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Fixing a Disintegrated Financial System Requires Political Consensus and Transparency

 February 21, 2009 10:24 PM
 


According to George Soros, "We witnessed the collapse of the financial system." "The bankruptcy of Lehman Brothers in September marked a turning point in the functioning of the market system. (The financial system was then) "…placed on life support, and it's still on life support. There's no sign that we are anywhere near a bottom." According to US President Obama "The credit crisis is real, and it's not over,"

The debate about nationalizing major US banks has already hit a fevered pitch, and if the first quarter is going to bring another series of multi-billion losses, institutions including Citigroup (C )and Bank of America (BAC) may simply not have the balance sheet resources to remain independent. Having the government seize one or two major banks is increasingly seen as the ultimate key to their survival.

The "snake in the box" however is the concern is that, if the public loses confidence in the rest of the independent banks, brokers, and money managers in the country, (nationalization) could trigger a series of bank runs not seen since the Great Depression. While there may not be a great deal of logic to the prospect of heightened fear about the future of banks if the government ends up owning a few of them, the psychological effects on consumers could be devastating.

Treasury Secretary Timothy Geither has proposed bank balance sheet "stress tests" in his financial stability plan, which will naturally lead to nationalization if these tests reveal that a bank is insolvent. Once the government faces the truth that major banks are effectively insolvent, there really isn't much left to do but nationalize, apparently aka the Nordic model (as examined by two recent papers on the Nordic bank rescues by the Federal Reserve Bank of Saint Lewis and the Federal Reserve Bank of Cleveland)—i.e., a temporary takeover, cleanup and then resale of these banks. But the longer nationalization is delayed, the longer the solvency of the entire banking system will be in question. Thus, more good banks will get dragged down into the mud with the bad.

The worry of course is that the Obama Administration is running out of time and options.

Government bank balance sheet stress tests are expected to begin next week, and will be required for any bank with more than $100 billion in deposits.

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