Nouriel Roubini, the economist who famously forecast the current crisis and therefore has more credibility on the issue than virtually anyone else, has this to say about what the government should now do about the banks:
There are three basic approaches to a clean-up of the banking system: recapitalization together with purchase by a bad bank of toxic assets; recapitalization together with guarantees – after a first loss – of the bad assets; outright government takeover (call it nationalization) of insolvent banks to be cleaned after takeover and then resold to the private sector.
Of the three options the first two have serious flaws: in the bad bank model the government may overpay for the bad assets as the true value of them is uncertain; even in the guarantee model there can be such implicit over-payment (or over-guarantee that is not properly priced).
In the bad bank model the government has the additional problem of having to manage all the bad assets it purchased.
Thus, paradoxically nationalization may be a more market friendly solution: it creates the biggest hit for common and preferred shareholders of clearly insolvent institutions and – possibly – even the unsecured creditors in case the bank insolvency is too large; it provides a fair upside to the tax-payer; it can resolve the problem of government managing the bad assets by reselling most of the assets and liabilities of the bank to new private shareholders after a clean-up of the bank.
This “nationalization” approach was the one successfully taken by Sweden while the current US and UK approach may end up looking like the zombie banks of Japan that were never properly restructured and ended up perpetuating the credit crunch and credit freeze.