Why the case against nationalization may be flawed?

In one of the more convincing cases made against nationalization, Alan Blinder says that the complexity of the US banking system and financial markets militates against it. Unlike the Swedes who had to deal with just a handful of banks, there are more than 8300 banks in US. He points to essentially two main concerns,

1. Domino effect on other banks - Nationalization of a few banks would leave the others vulnerable on two counts. First, especially in such times of deep uncertainty about counter-party risks, the remaining banks would need to pay much higher interest rates to attract depositors and other creditors, and consequently their profitability would suffer. Second, the share prices of the remaining banks would fall, and short sellers would only drive it down even further.

2. Management challenge - The challenge of managing the massive and complex financial behemoths and their transition back to the private ownership. And the strong possibility of political interference and corruption, a feeling exacerbated by the numerous examples of greed, coprruption and cronyism that led to the sub-prime mortgage crisis, only complicates the task.

While the objections are very real and valid, these are not unsurmountable. The domino effect can be overcome if the nationalization is comprehensive, both in its coverage of assets (instruments) and institutions. This means that the stress tests should be universal and standards rigorous enough, and the take-overs should be swiftly done in one stroke.

The management challenge may not be as difficult as it appears since a few large institutions dominate the US banking sector. As Paul Krugman points out, the four biggest US commercial banks – JPMorgan Chase, Citigroup, Bank of America and Wells Fargo – possess 64% of the assets of US commercial banks. Further, banking take-overs into receivership is an ongoing process and the FDIC has enough experience in managing such banks. In any case, as James Kwak and Simon Johnson point out, the government is already responsible for a large portion of bank liabilities, through insurance on deposits and new bank debt and is the only source of new capital for banks.

It needs to be borne in mind that the choice is between all bad alternatives to private management. To para-phrase Chiurchill, nationalization appears to be the worst option except all the others under consideration. The case in favour of nationalization is laid out here, here, here, here, and here.

Finally, Blinder proposes the "good bank - bad bank" solution, which would break each sick institution into two. The "good bank" gets the good assets, presumably all the deposits and a share of the bank’s remaining capital. As a healthy institution, it can presumably raise fresh capital and go on its merry way as a private company. The "bad bank" inherits the bad assets and the rest of the capital — which, after appropriate markdowns of the assets, will not be enough. The tax-payers will have to cough up the required capital.

This proposal runs up against a few serious objections. How do we split the bank capital between the good and bad banks, especially given the difficulty of valiung the bad assets? Using the same complexity arguement (both political intereference and compex shareholding patterns), is there not a serious danger of shareholders benefitting at the cost of tax-payers, leaving open to charges of shareholder bailout? How do we differentiate the good from the bad assets? Is there not a moral hazard dimension, as the management tries to minimize its risks and off-load all risks into the bad banks? Further, given the fact that many of the bad assets are virtually worthless and cannot be expected to yield anything even in the future, is there any point in keeping them in the balance sheets of the bad banks? In such uncertain times, can anybody be even remotely sure about the "markdowns" the assets of the bad banks will have to suffer from?

And all this presupposes that the financial markets will rebound in the medium term. If as Nouriel Roubini suggests, the recovery is L shaped, the tax payers may end up paying virtually all the liabilities of the bad banks. In other words, the greedy Wall Street managers and their shareholders will have the last laugh - heads I win, tails you lose! Or a classic case of privatizing the gains and socializing the losses!

Update 1
James Kwak sums up the debate on reviving the banking sector. He writes, "I think there are three main positions in this debate:

A1: The banking system is broken. Banks need to get rid of their toxic assets and they need more capital. The solution is for the government to buy their toxic assets at a high price (or insure those assets) and to give them lots of cheap capital.
A2: The banking system is broken. Banks need to get rid of their toxic assets and they need more capital. The solution is for the government to take them over, transfer off their toxic assets, recapitalize them, and (when possible) sell them back into the private sector.
B: The banking system is basically sound and will recover if we give it some time. In the meantime, the government should give the banks just enough money and intervene as little as possible to keep them afloat until asset prices recover."

Kwak feels that A2 is the best alternative, and is in keeping with the best traditions of capitalism. The Obama administration is following B.