Month: October 2008

Banks and the scale of their lending are currently controlled by regulation. The regulators place on them capital requirements. Clearly the Regulator has confidence in our banks and believes all our main UK banks have sufficient capital to trade – as his permission is needed for a bank to enter and stay in business.

Because there is such an intense de-leveraging underway – stemming from a wish by the authorities to cut overall lending and borrowing – many now think banks should have more capital than the minimum required by the Regulator, and more than some of them currently have above that minimum. Fear within the banking sector is also forcing banks to raise more capital than the Regulator requires, and more than they have been used to employing in recent years for a given level of lending.

The principal requirement is to have sufficient Tier One capital. This is basically funds provided by shareholders to their bank when the shares are first issued, and the accumulated profits left in the bank after all payments of bonuses to staff, dividends to shareholders and other payments. Typically a bank will have at least £5 or £6 of Tier One capital for every £100 of advances made to customers. The idea is that if the bank proved a bad judge of these loans, then the shareholders funds can pay the losses. It would usually be unheard of for a bank to lose more than 5-6% on all the advances it made, owing to failure of customers to repay, or failure to raise enough money to repay the loan from the security lodged when a customer does give up the payments. Bad debts on most quality lending would normally run at less than 1% overall, after taking into account money released from security where payments are not met.

The back up requirement is to have some Tier 2 capital as well. This is money held as provisions against losses, surpluses on the banks assets like its directly owned property, and long term money borrowed from others. In the unlikely event of the bank having to go into Administration this money could also be drawn down or released by asset sales to pay off the depositors and other creditors. Tier One and Tier Two capital together might amount to say £10 for every £100 of loans.
A bank does not have to provide the same shareholder cover for assets held like Treasury bills and government bonds, as the Regulator assumes these can easily be turned into cash. It is just the “risk assets” – the mortgages and company overdrafts – that need the full shareholder cover.

This means a bank may be 10x geared – it can lend 10 times its combined Tier One and Tier Two capital. It raises the money to make these extra loans by taking in deposits from the public and companies, and borrowing in the markets. Those banks that have relied heavily on shorter term borrowing in money markets are the ones who have faced the most difficulties – Northern Rock was the worst example. When the money markets dried up the Rock was left short of borrowing to finance its substantial mortgage lending.

The authorities have to decide how much extra capital cover they think banks should now be required to hold. The more they request, the less lending will continue to British individuals and businesses. The banks themselves may decide to hold more capital, to reassure fellow banks that they are safe to do business with in current conditions. Banks also have to raise more capital if they make substantial losses, as the shareholders have to make good the funds their managers have lost.

NB THE ROUGH FIGURES ARE FOR ILLUSTRATION ONLY AND DO NOT REPRESENT ANY PARTICULAR BANK. THE DEFINITIONS ARE APPROXIMATE, NOT PRECISELY TAKEN FROM THE REGULATIONS

The number of contributions is increasing rapidly. I am happy to act as host and put as many up as possible. I do not mind people disagreeing with each other or with me. Nor do I mind well informed and hard hitting criticism of governments or political parties.
I do not wish, however, to put up comments which make unpleasant or damaging comments about individuals or institutions. I have so far sought to delete these and then post the remainder of the piece. Given the volume I may in future simply have to drop the whole post, as the editing can take too long.

Yesterday at a little after noon the Prime Minister announced a 50 basis point cut in UK interest rates to the Commons. He told us the Governor of the Bank had decided it. The decision came a day before the Monetary Policy Committee had completed its usual monthly processes to settle their view of interest rates. The statement did not say rates were being cut in order to hit the inflation target, but to take part in concerted action around the world to help with the banking crisis. I agreed with the need to take urgent action to cut rates, and am glad the authorities did it.

I have long argued there can be no such thing as a truly independent Bank or Monetary Policy Committee in a democracy. Parliament – or Congress and President – can leave an “independent” body free to do these things as long as they like. However, this freedom will only be extended for as long as the “independent” body does it job well and the system still pleases the people and elected politicians. Once there are worries, concerns or doubts, it is likely the elected officials will reassert their direct power, or change the system. The US system has always required the Fed to support the economic policy of the Administration. Mr Darling has reminded us that the Bank of England too has another duty as well as curbing inflaiton.

You could argue that the lack of independence of the MPC was obvious as long ago as December 2003, when the government changed the inflation target from RPI to CPI and from 2.5% to 2%. This in effect encouraged the MPC to set lower interest rates, as the CPI was going up much less quickly than the RPI. You can argue that the lack of transparency over who gets reappointed to the MPC and who does not was another weakness in its structure. Surely no sensible person after yesterday can say the MPC is independent?

I do not mourn the passing of the “independent” phase of the MPC. This is the body which kept rates too low in 2003-6. Its main aim was to keep inflation down to 2%. It has shot up to two and a half times that. It failed in the good years to be tough enough. It failed to control prices as advertised.

Now we are on the threshold of bad years it has been too tough. Its actions in keeping rates high as we peer towards recession will increase the number of people who lose their jobs and their businesses during the downswing. Once again the MPC seemed to be driving by looking into the rear view mirror, to capture the inflation it has already allowed, rather than looking through the windscreen to see the crunch ahead.

