Rolling out bank bail-out plans

As predicted by John Greenwood, Invesco's chief economist, in his FastFacts of 10 October, the Paulson and Darling bank bail-out plans (Round 1) have quickly been followed by a further series of bank stabilisation plans across Europe, Asia and Australasia (Round 2)...

...and a significant modification of the Paulson TARP (Troubled Asset Recovery Programme) in the US. Against the background of extraordinary volatility in world stock, commodity and currency markets this past week, we have again asked John to assess these unprecedented developments.

WHY DID GOVERNMENTS NEED TO TAKE SUCH DRASTIC STEPS?

"The problem with banks' balance sheets is that on the left there is nothing right, while on the right there is nothing left". This little aphorism concisely summarises the potential threat to national banking systems across the world over the last two weeks. To understand its wisdom, remember that under (US) accounting conventions, assets are placed on the lefthand side of the balance sheet, and liabilities and capital are placed on the right. Over the past 14 months, banks' losses from mortgage-related assets have mounted. In recent weeks this has been exacerbated by the intensifying credit crunch, which has made it harder for firms to roll over their borrowings or draw down new loans, putting more and more pressure on banks. Tumbling commodity prices, crashing share prices and volatile currency movements threatened a whole new raft of bank loan losses. As recession has loomed, expectations of even further loan losses have escalated. On the left (asset) side of the balance sheet, nothing was going right.

More frighteningly, since loan losses erode the capital of banks (on the right), their share prices plunged. This, in turn, prompted lenders in the wholesale money markets to withhold funds, and in some countries depositors started to shift deposits away from more vulnerable banks. In other words, in addition to the freezing up of credit markets, there was a significant risk of an imminent run on banks at the wholesale or retail levels. In short, there was a threat that "on the right there would be nothing left". At its simplest, a run on a bank is like someone crying ‘Fire!' in a crowded theatre. The risk that any individual may lose their life (their deposits) prompts everyone to rush for the doors at once (withdraw their funds). Banks cannot, of course, pay out all their funds instantaneously, which means that they have to respond to a panic run in one of two ways: either they must pay out slowly and hope the panic dissipates before they run out of cash; or they must put themselves in the arms of a stronger bank or the government.

So great was the threat to banks in the past two weeks - both to their capital (from the perceived buildup of prospective loan losses) and to their liquidity (i.e. their ability to fund themselves with deposits or money-market borrowings) - that governments and central banks across the world have had to bite the bullet, stepping in to quell the panic.

Only governments or national treasuries have balance sheets big enough and creditworthy enough (thanks to the flow of tax revenues) to rescue banks when the run becomes systemic, and only central banks have the power to create enough money to pay out to calm the storm. Walter Bagehot, in his famous book, Lombard Street (1873), prescribed what has now become the orthodox central bank approach to dealing with banking panics:

The way in which the panic of 1825 was stopped by advancing money has been described in so broad and graphic a way that the passage has become classical. "We lent it ," said Mr Harman on behalf of the Bank of England, "by every possible means and in modes we have never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice." (i.e. We were not too discriminating about the quality of the collateral).

Substituting the names of modern financial instruments, the same passage could be applied to Mr Bernanke's Federal Reserve (the Fed) in 2008. In the 19th century bank runs were typically attempts by the public-at-large to convert deposits into banknotes. Nowadays, however, a ‘silent run' on a bank can occur if other banks are suspicious of one bank's capital position, and refuse to offer it funding in the wholesale money markets. This is effectively what has been happening in the money markets recently, and is preventing borrowing banks from rolling over their obligations, critically damaging them or forcing them into mergers or bankruptcy. Since Mr Paulson initially proposed his TARP on 28 September, bank stabilisation plans have generally progressed in two stages:

First, a number of governments expanded their deposit insurance schemes or issued blanket guarantees on deposit or wholesale money market obligations of banks operating within their borders. The problem with this ad hoc country by country approach was that

1) it did not protect banks' capital from loan losses or from write-downs on securities, and

2) it triggered sizable fund transfers from unprotected banks or from countries with no such guarantee. Ireland was one of the first to announce such a measure on 30 September. Since then Germany, Greece, the US, Hong Kong, Australia and numerous other economies have all expanded their deposit-guarantee schemes or offered more comprehensive protection for a range of bank liabilities.

