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Government Investments in Banks

Should the government bank bailout take the form of direct equity investment? David Skeel identifies two very serious concerns with such proposals:

One is the obvious risk that government ownership would distort the decision making of both the government and the banks going forward. This is indeed a scary prospect. Paulson has suggested that the government will buy nonvoting preferred stock, to reduce the ability of the government to meddle in bank decision making. That’s better than having the government vote on bank decisions, but it still leaves the government tied at the hip to the banking sector.

The second problem has gotten less attention: which banks’ stock will the government buy? If the government buys the stock of banks that are struggling because they leapt into the subprime mortgage market and now are incapable of surviving on their own, it is rewarding precisely the banks that least deserve help. More likely Paulson will try, at least to some extent, to target good banks- banks that are viable though struggling- and to do what Warren Buffet did with Goldman Sacks- signal confidence through the willingness to invest. The danger with this strategy is that it could set off a political scrum, as banks lobby heavily for government investment for fear that the banks that are left out will be viewed as losers by the market. The negative signal of being passed over by the government could be devastating.