Let us hope we now can have a more intelligent debate about how to control money in a democracy. It is a great pity that the “independent” MPC did not succeed in curbing excess money and credit growth in the good years. We need new people or a stronger system that will control inflation next time round, when the extent of public debt will lead some to hanker for more inflation to reduce the liabilities. In the meantime we need an MPC and Bank fully committed to countering deflation.

The Uk Stock market plunged another 3.6% this morning on the back of the banking package. Then came the news of a 50 basis point cut in the UK, matched by the same in the US and Euroland. The market immediately rallied and is now up on the day.

Subsequently markets decided the interest rate cuts are not sufficient to stop a recession and fell again.

I don’t know where that leaves the independence of the MPC, but it was the first downpayment on the action we need to fight recession.

At last the authorities have woken up to the scale of the problems in the money and banking markets. Any sensible person this morning wishes the government’s plan well and hopes it will succeed. Let me begin with some supportive points.

It is good that more money will be made available to try to make money markets more liquid. The Bank of England can accept a range of assets as collateral or security for the loans, valuing them in a way which ensures no taxpayer loss. It is also sensible to try a government guranantee, with suitable reward for the taxpayer for offering one, to trigger interbank lending again. The sums involved are large, as they need to be. It is still better that any bank needing more share capital should seek to raise it from the private sector. At least we are not going the route of more bank nationalisation. Nationalising Northern Rock has just meant a more frozen mortgage market and P and L account losses for the taxpayer.

It is time now for those operating in the money and interbank markets to make their contribution to recovery.What more are they waiting for? Will they now start to resume more normal lending and borrowing to each other? Will the great banks now set about sensitive and sensible banking of all the businesses and individuals in the country, at a time of downturn and difficulty? That means making facilities available where a business has a potentially viable future. Given the extent of state support, the public will be expecting helpful and mature banking on the high street.

I am critical of the way the proposals to offer new capital to the banks was leaked. It led to a wave of selling of bank shares yesterday based on rumours of what might happen to existing shareholders. I had recommened some time ago that the regulators behind the scenes with no public announcement should have required any bank where they thought the capital inadequate to raise it from the market as quickly as possible. These things must not be done in public – they must be done promptly, in private, and once the decision is taken that must be communicated immediately to the Stock Exchange. Leaking discussion will undermine share prices, and make it more difficult for any given bank affected to raise money from it own or new shareholders in the market, the opposite of what the authorities should be seeking to achieve.

This site has declined to name any global bank that might need new capital or be in cash difficulties, until such a bank is being nationalised or put into Administration. I have taken the view that it is irresponsible to join in circulating rumours about individual world banks, at a time when there is a desperate need to rebuild confidence.

The Stock Exchange is still falling as I write this. That is no surprise. People are having to adjust their expectations to a very different economic prospect. Events in the banking sector do mean difficult days ahead for most other businesses. It does mean a bigger downturn than many forecasters were predicting. Readers of this site will know I have been pressing the government for some transparency on the UK’s economic prospects. The totally out of date forecasts the Treasury is using are not helpful. We need to know the government’s latest and best estimate of how bad it will be in 2008 and 2009, so businesses can plan accordingly. Quoted Companies are under a duty to report to the Stock Exchange any material change in their circumstances and forecasts. We now need similar transparency about the overall condition of business and the prospects for the next year or so ahead.

The economy still needs a fall in interest rates. Now the authorities are fully engaged in fighting the banking crisis, they also need to be fully engaged in fighting recession.

It was another bruising day on European markets. German shares fell 9%, partly because the German government offered a guarantee for all bank deposits then appeared to water it down. UK shares fell 8% where the authorities said they were thinking about what further measures to take. US shares fell a mere 3.5%, a further fall on the top of last week’s despite the approval of the massive Paulson bail out plan for the banks. Why?

Confidence has gone in the inter bank market. The money markets, under the influence of the Central Banks, are not functioning properly. If banks cannot borrow from each other and from the money markets, they have to reduce their own lending activities. Central banks are now trying to make cash available to the banks to get things moving again, but the banks are so battered by their losses and by past attempts of the authorities to reduce liquidity that they hoard the cash, putting it into ultra safe investments, when they do get hold of some.

I have been warning for months that this is a serious banking crisis, and that the authorities need to do more – behind the scenes – to strengthen liquidity and capital adequacy, seeking private sector solutions wherever possible. Now they are doing so, the second crisis erupts. This could never be contained as just a financial crisis. Because the authorities have taken so long to get up to speed, and because they have dithered or done the wrong things, the impact of the financial crisis on the rest of the economy will be worse.

The two crises now merge. The recession that is beginning to hit shops and garages, restaurants and factories, will cut the money coming into businesses. They will need to borrow more to see themselves through the downturn, but the banks will be unable or unwilling to help. Just at the time when business needs longer lines of credit at cheaper prices to avoid large scale redundancies and closures, the banks will reduce the credit they supply and increase its price.

