The most straightforward way to solve the current crisis is bank nationalisation. There are a few reasons why the government might not want to take this path, one of which is the large overseas assets and liability of UK-based banks. The sovereign has limited fiscal credibility; the key to avoiding future hyperinflation is not biting off more than it can chew. It should focus on the UK and on creating a 'good bank' to promote future lending.
I never suggested that the government buy stakes in banks, as the UK government did late last year. However, in retrospect it seems to have been a good plan. The systemic collapse of the banking system was forestalled.
Of course, most of that money went into a black hole. But the government did end up by owning large parts of the banks' equity, which might be worth a lot in the future if the banks recover. £37 billion for pure upside on say £2trillion of assets isn't too bad a deal. And having an equity stake is clearly not the same as guranteeing the banks liabilities for free. Limited liability still applies.
However, the government obviously has certain responsibilities in the UK banking system - it needs to guarantee the deposits of UK savers, and it needs the banks to lend enough to keep the economy going.
To summarise, the UK government has two clear requirements, both UK based
a) 'Get lending going again' to UK individuals and companies
b) Guarantee the deposits of UK individuals, charities and (probably) companies
These objectives can be acheived by a transaction that involves:
a) Buying the branch networks of the major UK banks (needed to 'get lending going')
b) At the same time, taking on the liabilities of the domestic depositors
c) Taking on the 'good' assets in the corporate lending and mortgage book
The old banks would be left with more cash (from being able to sell some of their tangible assets). This would leave a deleveraged, cash-rich rump (including in effect an overseas lending unit) which might die slowly.
HBOS would be a good example. The government should take on the branch network, and the brand and the domestic depositors (liabilities), and the good parts of the domestic mortgage book (assets); but none of the 'toxic debt'. This would then be a 'good bank'.
The government could then progressively sell stakes in the 'good bank' to private investors.
The main risk for this plan, would be that if only some of the branch networks were bought, there might be a run on the other, privately owned banks.
There would still remain the question of what to do with the remaining 'bad bank'. Few might lend to it; but in any case few are lending to the big banks now anyway. Bankruptcy is one option, but it usually involves plenty of money for lawyers.
If the banks are insolvent, they need to be declared bankrupt. Bankruptcy has risks; the main one being the huge 'costs of financial distress' (Lehman Brothers will keep its' liquidatorsarmy of lawyers and accountants busy for many years) the advantage of the government buying the 'good bank' first, is that systemically important assets (uk depositors, interbank lending) can be trasferred into the public sector first.
New lending must be seperated from existing lending. Current government thinking suggests that we need a government-backed good bank much more than we need a government-owned bad bank. And taking on the bad assets is socialising private risks - not a good idea. Better to create the good bank first, including both high-street and capital-markets elements. Use the good bank to get lending going and to 'look to the future'. The remaining bad bank would be cash rich with a more volatile and non-domestic balance sheet and fewer tangible assets. It would have in effect a skeleton team remaining. If insolvent it would wind itself up naturally.