No Future Without the Market

The massive bailouts of banks by European governments raise issues of governance and property structure. State intervention was needed to stave off insolvency: if banks had gone bankrupt, the consequences for the economy of the financial crisis would have been destabilizing. Absent explicit government guarantees vis-à-vis the massive debts incurred by banks, the crisis would have certainly led to widespread panic. There would have been generalized bank runs. Panic was avoided, and panic has a way of overrunning even perfectly healthy institutions with solid balance sheets.

But if public intervention is unavoidable at the present stage, medium- and long-term consequences could be worrisome. The presence of the state in the bank's own capital produces well-known effects, highlighted in a recent study by Bocconi's CAREFIN (Center for Applied Research in Finance). Its authors, G. Iannotta, G. Nocera and A. Sironi, show that nationalized banks are riskier and more inefficient than private banks. But since they enjoy stronger government protection they are deemed more trustworthy than private banks, even if they have worse balance sheets. This biases competition and nullifies the effects of market discipline: the creditor of an illiquid bank has no incentive to sanction risk and demand a higher interest rate, since the bank cannot fail, now that the bank is under government protection.

Markets distrust the government doing the banker's job: as soon as the word nationalization is uttered the stock of the bank in question plummets. Recently, there has been a return to the doctrine according to which credit and savings are areas of public interest, and as such cannot be subjected to the vagaries of the market. After all, it is said, after the 1929 crash, the near totality of the Italian banking industry was nationalized, without jeopardizing the economic growth that took place after the war. Actually, one should wonder how it would have grown if it had had a private banking system instead: probably better and faster. So even if government intervention is needed now, nationalization is likely to have higher long-term costs than short-term benefits.

Saving banks today should not compromise the efficient allocation of credit and competition tomorrow. More effective transitional solutions can be envisaged, such as the government purchase (at market prices) of the toxic assets owned by banks, or for the government to guarantee banks' debts. Something clearly did not work in private banking over the last year, but the state as banker, i.e. no market, cannot be the answer. We will have to reflect upon new rules, once the emergency is over. Ben Bernanke, in charge of the Federal Reserve, has noted that when there's a fire, first you must act to put it out, and then you write the handbook on how to handle fires.