After a generation of increasingly relaxed regulation of the financial services sector, the very concept seems stunning: Nationalization of banks in Europe and the United States. But with many global banks still teetering on the brink of insolvency — even after rescue efforts that have included multi-billion dollar infusions of capital and other forms of assistance — a growing number of economists now argues that government takeovers of the most deeply troubled institutions, at least temporarily, may be the only remaining solution.

In the U.S., former Fed chairman Alan Greenspan has unexpectedly joined a list of notable financial experts who believe some banks may have to be nationalized temporarily. Additional surprising converts include prominent Republican politicians such as Sen. Lindsey Graham of South Carolina and former presidential candidate John McCain.

Many Wharton faculty also agree. Among them is Wharton finance professor Franklin Allen, who argues that a temporary nationalization of the affected banks is the only way to remove the top executives who helped trigger the financial crisis, while ensuring that the interests of taxpayers are valued over those of stockholders and bondholders. “This is not something the government should be doing in the long run,” says Allen. The banks should be nationalized “for however long it takes for things to get back to normal. I would imagine that would be less than three to five years.” Like other advocates of bank nationalization under the current circumstances, he points to the example of Sweden, which nationalized its banks during a crisis in the early 1990s and for the most part privatized them again once they had been stabilized.

The U.S. is not the only Western economic power in which recent talk of bank nationalization abounds. Ireland nationalized Anglo Irish Bank in January and has spent some $9 billion to recapitalize Bank of Ireland and Allied Irish Banks. In Berlin this week, the government said it would prefer to take a majority stake in Germany’s struggling Hypo Real Estate Holding rather than nationalize the property lender. “Nationalization is only an option after attempts to take a majority stake have failed,” a government spokesman said. “Everybody agrees that nationalization can only be a measure of last resort if it’s necessary for the stabilization of financial markets and other, less severe solutions” have been exhausted.

There has also been speculation — frequently denied by U.K. Prime Minister Gordon Brown — that the British government aims to nationalize Lloyds Banking Group or Royal Bank of Scotland (RBS), in which it holds stakes of 43% and 70% respectively. Just a year ago, the U.K. nationalized Northern Rock, one of the first banks to suffer catastrophic losses from its exposure to securitized subprime mortgages in the U.S.

European experiments with bank nationalization have essentially treated it as a temporary measure, to be reversed when the financial system returns to normal. In contrast, Asian countries such as India and China have adopted a different nationalization model — which has had results that are often negative. As governments in the U.S. and Europe ponder their own rescue strategies for banks, these experiences could serve as cautionary tales of the risks involved in nationalization.

Fear of Bureaucracies

One reason that bank nationalization has been the subject of more talk than action is the central role that banks play in free-market economies. Critics say that nationalized banks can quickly devolve into inept bureaucracies, prone to politics and other pitfalls.

“Nationalized banks do not generally perform as well as privatized banks because they have much more complex objectives — employment, subsidies to a particular sector or politician — and because they generally have much looser corporate governance,” says Wharton finance professor Richard J. Herring, co-director of the Wharton Financial Institutions Center.  “Employees are generally civil servants and the board is generally packed with political appointees.” 

Even so, Herring agrees that the current crisis in the American banking system is so severe that a temporary nationalization of some banks — serving as a kind of a bridge until new buyers can be located — is probably necessary. Such a framework “provides officials and potential buyers with the time and opportunity to undertake due diligence to make an optimal disposition of a failed bank. I am puzzled about why the Treasury is so reluctant to use it.”

The reason may lie in politics, and the aversion even among more liberal public officials to take steps that could be criticized as appearing “socialist.” One of those hesitant politicians appears to be President Barack Obama, who recently told ABC News he is wary of the Swedish model of bank nationalization because of the sheer size of America’s banking industry. “The scale of the U.S. economy and the capital markets [is] so vast, and … the problems in terms of managing and overseeing anything of that scale,” would be so complex, Obama said, “that it would not make sense. And we also have different traditions in this country.”

But many experts predict that the current crisis may trump tradition. Two large American banks are especially at risk: Citigroup, which received a $300 billion federal aid package — mostly in the form of loan guarantees late last year — and Bank of America, the beneficiary of a similar $120 billion program earlier this year. Many experts believe the two bailouts, despite the massive amounts of money involved, did little to take the banks away from the edge of insolvency, and the federal government can take little further action without becoming the majority stakeholder. They note that Washington is already seeking to impose strict controls without ownership, such as the limits on executive pay that Congress included in the recent economic stimulus bill.

