By Ian Fraser
Published: Sunday Herald
Date: 12 October 2008
LAST WEDNESDAY, the British government took a massive punt on the future of the British banking system, potentially jeopardising the future solvency of the UK in the process. The government clearly hoped its dramatic move would draw a line in the sand, and set the UK’s banks on the path to recovery.
The evidence so far suggests that the package has done nothing of the sort. Some are even suggesting that the government has been extremely foolish to throw good money after bad. Experienced voices are warning that, far from persuading banks to behave more responsibly, prime minister Gordon Brown’s extraordinary package of bail-out measures could end up having exactly the opposite effect.
“The partial nationalisations in the UK are associated with claims by politicians that there will be more lending to fund small businesses and home ownership for poor households,” said Gilles Saint-Paul, professor of economics at the University of Toulouse. “This is clearly allocating credit on the basis of a political agenda, and is doing nothing to prevent a sub-prime crisis in the future.”
Before the markets had opened last Wednesday, Brown and his chancellor Alistair Darling unveiled an ambitious package of measures designed to shore up Britain’s troubled banks, which is likely to include the part-nationalisation of several of them.
The swaggering proponents of no-holds-barred, free-market capitalism, financially crippled through a mixture of their own incompetence, greed and recklessness coupled with external factors such as a near total absence of wholesale funding, have been put into a state-funded intensive care ward.
As the detailed workings of the government’s life-support system were talked through by Brown and Darling, the banks were also hit with a second bonanza of a 0.5% cut in UK interest rates, a loosening that was simultaneously matched by many other central banks around the world.
By last Tuesday, it had become painfully obvious that something had to be done. Rumours that shareholders’ equity was about to be wiped out in a forced nationalisation of the UK banking sector caused several banks — especially RBS, HBOS, Lloyds TSB and Barclays — to suffer calamitous share price falls. Scotland’s damaged national champions HBOS and RBS were the worst hit, falling by 39% and 42% respectively.
These sorts of falls suggested the banks were on the brink of meltdown. Indeed, without Brown’s intervention, one or other or both of these banks might have expired by now. This weekend there are strong suggestions that the figures responsible for the destruction of these banks — including Lord Dennis Stevenson, Andy Hornby, Sir Tom McKillop and Sir Fred Goodwin — might fall on their swords early this week.
Even Brown’s arch-critics were impressed by the boldness of the £500 billion package unveiled on Wednesday. Unlike Hank Paulson’s $700 billion bail-out or the Irish government’s controversial 100% depositor guarantee scheme, the UK scheme sought to tackle three of the issues that have dogged the banking sector since last September: lack of capital, lack of liquidity and lack of funding.
A key part of the package is that banks must first recapitalise before they can enjoy support with liquidity. The government therefore set aside a total of £50bn of taxpayers’ funds to buy preference shares in the banks (half is available before Christmas with the remainder available afterwards).
Furthermore, if a participating bank feels the need to raise additional capital from shareholders, the government said it would be prepared to underwrite the rights issues — which was a big relief to the banks after the fiasco of HBOS’s rights issue last year. If private shareholders were to shun a rights issue, as happened then, the government could end up owning a further equity stake in a bank, over and above the preference shares.
To boost liquidity, the government announced an extension of the government’s special liquidity scheme, making a total of £200bn available to banks to borrow. And finally, the government said it would guarantee £250bn of the banks’ debt, making it easier for them to refinance their short-term wholesale funding. By guaranteeing new debt issuance, for an appropriate fee, the government has removed a big headache for the more stressed banks. Eight banks have agreed to take part in the scheme, with better capitalised banks such as HSBC and Standard Chartered apparently being forced to participate, at least in name, to ensure there was no stigmatisation of weaker banks that have no choice, such as HBOS.
However, the scheme has a number of weaknesses. According to Colin McLean, chief executive of SVM Asset Management, the “fatal flaw” in the package of measures was the lack of a 100% guarantee for bank depositors — including both institutional and retail funders. “The government is sooner or later going to have to address that,” he said.
Some have attacked the lack of strings that Brown had attached to his generous bail-out scheme. For example, many observers thought that, in exchange for this taxpayer-funded largesse, the government would have ensured representation on bank boards, the ousting of failed leaders and that banks would have been forced to make a stronger commitment to the curbing of executive pay.
There was also an expectation that the government would take steps to end the bonus culture that had promoted the reckless lending that meant the banks had to be transferred to the state-sponsored recovery ward. Other measures that had been expected included an enforced reduction in dividends paid to bank shareholders. However, none of this seemed to have made it into the official documentation at the time of last Wednesday’s announcement, even though there was talk that the banks had pledged to continue lending to home owners and small businesses.
