INTRODUCTION

Although the comprehensive bailout package of October 2008 saved, at least temporarily, the British banking system from collapse, it failed to stimulate bank lending, as intended.1, 2 As a result, a desperate attempt was made by the Government in January 2009 to try to unblock lending channels, as evidence emerged pointing to a serious contraction in the real economy and the withdrawal of foreign banks – Icelandic, Irish, EU and North American – and others (for example, GE Capital) from UK loan markets. The package, revealed on 19 January,3 comprised seven elements, and was supported by the Financial Services Authority's (FSA's) decision to tweak the rules relating to banks’ (that is, those that benefited from the October 2008 bailout) use of internal models to generate regulatory capital charges – by switching from a ‘point-in-time’ to a ‘through-the-cycle’ assessment basis, the probability of loan default can now be averaged over the economic cycle rather than being based on the most recent, and hence more dismal, data – in order to increase the banks’ capacity to lend in the downturn.4, 5 The FSA has also indicated its willingness to treat a (post-stress test) 4 per cent core tierone ratio (equivalent to a 6–7 per cent tier one ratio) as an ‘acceptable minimum’, potentially providing further scope for an expansion in bank lending.

The detailed nature of the latest bailout package, which complements the Government's earlier introduction of a partial (50 per cent) guarantee on up to £20 billion of working capital loans to Small and Medium-sized Entities (SMEs), is duly analysed in the next section before a wider assessment of the likely impact of the package and its chances of success is provided. The final section summarises and concludes.

THE BAILOUT PACKAGE OF JANUARY 2009

The first element involves the Government, in return for a fee payable in cash or preference shares and verifiable commitments to support lending to ‘creditworthy’ customers, insuring some of the risky assets currently held by UK-incorporated, authorised deposit-takers against extreme, unexpected losses.6 Banks, however, will still be liable for a proportion – likely to be around 10 per cent – of any future losses on such assets beyond an agreed ‘first loss’ amount before the insurance threshold is reached. And banks that have not yet written down such assets to reflect market prices will be asked to shoulder a higher proportion of possible future losses. The idea behind the scheme, which will be in place for at least 5 years and has recently been adopted in the United States with respect to the bailouts of Citigroup and Bank of America, is to set a floor to the scale of losses that banks might incur on their existing loans and investments, thereby increasing certainty about bank solvency and enhancing financial stability. For the participating banks, this, in turn, should increase their willingness to lend, as their need to hoard capital and liquidity against an uncertain future is correspondingly reduced. And, for the system as a whole, it should help to de-freeze the interbank markets, thereby increasing each bank's capacity and willingness to lend.

The main problems with the scheme – which was preferred to the creation of a ‘bad bank’, which would assume the illiquid toxic assets of the banks direct, because of the lack of up-front costs and the hope that merely offering to write the insurance will reduce the need for it as increased lending and economic activity are stimulated – lie in its practical application. For example, which assets should be insured, what premia should be charged and where should the insurance threshold be drawn? The initial focus will be on the banks’ most toxic assets (for example, Collateralised Debt Obligations (CDOs) and Mortgage-Backed Securities (MBS), which will continue to fall in value as long as house prices decline), as well as commercial property loans. Loans to SMEs and residential mortgages (including buy-to-let) may also feature; and Royal Bank of Scotland (RBS) is to be the ‘guinea pig’. As for ‘price’, this is the same problem that the US authorities faced with their Troubled Asset Relief Programme, or ‘TARP’, the focus of which was switched from buying up toxic debt to bank recapitalisation direct;7 too high a premium and the banks will not play ball, probably accelerating their full nationalisation, while too low a premium will saddle taxpayers with larger contingent liabilities. And, with respect to the establishment of the insurance threshold, again drawing it too low (that is, forcing the banks to shoulder more of their unexpected losses) or too high will have the same effects as outlined immediately above for imposing too high/low a premium.

The second strand of the ‘economy bailout’ package, as the Government prefers to call it, involves an extension of the time limit on the £250 billion Credit Guarantee Scheme for bank funding, announced as part of the October bailout package – see note 1 – from end-April 2009 to end-2009. The focus here is on keeping open this line of attack on the currently frozen interbank markets.