A leading advocate of bank nationalization is New York University (NYU) economist Nouriel Roubini, who recently co-authored a Washington Post op-ed on the topic with NYU colleague Matthew Richardson. They wrote that it may sound “somewhat blasphemous” for economists who believe in a free-market system to advocate a bank takeover by Washington, but they saw no alternative after they estimated that looming losses by U.S. banks amounted to a staggering $1.8 trillion, which is more than their $1.4 trillion net worth. It’s critical, they wrote, that the Treasury Department determine which banks are actually insolvent, take them over, and separate out the so-called “toxic assets” so that the remaining healthy assets can be sold quickly to private investors while the bad loans are disposed of in due time. “We have used all our bullets, and the boogeyman is still coming,” they write. “Let’s pull out the bazooka and be done with it.”

That once-radical position is finding some support. According to Allen, the biggest problem with the current bank rescue plans is that they have not removed the executives who caused the crisis, and have allowed them to continue to collect large salaries, bonuses and other perks despite taxpayer outrage. “We’ve got all this money invested and no control over what they’re doing at all,” Allen notes. “The classic example is what happened with the bonuses at Merrill Lynch, which gets dealt to Bank of America and says that they need $20 billion. The government says ‘yes,’ and then they turn around and hand out $4 billion in bonuses.”

Cleaning House

Like other proponents of bank nationalization, Allen argues that the successful experience of Sweden in the early 1990s should be an example to American officials. At that time, the Scandinavian nation faced a crisis that was strikingly similar to our own: Banks that had been largely unregulated by the government over the prior decade suffered large losses in the collapse of a real estate bubble.

Swedish officials insisted that the banks write down their losses, which wiped out shareholder value. The government then recapitalized some banks in return for an ownership stake. It also created an agency to sell the bad loans. The spending involved was significant — more than $18 billion in today’s dollars in a nation much smaller than the United States — but Sweden earned a significant portion of that money back through the sale of the assets, and even today it still owns nearly 20% of the Scandinavian banking giant Nordea.

“In Sweden they went in and fired all the senior management,” Allen notes. “The shareholders got nothing, but [the government] put the banks back in good shape — it was a better way to proceed.” Allen and other experts note that Sweden’s comprehensive approach was much more successful than Japan’s woeful performance during its so-called “Lost Decade” of the 1990s, when the government’s intervention to help out banks was seen as too piecemeal and not dramatic enough to end a prolonged slump.

Wharton finance professor Itay Goldstein has concerns about bank nationalization in the U.S. Still, he adds, the initial stage of the federal rescue plan showed how hard it is to attack the problems at U.S. banks without the kind of large-scale coordination that comes from a central government. He said that individual banks are reluctant to make loans during the current crisis — even after the initial cash infusion from Washington — because they worry that borrowers will default as the economy drifts deeper in recession.

“There’s also a coordination problem,” he says. “If you feel that banks are not seeing the full picture of their impact on the economy as a whole … taking over the banks could be justified. The costs are huge — it is almost impossible for the government to take over so many big banks and actually control them. I don’t know if the government has the personnel for that.”

“While we’re not happy with the CEOs of the banks, I don’t think many people want the government and a bureaucracy running the banks,” says Wharton finance professor Jeremy J. Siegel. “You could get rid of all these CEOs and say that you’re going to get a new board, but there’s a feeling that you want to keep [the banks] in the private sector.”

Siegel believes the Obama administration should continue along its current path, which aims to separate the banks’ good assets from their toxic holdings, even though he acknowledges that developing such a plan is difficult. He also argues that any additional infusions of taxpayer money should ensure that the banks’ bondholders “take a haircut” in addition to the losses already felt by stockholders who have watched the value of their shares plummet.

Allen says the current response to the economic crisis has been characterized partly by the amount of coordination involving Western governments. He notes that the U.K. has been reluctant to go the full nationalization route because of lessons that it learned during the 1970s, but he expects that stance to change soon. “They were reluctant,” he says,” but now they already own 70% of RBS, so I think they’ll do it.” From the late 1960s through the early 1980s, the British government nationalized nearly a dozen industries, including auto manufacturers, utilities, transportation and aerospace firms. Many of them have since returned to private control.

Mexico also managed what is generally viewed as a successful, temporary nationalization of much of its banking system following the peso crisis of the 1990s. But critics of bank nationalization contend that while this radical solution may look like a speedy panacea for the financial crisis in the U.S., history has not been kind to most efforts — especially a wave of such efforts by socialist-leaning governments in Europe and elsewhere in the generation following World War II. Many of these efforts failed for the same reasons — lack of competition led to inefficient bureaucracies as well as corruption and bad decisions based more upon politics than upon sound business practices.

A Cautionary Tale from India

Bank nationalization has had a long history in India, though it was more a matter of political ideology at first as India pursued socialist-leaning policies after gaining independence from Britain in 1947. This bank nationalization was intended to be permanent — not part of a temporary rescue — thus there are limited parallels to what occurred in India and what is now being contemplated in the U.S. Still, it’s worth noting the effects of bank nationalization on another large country.