As the week wore on, it emerged that few conditions had been properly hammered out by the government. There will be no forced dismissal of failed bank executives. Also, despite talk that the FSA had been tasked with bringing in new measures to police executive pay, it emerged on Friday that the City regulator has no intention of introducing a code of conduct on this topic.
In financial circles the hope was that the emergency basket of measures would reopen the clogged arteries of the global financial system by reducing Libor — the rate over base at which banks lend to each other. However, the evidence here was not particularly promising. On Friday, Libor had risen by seven basis points to 4.82%. This compares to 2.82% a month ago.
The rate remains stubbornly high because banks and financial institutions remain unclear about the extent of the losses they are going to endure as a result of the collapse of US investment bank Lehman Brothers on September 14. An auction of Lehman’s “assets” held on Friday suggested they might be left with a bill of $400 billion to $600 billion.
Also, early indications suggest the measures have failed to persuade mortgage providers to open the credit taps once more (which, in any case, is hardly desirable given the movement of the UK housing market). The Spanish-owned bank Abbey, a participant in the lifeboat, actually raised the interest rate on its tracker mortgages by 0.5% last Thursday. This was the financial equivalent of putting up two fingers to prime minister Brown and chancellor Darling.
Saint-Paul, also a professor at Birkbeck College, London, does not believe that Brown’s bail-out is going to radically alter banks’ behaviour. If the government was hoping to stave off recession, he believes the measures will fail, largely because they do nothing to ensure that financial resources do not continue to be misallocated in future. One view is that the banks will soft soap the government but continue to favouritise their preferred clients — professional borrowers such as hedge funds, private equity funds, large commercial property groups — over more needy consumers and homeowners.
Even if the monetary taps were to be turned on for UK consumers, Saint-Paul believe this would be a bad idea, as it would only create a return to unsustainable consumption, further individual and government indebtedness and the return of an artificially inflated housing market. “If the socialisation of the financial sector is just there to avoid a recession, it’s a pretty poor idea,” said Saint-Paul.
He argues that, just like the defunct heavy industries of yore, the banks are now peddling obsolete products. He says this is particularly true of the derivatives and other sophisticated financial instruments that were the cause of the current crisis. In his view, their obsolescence is demonstrated by the fact they cannot be priced in the face of systemic shocks such as the bursting of the credit bubble. Overall, therefore, he cannot understand why the government is so terrified of allowing more banks to fail.
Under what he describes as a “Hayekian proposal”, Saint-Paul says he would prefer to see the payment system — a public good — separated from banking activity — a private good. “By doing this, it reduces public incentives to bail out the banks that are in trouble, thus enforcing sound loans and individual responsibility.”
Saint-Paul compares the government’s desire to bail out failed and failing banks with the now discredited policy of bailing out lame-duck heavy industries such as iron and steelmaking in the hope of preserving jobs during the 1970s. The experience of such rescues is not a particularly happy one.
In his view, such rescues usually leads to poor corporate governance, decisions that disregard customer value, and therefore future losses which inevitably get borne by the taxpayer. In Scotland, white elephants such as the Corpach paper pulp mill, the Invergordon aluminium smelter and the Linwood car plant are testimony to this.
Whereas state bail-outs may save some financial institutions in the short-term, the Frenchman is convinced they will be bad news for the allocation of capital in the long term. Writing in RGE EconoMonitor, he added: “Moral hazard problems are exacerbated in publicly controlled firms. In fact, the current problems stem in part from excess political involvement in credit markets: Freddie Mac and Fanny Mae (troubled US secondary mortgage bundlers) have a federal guarantee on their debt.”
He points out that the French bank Credit Lyonnais, which was first nationalised in the 1940s, is a good indicator of the sort of risks that Brown is taking. During the 1990s, the French government had to rescue Credit Lyonnais on several occasions from mismanagement and its own incompetence. This included an ambitious international expansion programme which saw it acquire Germany’s Bank fur Gemeinwirtschaft in 1991 and two loss-making Spanish banks from Banco Santander in 1988. “In this instance, politically appointed executives lavished their publicly-owned bank’s capital in all sorts of worthless projects,” said Saint-Paul. Some of the French bank’s more disastrous projects included the expropriation of bank funds by organised criminals and the unwanted purchase of 100% of Hollywood film studio MGM.
Saint-Paul added: “The only advantage that publicly controlled lenders could have over private lenders is that the former could refrain from joining asset bubbles and would value collateral at its true fundamental level. As far as housing is concerned, experience shows us that this is certainly not the case: political considerations make them even more likely to engage in poor loans.
“So the current wave of bail-outs is the next stage of crony social-capitalism with the associated drain on the allocation of capital and a real risk of yet another round of reckless borrowing and another crisis.”
This article was the business focus in the Sunday Herald on October 12th 2008.