The third component relates to the introduction (to commence in April 2009) of a new guarantee scheme for triple-A-rated asset-backed securities – initially involving new mortgages, but later to include corporate and consumer debt – as called for in the ‘Crosby Report’.8 The intention here is to try and restart the securitisation markets, thereby improving bank/building society and market liquidity, and hence increasing bank lending capacity and reducing UK borrowers’ cost of funds. Again, however, practical difficulties abound. How will the fees be determined (by auction, as suggested by Crosby?)? How long should the scheme last for? And how can market distortions be minimised (for example, to limit the subsidisation of poor-quality credits)?

Fourth, the Government, as owner, is to force Northern Rock to slow the rate of contraction in its lending activities, thereby reversing the previous policy of trying to extract the fastest possible repayment of the bank's loan from the Bank of England.9 Although serving to limit the contraction in housing-related loans in the United Kingdom, and thereby limit house price deflation, the policy volte face does highlight the inherent contradiction in current government policy; on the one hand it wants to limit the severity of this recession by slowing the pace of credit contraction in the economy yet, on the other, it wishes to limit taxpayers’ losses arising from its policy actions. Encouraging increased mortgage lending at a time when house prices are widely expected to fall by at least another 10–15 per cent on average before the floor is reached is not going to improve bank solvency; nor should would-be homeowners be induced to enter the housing market currently with the prospect of negative equity looming for an uncertain period of time. Similarly, forcing, exhorting or otherwise inducing banks to lend more to industry and individuals at a time of deepening recession, when output is plummeting and unemployment rising remorselessly, is again going to do little to boost individual banks’ short-run profitability/solvency. Indeed, the danger is that adverse selection ensures that the banks end up with the credits that they least need, as rising unemployment and falling demand create a new wave of ‘sub prime’ (that is, uncreditworthy) personal and corporate borrowers, respectively. Moreover, it is not clear that stemming house price deflation, and hence slowing the pace of adjustment to a more sustainable level, nor indeed keeping Northern Rock going, either as a public or privately‐ owned entity, is in the long-term interests of either taxpayers or the UK economy.

Fifth, the Government is set to revise the terms of its October 2008 bailout of RBS in recognition of the fact that demanding a 12 per cent coupon on the preference shares received – which must be redeemed before dividend payments to shareholders can resume – was too harsh (similar bailouts carried out subsequently elsewhere in the world have set the coupon payments at a much lower level).10 Accordingly, it is set to swap its preference shares for common stock, as it boosts its stake in the bank from 58 per cent to 70 per cent, a move designed, in part, to stimulate the banks’ lending activities by up to £6 billion.

Sixth, in order to ensure the availability of long-term bank liquidity, the period for which banks can swap illiquid assets for Treasury bills under the new Discount Window Facility has been increased from 1 month to 1 year, for an incremental fee of 25 basis points2.

Finally, the Government has given the nod to the Bank of England to start lending directly to UK businesses, as the Fed has been doing in the United States now for some months with respect to US corporates, through the purchase of ‘high quality’ (that is, investment grade or better) private sector assets (including corporate bonds, commercial paper and some Asset-Backed Securities (ABS). Under a new ‘Asset Purchase Facility’, the Bank will thus initially purchase, through a newly created subsidiary, up to £50 billion of commercial paper,11 with the Treasury indemnifying the Bank against loss. The purchases, however, will be ‘funded’ (that is, ‘sterilised’), with the Treasury issuing Treasury bills to finance the purchases, thereby nullifying the impact of the purchases on the money supply. The door has been opened, however, for the Bank to move towards ‘quantitative easing’ (that is, unsterilised asset purchases, involving the ‘printing of money’) should it prove necessary in the wake of its effective policy rates falling towards zero, a policy already prevalent in the United States and adopted long ago in Japan in the face of 7 years of deflation and near-zero nominal policy rates.12 Although the intention of the policy initiative is to widen large corporates’ access to credit and reduce their costs of funding, the scale of potential losses that may ultimately fall upon taxpayers’ shoulders is difficult to quantify. What seems ‘high quality’ today may have lost its lustre by tomorrow if the rate of economic contraction continues at its current pace. And, if quantitative easing becomes a reality in the United Kingdom, the Bank needs to identify in advance a clear exit strategy if runaway inflation down the road is to be avoided.

