11/10/2012 09:30 BST | Updated 09/12/2012 05:12 GMT

Swedish Lessons for EU Bank Owners

Who would own a Spanish savings bank? Well, at some point soon most Europeans will. Once the Spanish government's bailout for the country's crippled and failing Cajas and smaller struggling banks are 'Europeanised' via transfer to the European Stability Mechanism, all European taxpayers will indirectly have their own small stake in one of Europe's more intractable financial disasters.

When the Swedish banking system crashed in 1992, the government was faced with an identical problem. The knock-on effects of the banking crisis notwithstanding, Sweden's taxpayers actually came very well out of their experience of bank ownership. How was this achieved, and what lessons can be learnt for Madrid and the EU's new bank resolution policy?

First, move fast. Spanish authorities and bankers have been in denial about the scale of bad lending in the Spanish banking system for too long. The Rajoy government rightly came to office this year on a promise to force banks to write down bad loans. The situation has predictably turned out to be much worse than assumed, but their policy is the right one. As painful as it is, transparency on the scale of bad debt is vital for the market to be confident that it understands the risk and uncertainty in Spain and can therefore start pricing it properly again.

Catharsis can only come with transparency and a purge of bad assets. Banks should present plans for how they intend to handle their problem assets, recover value, strengthen controls and improve efficiency. This process might require government or even supra national assistance in the orderly closure of moribund institutions. Also required is the de-merging of 'bad' parts of a bank from the 'healthy', in order to facilitate re-capitalisation. The state should never be left holding the junk while the healthy part of a bank wriggles free.

Second, maintain commercial principles. In Sweden, each state bank investment was made on what would have been commercial terms in a normal market, always with the aim of maintaining competitive neutrality. The terms of the investment must be structured in such a way that the bank and its owners have no grounds for requesting more state funding than is necessary, combined with the incentives to facilitate a swift exit from the investment. Each measure, including the size of the recapitalisation, must be sufficient to ensure that the bank can return to profitability without additional government assistance.

Third, develop an explicit and public ownership policy. Be clear about this. A taxpayer stake is not a budget expense but an investment and should be treated as such. The objective of the government as an owner, along with its appointed board members, is to ensure profitability, financial strength and, generally, to facilitate the Government's exit from its unwanted ownership at the appropriate time. European governments, even of a social democratic stripe, are typically nervous of anything that looks or feels like nationalisation. This can make them instinctively passive as owners of bank stakes, so as not to look interventionist. This is understandable, but they need to get over it.

Fourth, the best way to achieve this is by putting clear water between the government and the manager of the state's stake in a bank. As ultimate banking regulator, the government has no business directly running banks. A clear separation will help ensure that the market's fear of insolvency is not replaced by the fear of government intervention in the management of banks or of directed lending. Establishing a separate unit or holding company with sole ownership responsibility, including the execution of the exit strategy, is the best way to strengthen political separation. A professional cadre of managers will both reassure the market, and also remove the tendency of public servants and politicians to be excessively deferential to the bankers.

Fifth, maximise transparency. It is the unique vulnerability of banks that they fail not just because they are weak, but because the market thinks they might be weak. When trust in a bank's strength evaporates this can become a self-fulfilling prophecy. Once a state takes a stake in a bank, the market should be regularly updated with progress reports designed to demonstrate that the government is indeed complying with its own policies. Opacity feeds weakness.

The problem of public ownership of banks obviously goes much wider than just Spain. European taxpayers already own parts of banks in multiple European jurisdictions. Even now, Eurozone banks are probably now sitting on more than €700bn and rising in non-performing loans. More than a quarter of these are in Germany. The rest are spread through the vulnerable and weakening periphery economies. This legacy of the boom years and a decade of loose Eurozone monetary policy is the ultimate shackle around the Eurozone.

This makes it all but inevitable that there are more bank rescues to come, not just in Spain but across the Eurozone. A new European banking union with resolution powers and the 'Europeanisation of bank recapitalisations through the European Stability Mechanism make it all the more important to develop a clear protocol for interventions that protect taxpayer interests and maximise taxpayer profits. If we are all going to be taking a larger stake in the restructuring of the European banking system, we have to do it right.

This article was originally published in Financial Time