In 1955, India created the State Bank of India (SBI) to take over the Imperial Bank of India, which accounted for some 25% of the Indian banking system. Large-scale nationalization took place in 1969, when 14 major commercial banks were taken over by the Congress government led by Indira Gandhi. Another seven were nationalized in 1980. This increased the share of public sector banks in total deposits to 92%.

Several reasons accounted for these takeovers. Many of the banks had been set up by large industrial houses and functioned as appendages of these groups. Discretionary norms were ignored while lending to their parents and a very real danger existed that some of them would collapse. In 1993, when the Reserve Bank of India permitted private banks to be launched, it noted that “the new bank should not be promoted by a large industrial house.”

In addition, with its socialist inclinations, the government believed that the best way to help the farmers and the poor was through directed lending. A “priority sector” was created for such loans. Ministers organized loan melas (or fairs) in which money was distributed without the necessary security or expectations of repayment. Not surprisingly, the banking system was soon reeling under bad loans. Several banks nearly went under and had to be rescued through capital infusions by the government.

Since the reform process started in India in 1991, there have been no new nationalizations. There have been some rescues, however. New private bank Global Trust fudged figures and ended with a negative net worth. It was taken over by Oriental Bank of Commerce in an RBI-orchestrated shotgun marriage.

What has nationalization achieved in India? It has prevented some bank collapses, and it has created a secure and trusted institution: In the current crisis, depositors have pulled out of Citibank and ICICI Bank to put their money into state-owned banks. It has helped bank penetration in rural areas: India has a Composite Index of Financial Inclusion of 48, versus 42 for China. These banks — particularly the largest, SBI — have bucked global industry trends in the current slowdown.

Yet there has been a downside to nationalization. Some banks have had to be recapitalized for their populist lending. The World Bank has been asked for a loan of $4.2 billion for this purpose. State ownership has created lethargic organizations, where creativity and innovation is frowned upon and customer service suffers. Several of these banks are now publicly listed — a fallout of liberalization. But the government still holds majority stakes and it is only recently that the culture in these organizations has started changing. Competition does not exist, in effect.

Chinese Banks: The Opposite Direction

China, where so many companies, including banks, have been government owned, is now leaning in the opposite direction — partial privatization is now a goal.

Since the current administration came to power in China in 2003, policy towards state-owned banks has changed drastically, and reform of their shareholder structure (or privatization) has begun. The first step was a massive injection of state funds: The banks’ non-performing (NPL) loan ratio was widely believed to have stood at 40% or more, but the central government had written off almost all of their bad loans by the end of 2003. A sell-off to “foreign strategic investors” (mainly international financial institutions) followed, with a 20% cap placed on single foreign ownership and a 25% ceiling on cumulative foreign ownership of individual banks introduced before the banks were floated at home and abroad.

But banking privatization remains highly controversial in China. Fierce debates have raged among academics, particularly regarding pricing of shares sold to foreign investors, and the favoritism shown them over domestic investors. However, China’s authorities have pushed forward resolutely with reform. By the end of 2007, China had 24 banks with more than 30 foreign strategic investors sitting on their boards. Over one-sixth of the Chinese banking system is now foreign controlled.

Despite the debate on valuation and fairness in the privatization process, an improvement in China’s banking industry appears evident. Following their partial privatization, banks have introduced governance structures to transform themselves into modern financial institutions, and the NPL ratio has fallen from 30% a few years ago to single digits today. Some observers also comment that the banking environment in China has changed radically over the past 10 years, with better regulation and supervision, better macroeconomic policy making, better internal controls and better borrowers.

Due to its limited exposure to the international capital market, Chinese banks have not been impacted severely by the recent global crisis. In early February China’s big commercial banks, the Industrial and Commercial Bank of China, China Construction Bank, and Bank of China (ICBC, CCB and BOC) ranked as the top three banks globally by market share.

On June 17, 2005, the announcement that Bank of America (BoA) would purchase a 9% stake in China Construction Bank for $3 billion — the most expensive banking acquisition in China’s history — made headlines throughout the global financial media. Jonathan Anderson, chief economist at UBS Asia, commented at the time that it was a win-win strategy for both parties. He was right. On January 7 of this year, Bank of America, under financial strain, sold 5.6 billion Hong Kong-listed shares in CCB at a fixed price of HK$3.92, reducing its stake in the Chinese bank from 19.1% to 16.6%. BoA made a profit of around US$1.1 billion from the sale based on the price of the shares at the time of CCB’s IPO, according to the Financial Times.

On the other hand, although Chinese banks have performed strongly in recent years, their ability to manage risk has not been tested, notes Qian Jun, a finance professor at Boston College. “Most of the Chinese banks haven’t really experienced any true financial crisis, so they have not been tested in the areas of risk management and balancing between financial innovations and generating profits,” he says.

As the experiences of these countries indicate, bank nationalization is hardly a silver bullet that can solve banking problems forever. As consensus grows among U.S. and European economists in favor of nationalization, it may help them to keep these risks in mind.