A WIDER ASSESSMENT

Such, then, is the nature of the Government's latest plan for arresting economic decline and preserving financial stability. But what are we to make of it? Accepting the premise that economic recovery cannot occur before financial stability is restored and ‘normality’ returns to lending channels,13 is the current package of measures sensible? As alluded to above, when discussing attempts to reinvigorate mortgage lending, real concerns surround the wisdom of trying to slow the pace of adjustment to a more sustainable economy where house prices are lower, consumers and businesses are less indebted, the services sector (including financial services) is less dominant relative to manufacturing, and the twin deficits – budgetary and the balance of payments – are more readily financeable.14 Of course, overnight ‘deleveraging’ to achieve this more sustainable equilibrium would impose intolerable burdens on the real economy, and firms and individuals, but the extent to which this pain can be avoided, rather than simply deferred – to future generations – is not clear. Already concerned about the impact of the Government's fiscal stimuli,15 the markets are showing signs of alarm at the scale of the potential burden that bank/economy stabilisation initiatives are creating for the public finances, whatever the treatment of contingent liabilities in the national accounts. And the Government's economic forecasts delivered at the time of the Pre-Budget Report have already proved to be woefully optimistic, as widely argued at the time, compounding market fears about the sustainability of current policy.16 These fears extend to the possibility that, at some stage, a ratings downgrade for long-term UK sovereign debt will follow that recently meted out to Greece, Spain and Portugal, thereby raising gilt-funding costs and further deterring potential investors. Moreover, the rising cost of insuring against the possibility of a UK Government default on its debts in the CDS market is evidence that some, at least, believe that such a likelihood is certainly not negligible, raising the prospect – however remote – of the United Kingdom following the likes of Iceland, Hungary, the Ukraine, Pakistan and others (possibly including Ireland further down the road) to the doors of the IMF. As noted by many (including the IMF),17, 18 and in defiance of government assertions to the contrary, the UK economy has always been one of the worst-placed industrialised nations to weather the current economic and financial storm because of the relative size of its housing bubble, the extent of its people's indebtedness, and the significance of the ‘City’ and financial services more generally to domestic economic prosperity. And the Government's failure to better balance the books in the good times – a legacy of the Prime Minister's stint as Chancellor – has left the public finances seriously exposed to the worsening economic and financial climate.

As for the future direction of policy, and assuming some unconstrained action is possible, the current debate is focussing on the relative merits of full (but temporary) nationalisation of further elements of the banking sector compared with what some characterise as the ‘creeping nationalisation’ of current policy. Further steps down this road – nationalisation of the whole system is impossible as the banks’ assets amount to well over four times the GDP – however, while giving the Government greater leverage over lending policy will not resolve the fundamental problem alluded to earlier. How can increasing bank lending in a severe downturn be reconciled with the objective of minimising taxpayer exposure to government bailouts? Is it unambiguously the case that, without such governmental action, current taxpayers would be even more exposed? And what about the plight of future generations of taxpayers? Is it the least bad policy option available but one that nevertheless promises, at least, to deliver a ‘tomorrow’, some time in the future?19

SUMMARY AND CONCLUSIONS

The package of measures revealed on 19 January 2009 represents the Government's final attempt, short of full nationalisation of one or more of our leading banks, to reinvigorate lending to the domestic economy. This followed the failure of its October bailout plan to kickstart lending, as intended. As explained above, however, there are serious doubts surrounding the likely efficacy of the rescue package, and widespread market concerns about its likely impact on public finances. It remains to be seen whether further steps down the road to nationalisation of the complete banking system, and the concomitant consequences of this action for taxpayers, can be avoided.20