The Swedish model is the best hope for western banks

by Christopher Wood

Financial Times FT.com (January 20 2009)


As newspaper headlines are full of stories about more forced capital injections by governments into leading American and British banks, it has surely become time to end the present ad hoc approach to the intensifying banking crisis.

In the US and Britain most of the big banks have now become a weird hybrid of public and private sector, given growing government equity stakes in these banks. This raises the issue of the deeply flawed policy response to the crisis. This is that if the authorities are not prepared to let insolvent financial institutions go bust, which would be the quickest, most effective way to correct excesses, as the Lehman precedent demonstrates, the next best way is to nationalise the, in effect bust, banks outright. This remains the opposite of what is happening in the US and the other country most vulnerable to an imploding financial services sector, namely Britain. Rather, what is happening is nationalisation by stealth.

This approach reached its ludicrous extreme in the November bail-out of Citigroup, where the US government put more money in than the entire market capitalisation of the company on the day the deal was announced. But the taxpayer ended up with only a 7.8 per cent equity stake while incumbent management was left in place! Yet now, just two months later, still more taxpayer money looks as if it is about to be poured into Citigroup, while a similar sweetheart deal has been done with Bank of America.

This approach is a recipe for gross conflicts of interest. It means the institutions receiving taxpayer money are encouraged to continue to avoid ultimately necessary writedowns because of the hope of yet more bail-outs. Yet the reality is that there is an established template for what to do in banking crises if governments remain determined, as they do, not to allow bank failures. That is the Swedish model of the early 1990s.

Under this model banks were nationalised, fully aligning the interests of the institution with that of the taxpayer, while the depositor was fully protected. In the process shareholders were in effect wiped out, as they should be, and incumbent management was replaced, as it should be. This left none of the massive conflicts of interest, as well as perverse unintended consequences, caused by the present anomalous situation in the west where too many banks are being rewarded for failure - leading, incidentally, to a massive competitive disadvantage for those banks that managed their affairs more prudently.

A crucial principle of the Swedish model is that banks were forced to write down their assets to market and take the hit to their equity before the recapitalisation began. This is of course precisely what has not happened in either the US or Britain, where too many policy measures seek to delay asset price clearing and only add public sector debt on top of existing private sector debt. This is why the current approach in the west to the banking crisis can be compared more accurately with Japanese policy in the 1990s, and that clearly did not work. The outcome, as then, is increasingly zombie-like banks.

The ultimate endgame in countries such as the US and Britain is still likely to be full-scale nationalisation of most of the banking system, as the logic of such action finally becomes overwhelming. But it would be much better if this were done proactively rather than reactively, since it would accelerate resolution of the financial crisis. This is why nationalising the banks would also be bullish for stock markets, if not for the specific bank stocks themselves - although, obviously, there are powerful vested interests wanting to prevent such an ultimate course of action.

Another point about nationalisation, as in the Swedish model, is that it allows the government to separate the bad assets from banks' balance sheets and place them in one big "bad bank". This should enable whatever is left of the smaller "good" bank, which should be managed by old-fashioned commercial bankers, to become a viable private sector operator again more quickly. Another more technical, albeit important, point is that, given that many of the bad assets in this cycle will be derivative- related in some form or other, where two nationalised banks have been counterparties to the same transaction the derivative deal could be in effect terminated or cancelled because the government would be the owner of both entities. In this respect the limited number of counterparties in the $55,000 billion (as estimated by the International Swaps and Derivatives Association in mid-2008) credit default swap market could suddenly become a positive and not, as now, a systemic negative.

It is true the Swedish model is not a pain-free panacea. It would just mean the beginning of an orderly work out. Unfortunately, the deflationary pain is inevitable because of the scale of the credit boom of recent years, the excesses of which were ignored for so long by the relevant central bankers.
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Christopher Wood, equity strategist for CLSA Ltd, in Hong Kong, is the author of The Bubble Economy (first published by Atlantic Monthly Press, 1992)

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