(Don't Fear) the Receiver

This week, President Barack Obama called for the 19 largest banks in the country to undergo “stress tests” to determine whether they are adequately capitalized to withstand a significant economic downturn. Critics have claimed that the government’s worst-case economic condition forecasts are too weak, making the tests inadequate. Still, the tests should provide valuable information on the health of our banking system, and the administration was wise to order them. Should the results eventually show that any major bank is undercapitalized, the government should not hesitate in taking it into receivership.

Dramatic action in the banking industry is crucial, since the effects of the $787 billion American Recovery and Reinvestment Act will be strongly diminished if the credit crunch continues. The weeks spent debating the merits and drawbacks of the stimulus plan cannot go to waste. In an ordinary recession, the Federal Reserve could cut interest rates to get credit flowing, sparking the economy. However, in the words of our president in an interview with ABC News, “…we are in not just an ordinary recession.” With the target for the Federal Funds rate against the zero lower bound, the limitations of the Federal Reserve are quite apparent. Since no one can trust a bank’s balance sheet, laced with so-called toxic assets, the economy continues to be threatened. Our legislators are left two main choices: Inject the banks with more capital and hope for the best, or take over insolvent banks, wipe out shareholders, replace the executives, and make the bondholders the new shareholders.

After the bursting of Japan’s asset bubble in the late 1980s, its economy showed little growth in a period known as the “Lost Decade.” Over the following years, Japan injected capital into banks that were likely to be insolvent so that they could stay open without dealing with the reality of their liabilities. This story sounds grimly similar to the Troubled Assets Relief Program, by which the Treasury handed $700 billion to the nation’s banks with little positive result. The consequences of the Japanese—and hence our—rescue plan, according to Adam Posen of the Peterson Institute of International Economics, “is that the banks’ top management simply burns through that cash, socializing the losses for the taxpayer, grabbing any rare gains for management payouts or shareholder dividends, and ending up still undercapitalized.” A different course of action is necessary.

During the banking crisis of 1992, Sweden forced its banks to write down all of its toxic assets, took an equity stake in a handful of the largest banks at the cost of their shareholders, and eventually resold the healthy assets on the public market. Since the government held the reckless banks and their shareholders accountable, some officials say that, after the banks were reprivatized, the total cost of the bailout was close to zero.

Though Sweden is, of course, an attractive model, we must remember that it was successful because the banks were successfully reprivatized. We must make sure that, if we do nationalize the banks, we minimize the barriers for the private sector to buy healthy bank assets in the future. Also, we must limit this approach to the banking sector. Not all companies should receive this special treatment—in the automotive sector, for instance, we must strongly consider allowing firms to fail if they cannot compete in the open market.

President Obama has acknowledged the success of the Swedish model, but he says that “cultural differences” and the relative complexity of our banking system make the model unfit for America. However, only the 19 biggest banks would be up for government receivership. Moreover, keep in mind that the FDIC takes over small banks all the time. Even Alan Greenspan, the image of free-market capitalism as Federal Reserve chairman from 1987 to 2006, has acknowledged that, “once in a hundred years, this is what you do.” Now is certainly looking a lot like one of those times.