Step 1: Decide the criteria for nationalization, including legal authority There are multiple reasons why it is critical that the government consistently use a coherent set of criteria for determining whether to nationalize a bank:
Legal authority. This point is sometimes overlooked in calls for nationalization. The Bill of Rights in the Constitution specifically forbids arbitrary “takings” of property, which would include bank shares. Therefore, the government does not have the right to simply seize a bank without meeting specific legal criteria, such as the failure of the bank to maintain a legal minimum of capital to operate. Please see “Pre‐emptive Bank Nationalization Would Present Thorny Problems,” which surveys in much more detail the potential methods for taking over a troubled large bank or bank holding company.
That paper concludes that it would be very difficult under current law to move swiftly to nationalize one of the larger banks, unless the government were prepared to buy out the shareholders and leave the creditors largely intact. The Administration has proposed legislation that would substantially expand the regulator’s authority to take over a bank holding company. If passed, this would ease, but not eliminate the difficulties.
There are two core issues that would make it difficult to swiftly seize a major U.S. bank or bank holding company under today’s laws and economic conditions. First, regulators wishing to seize the bank itself would need to show that it is already very weakly capitalized, or soon will be, and that there are no reasonably possible steps that could be taken to remedy this condition. However, the major banks are all owned by holding companies, like Citigroup, that have maintained large pools of liquid assets which could be added to the capital of their subsidiary bank to prevent a regulatory seizure. Dangerous as the loss of that buffer of liquidity would be, it would be much less painful than losing their key banking unit altogether.
As a result, regulators would have to force a reduction of the accounting value of the aggregate assets of the weakest banks by close to 10% in order to exhaust existing bank capital plus the readily available liquid assets of the holding company that could bolster that capital. This large a hit would strike terror in the shareholders, debtholders, and trading counterparties of all but the strongest other banks since a similar action would wipe out the value of most large banks. That kind of terror would risk the kind of financial meltdown that the government has been at great pains to avoid. A seizure using this draconian a rationale would also be vulnerable to a massive lawsuit, potentially considerably worse than the ones that the government has lost stemming from the Savings & Loan crisis.
Second, regulators do not have the legal authority to seize a bank holding company, nor, in many cases, some of the other key financial subsidiaries. Bank holding companies are “normal” corporations that are subject to bankruptcy law, rather than the special insolvency laws for banks. Bankruptcy law gives the government few if any special rights and does not have an effective pre‐emptive action provision to allow a company to be forced into bankruptcy prior to the point where it ceases to pay its bills on time.