The second stage, led by the British government, and followed soon after by several European governments in the aftermath of the EU leaders' summit in Paris on 13 October, has been to implement more comprehensive, three-pronged support programmes to take care of the liabilities (righthand) side of banks' balance sheets:

A) injecting capital (with conditions)

B) providing specific guarantees for banks' wholesale funding requirements, and

C) arranging for the central bank to pump in substantial amounts of liquidity to try and ease the stress in the money markets

Since the implementation of the British and European plans, the Paulson TARP has morphed into a US$250bn plan to inject capital into nine leading US banks, grant moneymarket funding guarantees, and greatly expand the US Fed's liquidity injections. The original plan to purchase troubled assets is still retained, but since it cannot be put into practice immediately, it seems that it has been scaled back in favour of immediate adoption of the British template. However, the Paulson plan has some merits over its British rival. In particular, the terms for government participation are much less stringent (e.g. 5% coupons on preference shares rather than double-digit ones in the UK's case). This will make it much easier for private capital to participate alongside the government. Expressed differently, the risk is that the British authorities are making the same mistake the victors made after World War One in imposing unduly harsh reparation conditions on Germany, hampering recovery and laying the groundwork for trouble in the future. If it is intended to restore the banks to private ownership as soon as feasible, the terms for government participation must not be such as to deter private capital.

CAN THESE GOVERNMENT INTERVENTIONS STAVE OFF RECESSIONS?

In a word ‘no' - it is too late. Since the collapse of Bear Stearns in March, bank credit and money growth has been virtually zero in the United States. Elsewhere, in the UK, Europe and Japan, credit conditions have tightened markedly. This is the economic equivalent to cutting off the

blood supply to the human body. The result has been that economic indicators everywhere have been falling or slowing sharply, suggesting that most developed economies are already in the grip of recession.

The steep rise in LIBOR lending rates since the Lehman bankruptcy will have reduced the availability of money and credit even further. The only question now is how deep and how extended the recession will be.

Investors should therefore be cautious about committing funds to risky asset classes over the next few months. Banks and other financial institutions have become heavily overextended with large-scale borrowings over the past five years, and they are now faced with falling asset values and rising losses. As the recession deepens, financial sector losses will rise further. Consequently governments may well find themselves having to provide additional infusions of capital to the banks. In any case it is certain that many banks and non-bank financial institutions need to engage in a lengthy process of balance sheet repair - raising capital and/or reducing their lending. This could take several years to complete.

During this work-out period the performance of the leading western economies will be distinctly sub-par, and company profits will be much weaker.

However, what these bank stabilisation plans can do is to enable the de-leveraging of over-indebted bank and nonbank balance sheets to proceed in a more orderly manner. Instead of allowing the snowball to accelerate down the mountainside, getting larger and larger until it becomes unstoppable, there is now a reasonable prospect that the snowball can be slowed. The de-leveraging or debt reduction must still occur, and the recession may just be the necessary catalyst to galvanise banks, firms and households to do just that.

If there is a silver lining to all this gloom, it is that with the recession, inflation is likely to come down steeply. In addition, private sector demand for credit will weaken as the recession spreads. In combination this means that developed economy governments should have no problem raising

substantial sums in the debt markets (to meet their growing budget deficits) at progressively lower interest rates. Just as in 2001-03, the next couple of years should be a great period for investing in fixed income securities. The search for yields will be on again.

Important Information

Where John Greenwood has expressed views and opinions, these may change. Invesco Perpetual is a business name of Invesco Asset Management Limited (authorised and regulated by the Financial Services Authority). invescoperpetual.co.uk.