The pattern in the UK is now clear for all to see save the Monetary Policy of the Bank of England. Collapsing oil, food and other commodity prices will come together with squeezed margins and the price cuts required to move stock next year, so inflation in 2009 will fall rapidly from its highs this autumn. Small business will be squeezed very badly by banks who cannot lend more and by customers who cannot afford to spend more. Big businesses too will struggle to obtain the credit they need and will be cancelling expansion and other investment projects. The authorities should be fighting recession, not inflation – they lost the battle against inflation a couple of years ago but it will cease to be a problem within a few months.

What options do the authorities have? The first is to cut interest rates drastically. Australia showed the way yesterday, cutting 100 basis points off her rates, even though her economy is still enjoying the benefits of Chinese demand for her commodities. The Australian bank appreciates there will be troubled times ahead. I have been calling for a 250 to 300 basis point cut in the UK. There are now more voices backing that. Of course market rates will not snap back into line with base rates, but a big cut will help all those floating rate borrowers linked to MLR and will cut market rates to some extent. It’s bad news for savers, but we all have an interest in avoiding more bankruptcies throughout the business and personal sectors, including those of us safely paid by the state.

The second is to work behind the scenes, bank by bank, to ensure liquidity and solvency are up to good standards. There needs to be intelligent bank regulation and intelligent central banking, based on a better understanding of the realities of the banking and money markets.

The third is to put the public accounts into better shape. The government itself in the UK set a bad example with its PFI, PPP and other off balance sheet financing and with its big build up of debt. Transferring the liabilities of the banking sector to the taxpayer is not going to solve the problem. They will not necessarily be better managed by Ministers, and the state cannot afford to take on any more. Fiscal prudence must include caution about taking on difficult debts. The state is the lender of last resort and needs to be so. At the moment it is the main lender. It needs to wean the banks and markets off such a dependence. Buying out the banks would not remove that dependence, but make it much longer term , and ensure the losses rested with taxpayers. At least the Bank is being cautious – if reports are correct – in demanding plenty of security for the loans it makes the banks, to protect the taxpayers. That is the least bad way to handle it.

There is no single magic bullet. The authorities – and the wider political and media establishment – should think about the meaning of the Paulson plan. For a couple of weeks we were told that if the US Congress passed the plan we would be saved, and if they rejected it we would be in deep trouble. The plan passed. The full $700 billion with few strings attached to its spending got through. Markets fell further and banking markets remained frozen. Let us hope when some of the money is released it is spent effectively and its starts to help the banks it is designed to support. In the meantime, European authorities with less money to spend should say to themselves they need to spend less a lot more effectively to start to lift the gloom. Confidence is a precious flower, only appreciated when it is wilting. No-one can be sure what words, what deeds, what events it will take to rebuild confidence. Anyone in authority today is walking on eggshells. Their words could do good or harm. Their deeds could make things worse or better. I wish them well, for all our sakes.

There is no case whatsoever to nationalise more banks, let alone for taxpayers to be made to take equity stakes in all the banks. There is a new kind of madness stalking the government world, as the governments lurch from one inappropriate response to another in response to a fast moving banking crisis. Governments helped create the crisis, by keeping interest rates too low and looking the other way as the banks and Shadow banks heaped debts on debts. Then governments helped bring the crisis on by keeping interest rates too high and refusing sensible help in the early stages of the crunch.

Governments should look after taxpayers. Taxpayers cannot afford to nationalise the banks. If governments assume too many new risks by taking on the assets of the banks or buying them up, it merely shifts the problems from the private sector to the public sector. It does not solve it. The problem will then become how do governments pay all the bills? How can they finance themselves in a non inflatonary way? How high do taxes have to go? A banking crisis does not suspend the laws of public finance. Buying bank shares is just like hiring teachers or buying more paperclips for a government office – only less popular with the taxpayer.

The public will be angry if governments do this. The feeling will stay abroad that there is one rule for bankers and one rule for everyone else. All the other businesses that will now go under thanks to the hostile economic climate will not enjoy a bail out because they have “got it wrong”. The senior bankers paid themselves huge bonuses and salaries in the good times, so why should they benefit from a rescue when their businesses go wrong?

Some of the world’s banks should be put through administration because their balance sheets are blown to pieces by the changed climate. Many need appropriate action by the authorities to help them through the crisis. To do so the authorities need to stop misrepresenting the true problems.

This is not just an American crisis. It is also a European one.

Interest rates are far too high in Europe and the UK. What does it take to get the hopeless MPC and the ECB to recognise this? Do they want the whole banking system to melt down before they see the problem? Will they accept their responsibility for fuelling the inflation in the first place? When will they see the problem is no longer inflation but massive deflation?

This is a crisis of confidence in asset values, brought on initially by too little liquidity in banking markets. Will authorities now solve the short term liquidity problem with whatever it takes as they promise to do? They have at least made moves in that direction in the last few days, a year too late. Will they go on to require the banks to solve the capital adequacy problem by insisting they raise new capital from anyone but the local taxpayers who have no wish to go to the rescue of their local banks under the management of national governments? Again, this is something the banking regulators should have required last year as the crisis began.

Usually watching authorities around the world I reckon they do the right thing when all else has failed. This time I am not so sure.