Analysis: Bailout package
The government is pumping £500bn into a bank rescue package, but will it work?
A total of £500 billion is on the line – in the form of £50 billion to buy into the banks, £250 billion to guarantee interbank lending, and £200 billion of liquidity being pumped into the markets from the Bank of England.
The Bank of England – as part of an international move – has also cut interest rates by half a percentage point to 4.5 per cent.
Banks meanwhile are agreeing to increase their capital base, and cut back on dividends and executive pay if they turn to the taxpayer.
We expected a big rescue plan, but as officials worked through into the early hours of the morning, they came up with a massive bail out as the banking bubble burst.
But will it work?
The aim is to stop banks collapsing – with the government able to help small fish like Bradford & Bingley and Northern Rock but gulping at the prospect of aiding an HBOS or an RBS – and bring back lending to UK homes and businesses.
The theory works fine. With government backing and increased capital, more stability should come to the banks.
With a government stake, they are less likely to collapse.
Meanwhile, the guarantees on interbank lending and the added Bank of England injections, mean money should start flowing through the system and down to the High Street – with lending at reasonable rates.
The government will also put pressure on the banks taking up its offer to buy in and help them, to increase lending to small businesses and individuals.
Meanwhile, the Bank of England’s surprise interest rate cut should lower the cost of borrowing and make it easier to secure credit.
But in practice?
The practice, however, is a little more confused.
Turning for help from the government could be seen as the kiss of death for banks. Barclays and HSBC seem unlikely to take the offer, while Royal Bank of Scotland (RBS) may well do so.
Also, how the government will push those banks it is investing in to increase lending has not explained.
As with most of the recent turmoil, much rests on confidence. If the markets believe in the action and feel it will help to turn the corner, then it could work.
But the deal is far from a magic bullet that will suddenly free up the markets and see lenders queuing up to offer loans. The age of easy credit is over.
In the mortgage market, those without large deposits of equity behind them can expect to remain paying more for mortgages than those with a cushion. Also as rates fall, lenders are likely to increase their margins, so the cost of borrowing may not fall as much as hoped.
Cost to the taxpayer?
The government seems adamant the taxpayer can turn a profit on the bailout plan.
The guarantees on interbank lending will be offered at commercial rates, meaning banks are paying for the taxpayer to take on the risk of a loan falling through.
A £250 billion guarantee is massive, and as long as no one falls down, the government should be picking up some cash.
The argument the government is putting forward is they are buying shares at the bottom of the market and will make a profit as share prices rise and the market returns to normal.
However, the banking bubble has burst.
Tech stocks after the dot com collapse never recovered to the levels they reached at the height of the market and in a more conservative banking environment the massive profits built on high risks and easy credit that enamoured investors so much are unlikely to return.
It may be until the next generation of bankers comes along in 20 years and repeat the same mistakes that the price will rise again.
The move to choose preference shares, however, will mitigate risk. Dividends on preferred shares are paid before ordinary shares, and if dividends are not paid, they are carried forward to the next year.
However, the government is not getting a voice on the boards of the banks, as they did with Northern Rock. Also preference shares have less risk but in the long term can be less profitable.
The Special Liquidity Scheme – where the Bank of England hands out £200 billion – should also not damage the public purse, despite the amount sounding high.
What the Bank of England does is swap Treasury bonds for assets held by the bank. After three months, the cash from the bonds is returned, plus a bit extra. The system works as no one in the financial markets doubts whether Treasury bonds will be worthless, as they do with mortgage-backed assets. The banks can trade, and the Bank makes a bit on top.
So will it work?
A lot of people in the City and Whitehall are optimistic. As long as it provides confidence, the markets and lenders can start to pick themselves up off the floor.
But this is not a miracle cure and with house prices still falling, the mortgage market will not suddenly wake up tomorrow. However, endless falls to bank stock prices could well stop, at least for the time being.
Daniel Barnes
