Pre-emptive Bank Nationalization Would Present Thorny Problems

Douglas J. Elliott
Douglas J. Elliott Former Brookings Expert, Partner - Oliver Wyman

March 25, 2009

A number of prominent voices have recently called for a swift nationalization of the weakest among our largest banking groups and the press has consistently identified the likely candidates as Citigroup and, to a lesser extent, Bank of America. There are many misconceptions about how a takeover of either of these behemoths could be accomplished. The longer-term negatives mean that such a nationalization should be a “last resort” measure. (Please see “Bank Nationalization: What is it? Should we do it?” for a comprehensive overview.) Even the first step of taking over the banks would be risky and difficult, as this paper will demonstrate.

A swift nationalization of Citigroup or Bank of America would likely require buying out the shareholders. This action would then make it very difficult to force debtholders to bear a portion of the losses, despite the desire of many of those calling for nationalization. This protection of shareholders and debtholders results from the interaction of the structure of our banking system, the public policy rationale for regulating banks, and our constitutional protections of private property, including ownership of banks.

All large banks in the U.S. are owned by holding companies, which are standard corporations, not banks. Our banking laws are designed principally to ensure the viability of the banks themselves, rather than of the holding companies. As a result, there are provisions for the swift seizure of banks that are in deep trouble, but no such provisions to deal with their holding companies. These are governed instead by standard corporate bankruptcy law, which gives the government no special control rights.

The Citigroup and Bank of America holding companies retain a substantial capacity to bolster their banks by taking actions that would be painful for the stockholders of the holding companies, but less painful than allowing the government to seize the banks without compensation. This ability, combined with the substantial capital already at the banks, means that regulators would have to take quite extreme actions to justify seizing the banks. The government therefore seems to face a choice between: buying the cooperation of the holding companies; stretching the regulators’ discretionary authority to seize the banks to such an extent that it could lead to major lawsuits and create panic at other banks; or putting any nationalization on a much slower track.

Each of these options has major disadvantages. There would be great political resistance to “rescuing” the shareholders and creditors of banks that the public perceives to have failed abysmally. However, appearing to be ready to seize banks arbitrarily could cause a “run” on other banks by their creditors, customers, and shareholders, with each group’s reactions magnifying the panic of the others. In addition, the threat of a lawsuit is not trivial. The government has already paid out large sums as a result of losing lawsuits after the Savings and Loan crisis as a result of actions that were judged to be “takings” of private property. Finally, starting the moves that could lead more slowly to seizing the banks without compensation would risk panic by key constituents of Citigroup and Bank of America, making the ultimate nationalization more costly by reducing the value of the banks in the meantime.

Read the full paper » (pdf)