Banking on the state

A composite photograph showing the nine banks that the Bush administration plans to bail out.

AFTER much dithering, high drama and every effort to avoid the inevitable out of fear that it would straightjacket capitalism, governments in the developed industrial countries have taken the first, major, necessary step to begin resolving the financial crisis. They have, effectively, nationalised a large part of the private banking system.
These moves come at the end of a long series of interventionist efforts that pointed in two directions. The first was that governments believed that the problem facing the financial sector in the wake of the sub-prime crisis was not one of generalised insolvency but one of inadequate liquidity resulting from fear and uncertainty. The second was that to the extent that there were individual firms faced with insolvency, the problem could be resolved on a case-by-case basis, through closure (Lehman), merger (Wachovia) or state takeover (American International Group). It was only when the governments’ efforts based on these perceptions failed to stop the slide that they resorted to measures to deal with generalised insolvency, such as buying out all impaired assets or recapitalising banks with public investment. But even these were focussed on the banking system. In a world where non-banking financial institutions play an extremely important role and the banks themselves are integrated in various ways with these institutions, it was unclear whether these steps would be enough.
The perception that the problem was one of liquidity because financial markets were freezing up in the face of the difficulty in assessing counter-party risk yielded a host of responses, especially in the United States, that filled the media with acronyms: MLEC (Master Liquidity Enhancement Conduit), TAF (Term Auction Facility), TSLF (Term Securities Lending Facility) and PDCF (Primary Dealer Credit Facility). By the end of it, the Federal Reserve in the United States had offered to accept as collateral the bundles of worthless assets that were lying with financial firms and extend its credit facilities to entities outside the regulated banking system. Interest rates too had been substantially cut to make credit cheaper. When even this did not halt a slide in stock markets, recognition of the need to take other measures dawned on the governments. Some effort at dealing with insolvency was called for, they realised.Existing shareholders have the option of buying back the ordinary shares from the government. But if they do not, as seems likely, then the government would have a stake of 60 per cent in RBS and 43.5 per cent in the combined entity that would emerge after the ongoing merger of Lloyds TSB and HBOS. This clearly amounts to state takeover, which brings with it new obligations. The three banks will not be able to pay dividends on ordinary shares until they have repaid in full the £9 billion in preference shares they are issuing to the government. The Treasury would appoint three new RBS directors and two directors to the board of the combined Lloyds-HBOS to oversee the government’s interests. There would be restrictions on salaries and bonuses that had ballooned during the years of the speculative boom.
The decision to nationalise banks was forced on the British government because the problem facing the banking system was not just one of inadequate liquidity resulting from fears generated by the sub-prime crisis. Rather, credit markets had frozen because the entities that needed liquidity most were those faced with a solvency problem created by the huge volume of bad assets they carried on their balance sheets. To lend to or buy into these entities with small doses of money was to risk losses since that money would not have covered the losses and rendered these banks viable. So money was hard to come by. This is disastrous for a bank because rumours of its vulnerability trigger a run that devastate its already damaged finances.