Socialist banking...

Throughout the current financial crisis the threat of the requirement for widespread bank nationalization has loomed large in many countries around the world. With it, much has been made of the "necessity" for banks to remain firmly within the private sector, as it's only from that position that they can act as the engine room of private enterprise - the suggestion being that government owned banks will be inefficient in the process of allocating capital across the economy. It has always been somewhat of an oxymoron, at least to me, to think of banks as strictly private sector enterprises at any point in time anyway.

Sure, they have private shareholders and, yes, those shareholders get all the upside of the net interest margin intrinsic to the "alchemy" of banking (lend at a higher rate than you borrow). But, the truth is that the whole banking enterprise itself depends on various governmental safety nets, provided in different forms by the nation states of the world. All of the world’s banks are effectively nationalized in some form or other, and many of them always have been - it has just been implicit as opposed to explicit support.

I would argue that this divide doesn't matter as much as many commentators would suggest - the real discussion should be about whether incentives are correctly skewed. They haven't been in the past, as governments and their taxpayers have effectively owned all of the "downside" of banks (i.e. picking up the pieces after bad lending), but shareholders and employees have owned all of the "upside". The real debate really should be focused on how these incentives can be more fairly skewed in the future, without completely removing the willingness of banks to take risks.

Private sector banking has not truly existed in the United States since the Federal Reserve bank in 1913 allowed regional banks access to the discount window, where assets can be posted for loans to pay back flighty depositors. A second "sleep-well" governmental safety net was introduced in 1933 in the form of deposit insurance, in which the federal government insures that deposits - up to a point - will always trade at 100% of their nominal sum, regardless of how foolish bankers may be on the other side of their balance sheets.

The fact is that there is no use getting all ideological at the current time about keeping banks private, because they never really have been. What is understandable is that countries don't want to record their national banks liabilities "on balance sheet" - but these banks are, and since the early part of last century have been, contingent liabilities of governments and their taxpayers.
Ideas of nationalization, or the creation of "bad banks" by state bodies and various derivations of these, are methods that are being discussed to address the current shortage of capital in the worlds banking system. In and of their name, none of these solutions are necessarily trump cards - the devil is really going to be in the detail of any solution's structure. The solution we want is one where investment decisions are driven by economic value rather than political dictat, but at the same time capital formation has positive spillovers so there is good justification for it to be publicly subsidized.

How best to meet those objectives is a structural rather than an ideological question - yet many commentators seem to get caught up in standing firm on one solution over another for purely ideological reasons. I think many of them are missing the point.

Over the course of the past couple of months this debate has taken center stage in various countries. Currently it’s at the forefront of economic and political debate in Ireland, where banking woes have left the six main domestic lenders effectively insolvent in all but name. Badly timed or simply ill-judged loans to property developers are hung on balance sheets like bad smells, with limited deodorant available to minimize the odour. As the marketability of these loans has fallen so has the capital adequacy of each of the banks. It’s estimated that there are EUR 90bn worth of problem loans, which are virtually unmarketable at any realistic pricing levels. If these loans were written down by 50%, which is a potentially optimistic market clearing level, then the EUR 45bn hit would be equivalent to twice the core equity base of the main six banks. On these terms the banks are comfortably insolvent – so in a legal sense should not be trading at all. Understandably, private sector investment in the banks is fairly hard to come by currently without some form of very explicit government support or intervention.

The current ‘golden’ solution in Ireland is a form of “bad bank”, to be managed by a new government organization called NAMA (National Asset Management Agency). Their job will be to take these unmarketable loans off the balance sheets of the banks in a sort of mother-of-all exorcisms. The idea being that once these assets are transferred into this new institution, that the "clean" books of the main banks will engender confidence from global creditors and international credit will start to flow back into the Irish banks. In turn this credit will be passed on to domestic based enterprises, which will refuel the core of the Irish economic system. So far, so easy.

As with similar attempted "bad bank" solutions being proposed in the US, and elsewhere, the big question that is at the crux of matters, is what price the assets should be sold from the banks to NAMA. The price needs to ensure that banks capital isn't eroded so much that the government has to take them over fully anyway, or that the price isn't too high such that the taxpayer is being completely stiffed. The price also needs to reflect an acceptable compromise between protecting stakeholders from oblivion and ensuring that they are sufficiently whacked for their past involvement in the excessive risky undertakings of the banks they have been stakeholders in. Shareholders in the banks, for example, deserve to lose everything on the basis of expected write-downs on their loans, and if they don’t then how will the appropriate lesson be learned? On the flipside, if the approach is so penal that private sector investors are turned away from investing in Irish banks for good then that may be a consequence that has no long-term benefit to anyone. Similarly if Irish pensioners with AIB or Bank of Ireland shares are completely written off, then what does that say about the encouragement government has given them to save for retirement in this way in the past? What is clear though is that no solution will be known to be perfect in advance, nor is there a perfect solution for all. Furthermore, the commentators who argue so confidently about the merits of one solution over are deluded in their confidence as these truly are unchartered waters.

