Nationalizing Banks: What’s All the Fuss?

Our country’s banking system was effectively nationalized in October when then Treasury Secretary Hank Paulson called the heads of the nine biggest banks into his office and told them they couldn’t leave before agreeing to take billions of dollars of government money and hand over ownership stakes in return.

At least, that’s one way of looking at it. You could also say bank nationalization began in 1984 when regulators decided that Continental Illinois, then the nation’s seventh largest bank, was too big to fail and put the Federal Deposit Insurance Corporation (FDIC) in charge of it. Or maybe the crucial moment came in 1933 when Congress decreed that small depositors should be protected from bank failures by the FDIC. Or in 1913 when Congress created the Federal Reserve System to halt banking panics and regulate the money supply. (See pictures of the stock market crash of 1929.)

You could, if you really wanted to stretch it, go back to the 1864 advent of the national banking system and the first federal bank regulator, the Comptroller of the Currency. Or even the chartering in 1791 of the partly government-owned Bank of the United States–Alexander Hamilton’s baby, which died in 1811, seven years after he did.

The point is that the current breathless talk about bank nationalization is more than a little historically obtuse.

At least since the founding of the Fed, our banking system has been a public-private partnership. Apart from a few on the libertarian right who think we’d be better off with no government involvement in banking and an even smaller group on the socialist left who would like to see complete government control of the financial system, almost everyone seems to be in favor of continuing that partnership. What confronts us at the moment is not so much a philosophical debate over nationalization as a practical discussion about how best to put the banking system back on its feet. We’re talking tactics, judgments–guesswork.

The Paulson approach was to throw money at good banks and bad alike, so there would be no stigmatized bad ones–in return for preferred shares that promised income for taxpayers but no direct federal control. In the context of the imminent collapse of the financial system that Paulson and Fed Chairman Ben Bernanke feared, this was understandable. Now it’s time for a different approach.

Successful bank cleanups in the past have involved triage, in which government differentiated good banks from bad. That’s been combined with a mechanism to take bad loans and other unwanted assets, like real estate, off banks’ books. Beyond that, there’s no precise recipe. The government response in Sweden in the early 1990s, now cited as a blueprint, involved the takeover of precisely two banks. The rest of the country’s banks remained in private hands, even though the government guaranteed their assets. (See the worst business deals of 2008.)

The FDIC has taken over–nationalized, if you will–14 smallish banks so far this year. The tough questions have to do with the banking giants. Regulators deem them too big to be sold off or shut down according to standard FDIC procedures without risking another market breakdown like the one that followed the collapse of Lehman Brothers. The Obama Administration has already said it will buy shares in banks that need more help, and is negotiating a deal that would give it a big minority stake in Citigroup. But it has so far dismissed suggestions that it should take full control of Citi and other big banks. The argument for a takeover is that it makes executives answerable to taxpayers rather than shareholders. The argument against it is that execs solely answerable to taxpayers won’t take the entrepreneurial risks needed to return their banks to health.

The toughest question of all may come down to which banks actually stand a chance of returning to health. Bank regulators have embarked on “stress tests” of the 19 largest banks to determine that. But it’s not clear how exacting the tests will be, and to be honest, nobody knows for sure how exacting they should be. Judged by liquidation value–what they could get for selling their assets on the open market today–most major banks in the U.S. are probably insolvent and due for a total government takeover. But that isn’t the standard banks are judged by. In a panic, markets for certain assets simply stop functioning, and relying on the market to determine the health of banks means succumbing to panic. Then again, relying on bank execs to price their assets is no good either. Treasury Secretary Tim Geithner hopes to get around this by jump-starting a market for troubled mortgage securities, but he hasn’t outlined how he’s going to do that. So for the moment, we’re stuck with more judgment calls. And guesses.

Read “How to Know When the Economy Is Turning Up.”

See 25 people to blame for the financial crisis.