The net effect of these constraints is that the government would either have to resign itself to a slow process leading to a bank seizure or would have to buy out the shareholders of the bank or its holding company. It seems virtually impossible politically to simultaneously make the case that a bank is in enough danger to warrant a nationalization and at the same time that there is enough value in the banks that the government has to pay off the shareholders.
Reassurance for the markets. The government will need to make its criteria clear to the financial markets in order to avoid undue panic among creditors and investors who own stakes in other banks that are not being taken over. (See Step 9b for more.)
Optimization of the effort. Finally, it simply makes sense to have a clear basis for choosing which banks will be taken over. The government has limited resources, both managerial and financial. These need to be allocated in an efficient manner across the financial rescue efforts, including any nationalizations.
The stress tests currently being run on the 19 largest banks could provide the key data to be used for applying these criteria, because they will produce a detailed analysis of the capital adequacy of the banks under both the expected economic case and a more stringent, pessimistic case.2 However, these results are unlikely to be sufficient on their own as a legal justification. Beyond what is required for legal reasons, there may be additional market signals that could usefully be incorporated into the policy decisions, including stock prices, views of private sector debt and equity analysts, credit default swap spreads, etc.
Step 2: Determine which large banks meet these criteria This step is at one level mechanical. The criteria should be applied to each of the large banks to see which should clearly be taken over and which are on the borderline. Please note that we emphasize “large” banks here. These behemoths are central to the economy in a way that smaller banks are not, simply as a result of their large market shares. The same principles may need to be applied to smaller banks, but the emphasis should be on the largest banks.
As will be discussed in steps 9a and 9b, certain banks that are on the borderline for the chosen criteria may need to be taken over at the same time as those that fall squarely within the criteria. Otherwise, they may be so weakened by that first set of nationalizations that they almost immediately constitute a second round in their own right. In essence, the criteria need to be chosen to provide a “firebreak” between the nationalized banks and the next nearest major bank.
Step 3: Choose when to act There are two broad questions here. Most importantly, should the government wait until nationalization becomes unavoidable or are there compelling reasons to move as soon as it starts to seem likely to be necessary? Put another way, is the test more like in a criminal trial, “beyond a reasonable doubt,” or a
Please see “Bank Capital and the Stress Tests.”