That sinking feeling

Government hopes that its latest raft of measures would persuade banks to start lending to each other again – and thus kickstart the economy – seem, so far, unfounded. So why are institutions reluctant to throw the cash around … and what will it mean if they continue to refuse to end the credit drought? By Ian Fraser

You could sense the irritation in Gordon Brown’s voice last week as he announced the government’s latest attempt to save the British banking industry. At the time of his first stab wit the bail-outs announced in October , the prime minister believed he had done enough to cauterise the banks’ self-inflicted wounds and jump-start lending.

In a week when it was confirmed by the Office of National Statistics that the UK had entered its first recession since 1991 in the last quarter of 2008, this may have staved off a systemic collapse, but the £37 billion transfusion of fresh capital and £250bn in liquidity that Brown’s government poured into the banking system just three months ago did not solve the problem.

The banks could not — or would not — change their behaviour, and were showing little sign of increased propensity to lend to British businesses or individuals.

By Friday, 16 January, amid mounting fears over disastrous 2008 results pending from the UK banks, heightened by massive fourth-quarter losses at both Citigroup and Bank of America and the general sense of investor helplessness and pessimism, it was clear that further radical action was required. Again, there was a suspicion that one or more of the UK’s diminishing band of banks might fail.

The biggest basket case was the Royal Bank of Scotland. The Edinburgh-based bank has seen its market capitalisation collapse from £75bn in May 2007 to £4.7bn today, aggravated by RBS’s own admission last week that it expects to announce a loss of up to £28bn for 2008.

Though much of this will admittedly be “paper losses” relating partly to a write-down of the goodwill valuation of ABN Amro, it will still count as the biggest loss in UK corporate history. Its formerly lauded chief executive, Sir Fred Goodwin, has become Public Enemy Number One.

The rebranded Lloyds Banking Group, fresh from its acquisition of HBOS, is seen by many investors in much the same light, given its massive exposure to potential bad debts in the weakening UK economy. The renamed superbank’s shares fell by 9% in its first week of trading, adding to the slumps in the values of HBOS and Lloyds TSB that had gone before.

Barclays, which unlike the two Edinburgh-based banks has avoided having the UK government as a shareholder as a result of a deal with the governments of Qatar and Abu Dhabi last summer, also took a hammering on the markets. This is due to investors’ suspicion that, despite protestations from its board, the bank desperately needs more capital. Barclays shares have crashed by 67% since its deal with the sheikhs, and Bruno Paulson, an analyst at Bernstein Research, believes its current share price implies the bank has just a 25%-40% chance of survival.

Ahead of Monday’s announcement, the government realised that it would have to pull out all the stops if it was to have a chance of ending the credit drought and persuading the banks to lend again. So after nearly a month of deliberation on a raft of separate schemes, it chose to unveil them all at once as a complex “belt and braces” solution. With related bodies, including the Bank of England and Financial Services Authority (FSA) chipping in, the government was throwing almost everything it could at the problem.

Unveiled after yet another tense weekend of negotiations with bank bosses, the measures included further recapitalisations, asset guarantees, commercial paper guarantees, liquidity backstops, quantitative and qualitative easing (printing money) and a subversion of the Basel II risk weightings, which stipulate how much capital the banks need to hold to balance their lending.

FSA chairman Lord Adair Turner has also promised that bank supervision will in future be broadened to cover the so-called “shadow banking system” – which regulators formerly ignored and which is seen as one of the sources of the crisis. The shadow system incudes the clandestine networks of off-balance-sheet vehicles and derivatives that the banks used to disguise their capital positions. “If it quacks like a bank, we’re going to regulate it like a bank,” said Turner.

Yet for all its technical proficiency, many commentators doubt whether Brown’s bail-out 2.0 will do the trick. One worry surrounds the conditions the government is imposing. Banks that make use of the cornerstone of the package, the Asset Protection Scheme, will be required to pay fairly hefty premiums, either in cash or in shares, for every loan they insure. As the Treasury said in the small print: “The cost of establishing and administering the scheme will be borne by participating institutions.”

Participating banks will also be required to sign “contractual agreements” with the Treasury, locking themselves in to boosting their lending. They will also be forced to prioritise British customers over overseas ones. Given the remaining capital constraints imposed by the Basel II international bank capital regime, these could prove to be disincentives too far.

“The fundamental problem is that one cannot both rescue an organisation and punish it at the same time,” says John Greenwood, chief economist at Invesco Perpetual.

