Bank bailout mark II: Will it work?

Original Article Bank bailout mark II: Will it work? Maximilian J.B. Hall having graduated with a PhD in Economics from Nottingham University, joined the Economics Department of Loughborough University in 1977, where he is currently the Professor of Banking and Financial Regulation. He has published several books and has also published over 100 papers in academic and professional journals. Maximilian has acted in an advisory capacity to the central banks of Barbados, Indonesia, Japan, Macau, Pakistan and the People’s Republic of China, and as a consultant to the likes of the World Bank, the Asian Development Bank, the Inter-American Bank, the Cabinet Office, the British Council and IBM. His current research interests embrace UK banking regulation and supervision, central and commercial banking developments in the United Kingdom, United States, Japan, Indonesia and the EU, financial reform in Japan and deposit insurance design. He is also working on empirical studies of banking efficiency in Hong Kong, Indonesia and Japan. Correspondence: Maximilian J.B. Hall, Professor of Banking and Financial Regulation, Department of Economics, Loughborough University, Leicestershire, LE11 3TU, UK E-mail: ABSTRACT On 19 January 2009, the UK Government unveiled a second comprehensive bank bailout plan. This followed the failure of its October bailout package to stimulate domestic lending, as intended. The various components of the new ‘rescue package’ are duly explained and analysed in this paper, which also addresses the likely future course of policy should the Government fail in its latest ambitions to stimulate lending and thereby revive the flagging economy. Journal of Banking Regulation (2009) 10, 215–220. doi:10.1057/jbr.2009.5 Keywords: UK banks; failure resolution; regulation and supervision 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 ‘pointin-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 & 2009 Palgrave Macmillan 1745-6452 Journal of Banking Regulation www.palgrave-journals.com/jbr/ Vol. 10, 3, 215–220 Hall (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 216 r 2009 Palgrave Macmillan 1745-6452 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 MortgageBacked 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 – se (...truncated)