Tuesday, October 14, 2008

Banks in Trouble - Governments to the Rescue

European leaders and now the US have followed the UK example to take shares in struggling banks. Rather than buy bad debts, governments are taking an unprecedented stake in their major banks in an effort to recapitalise their balance sheets.

There was a time when the British Labour party was ideologically committed to nationalisation. The famous Clause IV of the Labour party constitution promised 'common ownership of the means of production' (before Tony Blair changed it - remember the days of New Labour?)

Gordon Brown has said that the government is in the business of protecting banks from going bankrupt and not in the business of running banks. The government has said that whilst the government will take part ownership, it will keep the running of banks at arms length. However, early evidence suggests that this arm may be very short indeed.

Already, the government has shown it can't resist making digs at executive pay and making the banks promise to limit the pay for banks. The government has also apparently made the banks promise to keep mortgages available to first time buyers.

These are both laudable policies, which will be popular with the general public. But, it raises the big question - is it good for governments to meddle in the running of banks and industry?

Arguments for Public Ownership.

Private Sector ignores externalities and social issues. Governments can run industries to maximise social efficiency. For example, private banks may be keen to repossess homes, a government run bank may be able to avoid home repossession. In transport, private run buses and trains ignore the positive externalities involved in public transport. The government could promote

Taxpayer can benefit from Dividends. The government is now a major shareholder in a potentially very profitable industry. The dividends can be used to reduce tax payments.

Market Failure. By pursuing short term profit maximisation, it is argued private firms may make bad decisions which harm the industry and wider economy. The banks inability to understand the risk involved in credit default swaps and speculating on the derivatives market is a good example of this irresponsible 'free market' activity.

Problems of Public Ownership.

Poor Incentives. The argument is that private firms responsible to their shareholders will try hard to maximise returns. Government owned industries invariably lack incentives to compete, innovate and maximise returns.

Government Meddling. The government struggles to resist meddling for political reasons. For example, the government may put pressure on banks to offer attractive mortgages to first time buyers because this will help the housing market. However, critics argue that the government could ignore market signals that house prices need to fall and therefore, artificially keep house prices too high; unwittingly the government could start another boom of excessive mortgage lending. Critics argue that the problem of Freddie Mac and Fannie Mae was government insistence they be willing to lend to all income groups.
  • Even limiting executive pay may have its problems. Only the most foolhardy city financer would try to defend bonuses being paid to executives who lead their bank to bankruptcy. But, supposing government owned banks imposed salary caps for executives and managers. The fear is that they would then struggle to attract the best executives and therefore the performance of the bank would suffer in the long run.
Tax Payer is Liable. My hope is that the government have a good deal with buying shares in the banks. But, if things are worse than expected, the taxpayer could be liable for huge losses. This increases the national debt. Also the fact that the government won't allow banks to fail could encourage banks to lose the incentive to worry about bankruptcy.



Michael said...

Of all the various rescue packages that would have been on offer, the (entire?) troubled financial world seems to have followed the UK model. Why?

Tejvan Pettinger said...

Mainly it offers a way to recapitalise banks and give the taxpayer the best chance to get their money back in the long term.

Buying bad debts is fraught with problems because the government may end up with useless stocks that doesn't solve the credit crisis.

Nationalising banks also seems to give general public confidence in banking system. This is important.

Difference between UK and US bailout

Tejvan Pettinger said...

also see: Krugman:


Anonymous said...

Would you be able to explain Lehman Brother's crisis and how Barclays Capital and Nomura have helped?