for dominance which will break out once the downturn ends. So either the government will overpay for bad assets or issue too large guarantees while being in a situation that they will have to continue pouring money into the banks as credit losses mount. We have already seen the effects of lining up the choices this way. In the US banks have received some €350bn in help and it is fair to say that this amount has not helped at all. The banks are not saying it openly, but a lot more money is needed if the banks are to be rescued. In the UK, where we are bit further down the road than in the US, nationalisation is creeping in as losses mount.

For buffs, it is a simple game theoretic situation where the banks hope to maximise their pay-off (at the expense of tax payers) by not supplying the correct information to the public. A sort of "Liar's Poker" if you want....

Given this situation, it is surprising that politicians are not discussing the third option right away: a temporary nationalisation. Sweden set a precedent for that in the early '90s, where the banks had got themselves in a pinch by excessive lending to the property sector. Banks were simply taken over, management and boards were kicked out, bad assets lifted off the balance sheets and sold off in the market a few years in a bundle. After some years, the banks were again sold in the market, and actually, Swedish tax payers appear to have made a small profit on the whole transaction. In the meantime, it did not really matter at what price the bad assets were evaluated or indeed how the balance sheet of the banks looked, since it all was part of the government balances.

A capitalist model
But this sounds as pure socialism, so for sure it should not be used as a model?? Think again. The Swedish model is in fact more conforming to the market than any of the models currently being discussed in the US or elsewhere.

If you own a substantial part of a business, but do not put in place a board who controls the management properly and act in your interests, you may lose the business and with it of course the money invested initially. If you do it right, you win. If you screw up, you lose. Nothing could be more capitalist. But strangely enough, this principle is apparently not popular when it comes to the banks across the world right now.

Instead the owners (i.e. the shareholders), who have not put in efficient oversight, and who have permitted the management to run the banks into the ground, now argue that taxpayers should compensate them for lack of business success? This is more socialist than to let the banks fall and let shareholders, board and management pay for their follies.

Apart from being yet another sign of the monumental greed and talent for self preservation rampant among bank managements, arguing that the taxpayers should bail out the banks is based on a serious misunderstanding of what needs to be saved and what is not really necessary.

The Swedish politicians were very clear that what needed to be saved were not the individual banks, but a banking system that would be able to act as the all-important intermediary between savers and borrowers. And that will not work without confidence and a high degree of transparency. They created that by acting swiftly and radically.

A lot of banking activities are nice to have, but definitely not "need to have". Securitisation of dud mortgage loans is an example of something we could do without. Or totally unregulated credit default swaps, to name another.

In the current situation, every bank across the world knows that the next competitor is economical with the truth. So the entire banking system, despite astronomical amounts already spent, is still not in a situation to resume normal lending activities.

Meanwhile the world economy is contracting at a disturbing phase. Every major financial institution has postponed the end of the downturn to 2010. Banks will begin to see serious losses on normal commercial loans in a few months.

The quicker we progress towards the true capitalist solution, and nationalise the banks, the better.