Nationalization of banks is neither inevitable nor desirable

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Yes, the share prices of RBS, Lloyds and Barclays have been crushed. The equity markets simply must adjust to banks' reduced status

The collapse in UK bank stocks last month reflected more than just fear that others would report results in line with the dire forecast from RBS of up to £28 billion ($39.6 billion) in operating losses and goodwill impairment charges for 2008.

The coincidence of that shocking trading update with news that the UK government was converting its high-yielding RBS preference shares into ordinary shares and launching a second banking sector bail-out plan led many investors to conclude that full-blown nationalization of RBS was imminent and might soon follow for Lloyds and maybe others.

John McFall, the Labour chair of the House of Commons Treasury committee, has urged the government to get on with the task of nationalizing the banks as a necessary step in the process of cleansing their balance sheets and restoring their capacity to lend.

This is bad advice. In the absence of urgent need to prevent outright failure, full-scale nationalization is neither needed nor desirable.

Yes, the share prices of RBS, Lloyds and Barclays have been crushed. The equity markets simply must adjust to banks' reduced status.

They have suddenly become an investment backwater. At the start of 2008, Royal Dutch Shell was the largest constituent of the FTSE 100 index with a market capitalization of £134 billion. Beneath it, six banks ranked among the top-20-largest companies in the UK. HSBC was the third-largest constituent, with a market cap of £99.6 billion; RBS ranked seventh at £44.7 billion; Barclays 14th at £33 billion; HBOS 17th at £27.5 billion; Lloyds 18th at £26.6 billion and Standard Chartered 19th at £25.8 billion.

Fast-forward to January 23 and HSBC remained the fourth-largest FTSE stock, worth £64 billion, behind first-ranked BP, worth £91.8 billion. But no other bank ranked within the largest 20 quoted UK companies. The combined market cap of RBS, Barclays and the new Lloyds Banking Group, now incorporating HBOS, amounted to just £17.8 billion. At such low valuations, should the banks need to raise more capital the markets might not provide it, in which case the government will have to.

But full nationalization should remain a very last resort. In other circumstances, such share price collapses might quickly have destabilized the entire business of the banks, spooked depositor and creditor flight and required rescue by the public sector. But that has not happened precisely because the government’s rescue has been a work in progress for five months already. Deposit guarantees have been raised, further guarantees provided for up to £250 billion of senior debt, £37 billion of capital injected and a new asset protection scheme announced to insure banks against fat-tail risk in damaged credit portfolios.

If you still need to nationalize the banks after all that, then you are condemning your own bailout plan as a failure: not a good signal.

The government already has vast economic exposure to the banks as guarantor, and nationalization might permit the accounting and reporting formalities to catch up with this reality. But continued private sector investment in the banks has value. It holds out a requirement that the new business model for banks, which government will now shape through its oversight and direct influence while the banks stand under its protection, should be geared towards the profitable funding of discerning risk-taking for a commercial return. Banks might ultimately become more utility-like but they should and must match their business model to the requirements of private sector investors.

The banks are hugely important to UK companies. They have a big marketplace to rediscover a profitable means of operating and on the back of which to attract private capital.

Private ownership brings requirements for regular reporting, which the proponents of nationalization say is unduly burdensome and at odds with the critical need to restructure. This is the heart of the matter.

The financial system’s failure has been a failure of government as well as of the free market. Governments have shown themselves just as capable of fudging the figures on the public accounts to make them look good as any bonus-greedy executive chasing the next short-term pay-off. Scrutinizing governments through both the established mechanisms of public sector accountability and the regular reporting requirements of the stock market might be the best safeguard taxpayers, investors and customers have for ensuring the restoration of a banking system fit for purpose.

And bank stocks will be a good place to watch for the first signs of sustained recovery.