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Explainer: Western Talk Of Nationalizing Banks Grows

The U.S. government is now the biggest single shareholder in Citigroup.
The U.S. government is now the biggest single shareholder in Citigroup.
The global economic crisis shows no signs of slowing and banks in the West remain particularly hard hit despite the fact that many governments have already injected tens of billions of dollars in hopes of getting banks to begin lending to businesses again.

Now, with the credit market still frozen, governments are considering new strategies. And the debate includes one step most Western officials are loathe to take -- partial or full of nationalization of some banks.

Nationalization of businesses is not something most Western governments like. As one American commentator put it recently, "nationalization is something foreign governments do to American companies; it is not something we do."

So it perhaps unsurprising that in the banking crisis so far, the remedies have focused upon strengthening privately owned banks.

In Washington, London, and across Europe, officials have pumped billions of dollars into banks under various rescue plans. They have cut interest rates to rock-bottom rates so that private banks can borrow money cheaply from the state treasury. They have also invested directly in banks in exchange for shares -- much the way private investors do.

But nothing seems to inspire the banks to start lending again. Instead, the banks have held on to the incoming money to offset the tremendous losses they suffered from speculating on the once booming U.S. housing market.

Now, the realization is settling in that the banks are not going to start lending for some time -- unless they are forced to.

"Governments have been prepared to provide the banks with more capital, and they have done that," says Howard Wheeldon, a financial expert at BGC Partners in London. "However, we have not arrived at any improvement in the overall and underlying credit situation and, in fact, it has got worse. And it has got worse essentially because the very nature of failing to understand, of being able to understand, the strength of a bank's capital and what they have actually got [including] what amounts of dead assets or toxic assets are in there, means that the trust has just not been restored."

The banks hold on to their capital to offset their own still unknown losses and refuse to lend to other banks or businesses until they are certain that those, too, are really solvent enough to pay back a loan. Meanwhile, the economy slows down further.

No wonder governments across the West feel they are standing on a slippery hill, unable to stop sliding downward. As they wonder what to do next, they are increasingly talking of more interventionist measures.

Essentially there are three options:
  • One is for governments to give banks more money, but on stricter conditions that they begin lending more. That can also take the form of offering banks insurance to protect their capital against extraordinary future losses.
  • Two is to create a government-financed bank -- a "bad bank" -- that would buy up the bad assets of troubled banks. This would help assure the health of the other banks, enabling them to both attract more investment and resume lending.
  • Three, is for the government to seize troubled banks and operate them themselves, that is, nationalize them.

The speaker of the U.S. House of Representatives, Nancy Pelosi, alluded to that option on January 25. Pausing in the middle of a debate about how to strengthen banks, she said, "Would we have ever thought we would see the day when we'd be using that terminology: 'nationalization of the banks'?"

Wheeldon says nationalization is widely considered to be the most drastic of the three options, and the one to use if the others fail.

"Nationalization is the very last possible route when all else has failed," says Wheeldon. "While smaller banks may well be nationalized, I think the solution to this problem is the formation of the 'bad bank' and I think that is really what the markets are looking to as the way out."

But even so, talk of nationalization is growing, partly because some observers already see a kind of creeping nationalization taking place.

Over the past few months, both Washington and London have acquired shares in several major banks in exchange for investing in them as part of rescue efforts.

The U.S. government is now the biggest single shareholder in Bank of America (6 percent of its stock) and in Citigroup (almost 8 percent).

Similarly, the British government has become the majority shareholder of the private Royal Bank of Scotland (some 70 percent of its stock).

By becoming the largest single shareholder, the government is able to exert enormous pressure upon the banks to do what the government wants -- for example, to start lending money.

Elsewhere, Iceland has fully taken over all three of its major banks. Ireland has done the same to the Anglo Irish Bank.

But is there likely to be widespread nationalization of banks worldwide in response to the crisis?

There are several points that any government is well advised to consider.

First, nationalization can be a risky strategy. When governments start taking over banks, investors try to flee ahead of time from the banking sector.

Why? Because nationalizing a bank means the government buys all the bank's shares from the shareholders at their current, depressed value, not at the price the shareholders originally paid. Thus just rumors of nationalization can spark massive sell-offs of stock by shareholders, bringing banks crashing down.

Second, once a government nationalizes a bank, the government itself comes under tremendous political pressure to lend to avoid necessary but unpopular steps that private banks routinely take to stay healthy. Those include repossessing and selling off the homes of people who cannot afford to make their mortgage payments.

But there are also benefits to nationalization. It guarantees that ordinary savers do not lose their life savings in bank crashes. And because the government assumes responsibility for a bank's bad debt, nationalization restores the bank's liquidity, and assures it will begin lending again.

A case in point is Sweden's experience in the early 1990s. Stockholm seized a vast portion of the banking sector to rescue the banks after a frenzy of real estate lending similar to that recently in the United States. After a few years of state ownership, the banks were re-privatized and emerged much stronger than before.

These are all issues likely to be hotly debated further in the coming months. But what everyone can already agree on today is that the banking crisis is so bad that all options are worth considering.