[Pen-l] The Swedish model for bank bailouts?

[Ann Davis <davisa@xxxxxxxxxx>]

The Swedish model as a solution to the bank crisis, as proposed in the
Financial Times.
Ann

The Swedish model is the best hope for western banks

By Christopher Wood

Published: January 20 2009 02:00 | Last updated: January 20 2009
02:00

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 $55,000bn (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


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