Another overarching problem is that there remains profound uncertainty about the future state of the UK economy, which Singapore-based US investor Jim Rogers last week wrote off as a hopeless case.

This lack of visibility makes it extremely difficult to get a handle on the actual value of many bank assets. It is not clear whether many of the business and consumer debts on their books will turn toxic as recession prolongs, which could cause protracted negotiations between the Treasury and banks participating in the Asset Protection Scheme.

It also means the government, and by extension the taxpayer, risks getting stung should asset values fall significantly from here. Some economists believe this could happen should US house prices fall further, for example, since it would likely aggravate the problems with securitised subprime debts.

Brown has also been criticised for his failure to follow the Swedish model, by launching a “bad bank” which could be used to mop up the banks’ bad and questionable loans and other toxic assets. The theory is that a “bad bank” could lock up such nasties in the equivalent of an isolation ward, making it easier for untainted normal banking business to be resumed. The government felt it would be difficult to decide which assets to put in the bad bank and how much to pay for them, but critics contend it should have taken the plunge anyway.

“In failing to create a bad bank, the government left itself open to the risk that open-ended intervention will be required in the future,” says Greenwood.

He and many others, including private equity chief Jon Moulton and Treasury select committee chairman John McFall, now also argue that full nationalisation would be a better solution for the UK’s banks.

Wim Buiter, chairman of European political economy at the London School of Economics, agrees, on the rationale that part-nationalisation has been counter-productive.

He says: “I believe that costly partial state-ownership and the fear of future state-ownership are discouraging banks from lending. If a bank has no option but to take the government’s money, it will try to repay it as soon as possible — to get the government out of its hair. Such a bank will, therefore, be reluctant to take any risk, including the risk of lending to the non-financial private sector. Such a bank will hoard liquidity in order to regain its independence from the government.”

Still others counter that adding the banks’ liabilities to the nation’s already creaking balance sheet could tip the country over the edge and that full nationalisation must therefore be avoided if at all possible.

Edinburgh-based banking economist Robert McDowell, argues that irrational markets are a large part of the problem. He says: “The government is acting logically, and it expects its logic to be understood and to be calming. The trouble is that the doomsters and the short-selling rumour-mongers have discounted the government’s measures as being likely to fail. The general panic-stricken mob is all too easily spooked into believing this. Illogic currently rules.”

McDowell suggests that the introduction of a new accounting standard, IFRS7, which the banks must use for their 2008 accounts, may be adding to the febrile mood. He suspects that accountancy firms are struggling with this standard and may, therefore, feel the need to “qualify” bank accounts for the 12 months to December. Since this never appears to have happened before, the very suggestion is exacerbating bearish sentiment.

“FRS7 means the banks will have to use more stochastic and risk-based modelling to inform their accounts,” said McDowell. “The only way they can achieve that is to implement full, economic-capital modeling, as laid out in Basel II, pillar two. Many of the banks currently lack the wherewithal to do this.”

Mark Dunleavy, financial services leader at the Californian data integration company Informatica, adds: “The banks will only start lending to one another once they have a complete and accurate view of their liabilities and exposures. Accomplishing this will involve a major industry-wide data integration initiative that drills down into the detail of hundreds of thousands of mortgage-backed securities to locate the toxic assets behind the crisis.”

Both McDowell and Dunleavy believe that, until such time as the banks improve their own IT systems to make such a profound and holistic analysis possible, the banking crisis may endure, and that rescue packages such as those unveiled by Brown will come to be seen as tinkering around the edges.

Ultimately, that could mean that Brown would have to keep feeding the disastrous and rapacious beast the UK banking has become on a quarterly basis for many quarters to come, and that those Treasury press conferences outlining further support for the UK banking sector could become his version of Groundhog Day.

That would be disastrous for the UK economy – the cost of regular bail-outs would cause the cost of government borrowing to soar and ultimately that national bankruptcy, a currency devaluation, or at least a national default on bonds could prove unavoidable.

This is what’s at stake if the government’s rescue measures are wrong. More radical moves like the ‘bad bank’, bank nationalisation and continued quantitative easing are likely to be among the next steps if Brown and Alistair Darling’s ‘Bail-out 2.0’ doesn’t do the trick.

But the clock is ticking. The weeks ahead will be about watching to see whether the markets are proved wrong and the current measures suffice. It doesn’t get more serious than this.

This article was the business focus in the Sunday Herald on 25 January 2009.