The local stockbrokers, Davy’s, said that it expected the banks to take a 15%, or EUR 13.5bn, haircut on the loans being transferred. This conservative estimate would still result in a hit to the main lenders capital that would be comfortably more than their entire stock market valuations at this point in time – so come what may, they will probably need more capital, which will most likely come from the Irish government.

What complicates the whole process is the lack of clarity that any solution will produce a good long-term outcome. Nobody has any experience in dealing with a situation like this, and there are few historical contexts to be learned from. Amidst the confusion there are some stakeholders keen to use this muddlement to their own advantage by confidently asserting the merits or demerits of one solution over another. The well-known Irish financier, Dermot Desmond, for example, has said that he opposes the State taking control of the banks' risky property loans through NAMA under the current plan. He has recently acquired substantial stakes in both Allied Irish Bank and Bank of Ireland - the two biggest domestic banks - and has commented that he could not support an entity "where it's impossible to value the assets". This begs the question as to why he bought the stakes in BOI and AIB in the first place - as if the assets are impossible to value, how did he know what he was buying when he made his investments?

His suggestion is that instead of transferring the assets, they should remain on the books of the banks: "Let's just park it and freeze everything, without gain or loss to anybody, until we know there is a market and then determine what the write-offs are". What he really wants, reading between the lines, is that the "bad" and extremely illiquid assets sit on the banks books and to be rollover financed by the government. The logic being that the current illiquidity of the market has meant that most of these assets are marked down to very low prices, potentially well below a future realizable value. To give an example - a loan to a property developer that is backed by a half built housing estate in Cavan has no current value, because with the developer bankrupt and no new equity available there is no scope for the project to be completed. Consequently the current mark-to-market of the loan if not at zero, will not be much above zero. In theory though, if new equity becomes available and the project is completed the "realizable value" of the bank loan will be higher than zero - to what extent depending on the terms of the restructuring of the loan.

At current mark-to-markets, the transfer prices of the assets in question would literally wipe out the entire capital bases of all the major 6 banks, and in doing so would clear out Desmond's equity investment with it. The game Desmond is playing, is based on the idea that over time as some order is restored to the global credit markets, that the capacity for banks to hold onto their impaired assets and to "work them out" will increase - in the case above, to find a property developer who is willing to take on the completion of the Cavan housing estate. That is currently a luxury of time that the banks don't have. The chances are that in the work-out process the upside versus where these assets are currently marked to market will be positive for the banks equity holders - of which Desmond would be a principle beneficiary. In effect Desmond is advocating the old situation where the government and their taxpayers perform the role of backstop financier, but with all the downside of the banks bad loans, and none of the upside - which would be retained by Desmond and the other shareholders. Hardly a move away from the skewed incentives of the old style banking model that was the foundation of the current mess.

On the flipside, if assets are transferred to NAMA at reasonable prices, and if NAMA is well run then there could be a very decent return on the government's and the taxpayers investment. These are very big 'ifs'. For example - in order to restructure and to "work out" these loans NAMA would require very bright and very commercially minded employees - who will likely cost quite a lot to hire. Hiring at big expense, however, is likely to be completely politically unpalatable amidst the current banker bashing in the Irish media.

The ideal outcome for any solution is one where the economic incentives for both taxpayers who have implicitly supported of the banking system in the past (and who are currently very explicitly supporting it) and those private sector stakeholders, who own the "upside" of banking endeavour, are fairly skewed. To me, this is an almost impossible task as there are so many potential conflicts of interest. Nonetheless, there are merits to many of the solutions that are being proposed around the world, but the effectiveness of any of these solutions over the long-term will be down to the minute detail of their agreement. What's abundantly clear, though, is that the confidence with which many commentators argue the ideological merits of the different solutions is misguided. It's not possible to be so confident about the long-term implications of something so complicated - which when the electorate want immediate answers to why we are where we are, makes things ever harder. May the force be with the decision makers.