More Cries For “The Swedish Model” To Fix Banks

For going on a year now, the U.S. government has tried to fix our insolvent banks with a patchwork of capital injections, secret backroom deals, and denial.  Not once has the government responded to the chorus of economists howling that there is a tried and true way of fixing banks: The Swedish Model.  Finally, however, the cries may be growing too loud to ignore.

What is "The Swedish Model"?

• Write down value of bank’s assets to nuclear winter levels
• Recapitalize bank

What’s missing from the way we’ve done it so far?  Writing down the value of the bank’s assets. 

Instead of doing writing down assets, we’ve allowed the banks to argue that someday, in some universe, their assets will be worth what they say they’re worth.  When they can no longer say this, we’ve handed them enough taxpayer money to get them to next quarter.  

Below, Christopher Wood lays out the case for the Swedish model in the FT.  Paul Krugman made a similar argument yesterday.  As did we.  If we’re lucky, we’ll begin hearing more screams for sanity on this score.  Perhaps soon the cries will even grow too loud for the Obama Administration to ignore.

Christopher Wood, FT: Under [the Swedish] 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* 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 workout. 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.

Read whole article here >

See Also:
Why Are We So Afraid To Fix Banks The Right Way?
Wall Street Voodoo (Paul Krugman)