Nations Face Thorny Issues in Acquiring Stakes in Banks

As governments in the U.S. and Western Europe consider plans to buy stakes in struggling banks, policy makers face a potentially daunting price tag and thorny questions about how such programs will be implemented.

In the U.K., Germany, France and the U.S., government officials this week have either unveiled or hinted at plans to pump taxpayer funds into cash-strapped lenders. In exchange, the governments would take ownership interests in the banks in the form of preferred shares, essentially nationalizing broad swaths of the banking industries and reversing a decadelong deregulatory trend.

The hope is that the fresh capital will improve tattered bank balance sheets and provide a much-needed confidence boost for the financial system. The erosion of confidence, especially in the past month, has led fearful bankers and investors to stop lending. That is threatening to freeze economies world-wide.

"By the government stepping in with preferred-stock investments...they relieve that uncertainty and should be able to promote the restoration of confidence and lending," said Robert F. Bruner, dean of the Darden School of Business at the University of Virginia.

But it isn't clear how much money governments will need to invest in the multi-trillion-dollar global banking sector. Key details, such as the role governments will play overseeing companies, are likely to ignite fierce debate among policy makers and industry officials.

This wouldn't be the first time the U.S. government effectively nationalized parts of the banking industry.

In 1932, in the midst of the Great Depression, Congress and President Herbert Hoover created the Reconstruction Finance Corp. Over its 25-year lifespan, the independent government agency bought stakes in more than 6,000 financial institutions and poured a total of $50 billion (not adjusted for inflation) into various parts of the U.S. economy, according to Alex Pollock, a resident fellow with the American Enterprise Institute.

The RFC's investments came with senior voting rights, meaning the government wielded broad control over the institutions, said Joseph Mason, a banking professor at Louisiana State University's business school. He said the RFC also barred the companies in which it invested from paying dividends to shareholders until they were financially healthy enough to buy out the government's stake.

In a speech last month, H. Rodgin Cohen, chairman of law firm Sullivan & Cromwell and one of the nation's pre-eminent banking lawyers, called for the creation of a RFC-type agency to invest in banks.

"Not only did the program help arrest the deterioration of the banking system, but it did so without loss," said Mr. Cohen. "The vast majority of the preferred-stock investments were repaid in full."

But today's RFC would need to be far larger than its Depression-era counterpart. "Considering the state of today's markets, I would suggest $1 trillion to $2 trillion," Mr. Cohen said in his speech.

That would dwarf the U.S. government's new $700 billion Troubled Asset Relief Program. That fund was originally intended to buy illiquid mortgage-related assets from lenders, but government officials said this week that it could also be a vehicle for capital injections into banks.

"The big question is how Treasury uses the $700 billion that Congress has given them," said C. Fred Bergsten, director of the Peterson Institute for International Economics, a Washington-based think tank. "It's becoming clear a big chunk of that should be used for direct recapitalization."

So far, government officials have remained mostly mum on the details of how they will structure or administer the capital injections.

One risk facing policy makers is that if the capital injections are seen as a government seal of approval, that could destabilize banks that don't receive investments, causing their customers to jump to other institutions, said Ellen Seidman, a former economic adviser in the Clinton administration.

"It's counterintuitive, but if we've learned one thing from this crisis, it's that we have a hard time predicting the behavior of the smaller savers and investors," said Ms. Seidman, now at the New America Foundation.

Treasury Secretary Henry Paulson and other senior government officials are trying to map out a strategy for potential bank investments. Among the variables they are considering is how aggressively the U.S. government would flex its muscles in the boardrooms of banks where it is a partial owner, according to a person who has been briefed on the discussions.

Sweden provides a possible case study. In the early 1990s, the Swedish government bought stakes in many lenders that were teetering on the brink of insolvency. Instead of staying on the sidelines as a passive investor, the government pushed to overhaul the country's banking industry, ousting executives and forcing mergers in an attempt to cleanse the system of ailing institutions, said Mr. Bruner of the Darden School. Within 18 months, he said, the Swedish economy was back on its feet.

Several banking experts said they doubt the government will take an activist approach. They said Washington is likely to restrict itself to nonvoting stakes that it will probably unwind within a few years.

"I don't think we've reached the point where we want the government calling all the shots in these institutions," said Cornelius Hurley, director of Boston University's Morin Center for Banking and Financial Law. "It was only a few months ago that we were worried about sovereign wealth funds" from the Middle East and Asia taking sizable stakes in U.S. and Western European banks.

Now, Mr. Hurley added, "the sovereign wealth fund is us."

Write to David Enrich at david.enrich@wsj.com and Stephen Power at stephen.power@wsj.com