Tuesday, 14 October 2008

Part-Nationalisation of the Banks and the Tide of History

At school I learnt about Atlee’s post-war Labour government nationalising large swathes of the British economy. At about the same time in the real world, there was a prolonged period of de-nationalisation of many of those self-same swathes under the Tory government of Mrs T. The tide of time had first pushed up the size of the state, partly in response to the fatigue of war, and then cranked it down again, as the wave of free market ideas reached an apogee and I thought that was that. The part nationalisation of three major UK banks yesterday, following the nationalisation of Northern Rock and Bradford and Bingley earlier this year, seems, by general consensus, to have been as unavoidable as it was surprising given the recent tide of ideas.

In fact, as recently as this spring, I argued at a Public Policy Round Table that the state had already become too large and that during a sustained period of full employment growth a succession of government budget deficits, since the fiscal year 2002/3, did not make a great deal of macroeconomic sense. I argued that we needed a commitment to a smaller state and with it would come the room for manoeuvre the Bank of England would need to cut interest rates and offset the ongoing credit market shock. The sequence of deficits meant that the public sector net debt to GDP, excluding bank liabilities, was pushing pretty hard at the government’s ‘self-imposed’ target of around 40% to GDP. But the bail out of the banks now seems to have made my wish for a smaller state pretty unlikely as public debt looks likely to swell to postwar levels, which will in the longer term increase the incentive for a bout of sustained inflation and cause me to dust off my textbooks on the dangers of public ownerships and directed state action.

So how did we overturn the tide of history over a weekend and (partially) enact an infamous promise in the 1983 election manifesto of the Labour Party to nationalise the banking system? The short answer is that the banking sector found itself desperately short of capital and could not find sufficient funds from the private sector to raise that capital. The irony is that banks normally stand on the other side of this problem, as they are themselves reluctant to lend to individuals who need capital and ask for significant collateral or evidence of good standing before parting with any money. Or as many a businessman has put it, banks do not give out umbrellas when it is raining. But in this case, there has been no rain for a long time and a drought has resulted as liquidity has dried up and many of our banks have had no option but to buy some water from the largest reservoir in town: The State. For exercising that right to buy, they have given up a controlling stake in their future.

To recap, the UK government, in a plan that seems now to have been mimicked throughout the world, has taken preference shares (hybrids of debt and equity, where an fixed dividend rather than a profit share is paid to holders and where holders have senior claim on assets in the event of any liquidation) in three major UK commercial (or high street) banks. These preference shares mean that the government in return for an injection of £37bn owns over 55% of RBS and HBOS and around 43% of Lloyds TSB. The UK government thus has a (temporarily until the share are sold back) controlling stake in these banks. It has also offered to insure interbank lending for UK banks providing they re-capitalise privately or through the state. Recall that interbank lending has all but ceased and the interbank rate spread over LIBOR has shot up to reflect both liquidity and credit risk. The insurance, if appropriately priced, offered by the government should help eliminate the liquidity risk I would expect as a spillover also help to alleviate credit risk. Various extensions to the Special Liquidity Scheme have also been announced.

In sum these measures aid liquidity of banks and by shoring up capital allow them to have a cushion against losses and thus promote some semblance of confidence in the financial sector. All this has been required because having extended loans on the basis of relatively little equity capital, with the blessing of the regulators, the banking sector faced extinction of their equity capital from a number of possible avenues. That the default rates on loans would be higher than expected, that collateral held against those loans would be insufficient and that funding for those loans from short term deposits from households or the wholesale money markets would dry up. Given the interconnected nature of these events, it turned out that a shock to collateral triggered defaults which triggered mistrust in wholesale money markets, not only between banks but also between the net supplier of funds (pension and insurance companies) and banks.

So what we discovered was the correlated nature of these risks, that they were not independent events and that the scale of liquid reserve or capital that banks held against these shocks was insufficient. And so banks have to ratchet up their levels of capital to cover both previous losses and to have a sufficient liquid store of wealth against future shocks. The trick is to try and engineer this capital injection quickly so that lending can now resume in the face of a rainstorm...the banks need to giving out galoshes a well as umbrellas right now.

As far as temporary part-nationalisation of the banks, to coin a phrase: There Is No Alternative (for the moment).

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