Bank Nationalization? Not Quite

October 14, 2008 4:45 PM

The United States government has now announced its plan to inject capital into the nation's banking system, in parallel to similar recent actions in Europe. Although the press has reported the plan will "partly nationalize the nine major banks" (Washington Post), there will not be much nationalization at all in a meaningful sense of the word. The early signs are that this action can restore confidence, whereas the announcement of TARP's (Troubled Asset Relief Program) purchase plan had failed to do so. The stock price surge on Monday (October 13, 2008), the fifth largest on record, reflected anticipation of a government plan to recapitalize banks and announcement of forceful similar measures in Europe. However, fundamental constraints on the capacity of the financial sector to expand credit seem likely to remain for some time.

Although some of the nine large banks were reluctant to participate, Treasury Secretary Henry Paulson pressed them to do so for the good of the financial system, in order to avoid a stigma of weakness for any participating bank. The terms of the plan are as follows. First, $125 billion from TARP will be used to purchase preferred shares in the nine largest banks, up to a ceiling of $25 billion or 3 percent of the amount of risk-weighted assets. JP Morgan and Citigroup both qualify for the $25 billion. Second, the shares will pay a coupon of 5 percent, which rises to 9 percent in the fifth year. Third, Treasury will receive warrants amounting to 15 percent of the capital injected in the bank, with the right to purchase the common stock in the future at the price on the day the warrants are issued. Fourth, participating banks cannot take tax deductions on more than $500,000 in salary paid to each top official, nor can they create new golden parachutes. Fifth, participating banks cannot raise dividends without government approval. Sixth, through a closing date of November 14, another $125 billion will be available for similar preferred equity purchases in the rest of the nation's some 8,000 banks, in amounts of 1 to 3 percent of risk-weighted assets. Seventh, in addition to the bank capitalization plan, the Federal Deposit Insurance Corporation (FDIC) will extend its insurance coverage to newly issued bank debt (i.e. bonds, not just deposits), and to all noninterest-paying bank deposits (typically those of small businesses) regardless of the $250,000 limit.

Secretary Paulson opposed proposals for publicly-supported bank recapitalization just a few weeks ago, in favor of purchasing mortgage-backed securities and other troubled assets. However, last week's stock market collapse and seizing up of interbank lending have forced the shift to potentially faster-acting injection of capital. Many economists have preferred such recapitalization over troubled asset purchase all along. But by diluting existing shareholders' equity (even using preferred shares, if tied to warrants at low prices), public capital injection risks pushing bank stock prices down (as has just happened in Royal Bank of Scotland and Lloyds).

Falling stock prices are a powerful signal of bank weakness. There is even an academic literature that measures default probability by stock price weakness. What has happened, however, is that the bank stocks already fell so sharply that any further negative confidence effects from the dilution effect were likely to be dominated by the positive effects from improved confidence of bank survival with higher capitalization.

The new plan would not inject capital in common shares, and the preferred shares would be nonvoting. So the fundamental feature of nationalization—government control—will be absent. That is all to the good, as the history of nationalized banking systems is one of "directed lending" disasters. Even the warrants represent minimal potential control of common shares. The 15 percent amounts to $18.75 billion (for the nine large banks), or 3 percent of their current stock market capitalization.

More fundamentally, President Bush has emphasized that the program is temporary, so in the event of a successful outcome in which the warrants are exercised and make a profit for the taxpayer, the shares acquired will almost certainly be sold back to the private sector rather than being retained to establish a toehold for a nationalized banking system. All this being said, the influence of the government on these and other participating banks will rise to some extent (as illustrated by control over dividends).

The underlying objective of the TARP as originally envisioned and now as recast to emphasize capital injection was to get the banking system back into a position to extend new loans to households, factories, and farms. It seems likely, however, that bank credit expansion will remain far below the pace of recent years even with the new recapitalization plan. Some slowdown was desirable: Bank credit growth rose from an average of 6.7 percent annually in the 1990s to an outsized 11.8 percent average in 2004–07. In contrast, this year the annual pace from March to September was only 2.5 percent. From the standpoint of individual bank prudence, shrinking the balance sheet in order to raise the ratio of capital to assets makes perfect sense under circumstances of far greater uncertainty and doubts about borrowing access.

The more compelling immediate goal is to avoid further outright collapses at the heart of the financial sector, like that of Lehman Brothers. Policymakers would do well to concentrate on that systemic survival issue first and tread cautiously along the path of pressuring banks to expand lending—which could indeed become a form of "directed lending" and partial nationalization. In the meantime, firms seem likely to have to rely more on retained profits, and households more on saving, than in recent years, as part of a healthy process of deleveraging the US economy.