Last week’s co-ordinated central bank rate cuts signalled an intention that the solution would be global rather than national. The direct effect of rate cuts may not be large (the problem is more about the availability of credit than the cost of credit). The three main thrusts of the UK bank rescue plan (availability of public money to invest in and recapitalise banks; guarantees on interbank lending; extension of the Special Liquidity Scheme) were made clear last week, and the last few hours revealed both how they would work in practice and how aspects of the UK plan will be adopted in other economies.
For the UK, the result will be massive state ownership of key financial institutions, to the tune of £37bn so far: a faster and a much more substantial capital-raising than markets had anticipated (and incidentally the largest nationalisation since the 1940’s). The state will end up as majority owner of RBS and close to it in the merged Lloyds TSB/HBOS. In these cases, the government is protecting itself both financially and politically, with investment in Preference shares (carrying a high “coupon”) as part of the package and with commitments from the banks that dividends on Ordinary shares will not be paid until the Preference shares are repaid. This signals both that the government does not intend to retain ownership for ever (though a period of several, perhaps many, years looks inevitable) and also signals to the wider public that the rescue will punish the banks and their shareholders – the symbolic head on a plate of RBS’s CEO Fred Goodwin and restrictions on bonuses complete that part of the picture. There are commitments that banks using the scheme will continue to make credit available to small businesses and mortgagees at 2007 levels. This may be problematic: surely the last thing needed in this situation is a prolonging of the irresponsible lending seen in the recent past and it is hard to believe that lending at 2007 levels could be achieved with the tighter lending standards that other players have imposed.
The detailed measures adopted by individual countries vary (and in some cases only broad outlines have yet been announced), but key steps include guaranteeing new lending to or between banks and availability of funds to recapitalise banks by taking equity/preference stakes. European leaders have agreed also to rescue any systemically important institution: the risk of another collapse like that of Lehman, whose consequences are still being felt, is reduced. Other measures seen overseas include state- backed entities buying up troubled assets from banks, as in the case of the US Troubled Assets Relief Plan. Handelsblatt reports that the German package alone may be worth up to €400bn, including funds available to recapitalise banks and guarantees on interbank lending. The US has now also signalled a willingness to buy stakes in banks to achieve recapitalisation, but concerns remain that the US measures seen so far do not specifically address the issue of medium-term financing for banks – this is a crucial area that must be solved before money markets can unfreeze.
We had believed that the risk of outright systemic failure was quite low until the last few weeks when it became clear that the interbank capital markets had completely frozen and even government bond trading was difficult in the extreme. The authorities had the intention to try to prevent such an outcome but were forced to take the extreme moves needed only after some prevarication. The actions taken now must work, there is no other remedy available – the alternative does not bear contemplation. However, for sometime we believed that the recession we face is likely to be very serious, probably at least as bad as the early 1990’s recession and maybe more intense and of longer duration. We have not yet seen anything to shake that view. Although the Government has said it wants bank lending to continue at 2007 levels, one must ask how sensible that is – since profligate credit creation is exactly what got us into this mess in the first place. Indeed, some governments should consider how their own borrowing record, with an emulation of Enron and WorldCom type of of balance-sheet gearing has contributed to the debt-fuelled economy.
It is our belief that this crisis will only be fully resolved when the excess indebtedness in the consumer sector as well as the financial sector and government has been worked through. For consumer driven economies that spells a long period of below trend growth.