[R-G] [BillTottenWeblog] The Swedish model is the best hope for western banks

Fri Jan 30 02:54:19 MST 2009

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.
_____

Christopher Wood, equity strategist for CLSA Ltd, in Hong Kong, is the
author of The Bubble Economy (first published by Atlantic Monthly Press,
1992)

Copyright The Financial Times Limited 2009

"FT" and "Financial Times" are trademarks of the Financial Times.

http://www.ft.com/cms/s/0/480fd936-e691-11dd-8e4f-0000779fd2ac.html

TO POST A COMMENT, OR TO READ COMMENTS POSTED BY OTHERS, please click
on the word "comment" highlighted at the end of the version of this
essay posted at http://billtotten.blogspot.com/