When will the banks work again?

It is time to review the different approaches adopted to handle the banking crisis. Two months on from the deepening of the troubles and from the co-ordinated government responses, we still have largely frozen money markets and a credit seizure on our hands. Meanwhile the views of recession are worsening, with most forecasters rushing to catch up with reality and now estimating a longer and deeper downturn.

On both sides of the Atlantic governments rightly but belatedly concluded two things in September – that money markets and banks were starved of cash and liquidity by the authorities, and banks were short of capital at a time when they were revealing big losses on their assets.

The US and then the UK authorities set about solving this. Shortly afterwards the continental Europeans were also dragged in when several of their banks needed emergency capital injections. The US announced the $700 billion Paulson plan. The UK announced the $800 billion Brown plan, and the other Europeans also announced substantial increases in liquidity, loans and capital for their banks.

I supported the major injections of liquidity. The authorities in recent years lurched from too much money to too little with disastrous consequences. They are now creating huge amounts, realising very late that it is not currently inflationary and is much needed to try to kick start the banking system. Unfortunately, confidence is so low that much of it at the moment is a money go round. The authorities put it into the banks who lend it back to the governments. They need to keep on putting in as much as it takes, whilst always securing the taxpayers interest by lending relatively short against full security.

I did not support either the Paulson or the Brown plan for recapitalisation. I did not do so for two main reasons. The first is the banks are too big for the UK state, and even for the US state, to take them over and support them, without damaging the credit standing and the budgetary position of the two governments. The second is, the banks need to take some strong medicine of their own. They need to get fit rather than being put onto life support by the taxpayers.

The Paulson (Mark I and II) Plan reasoned that the banks had lent too much money to people and companies that would struggle to pay it back. This debt was overvalued in bank balance sheets, and could no longer be sold on to others to cut risks. If the government bought some of this debt from banks it would establish a value for it in the market and relieve some of the pressures on bank balance sheets.
There were three problems with this approach. Firstly, there was so much of this debt that the government could only buy up a fraction of it, leaving the banks damaged by the rest. Taxpayers might pay too much for what they bought, losing them money and creating an artificial market for a bit. The government might end up setting a price for the debt which would weaken bank balance sheets further as all the rest of the debt would have to written down to the new market level.

The Brown plan (and parts of Paulson Mark III) reasoned that the banks were short of capital to pay the losses and accept the write downs on their dodgy assets. It would be cheaper to put capital in than try to buy the dodgy debt. If governments put in enough new capital banks could establish a new lower value for the debts and pay the losses from the taxpayer cash. There were several snags with this approach. It undermined the share prices of the fingered banks, making it more difficult for them to raise additional capital from the markets. It assumed that there was a once and for all loss to be admitted and paid for, whereas the worrying dynamic of this crisis is the further deterioration of the loans as the recession deepens and more become unable to pay. The plan failed to see just what huge sums were needed by the banks relative to tax revenue. It failed to acknowledge that if the government ended up nationalising some of the banks it had to take responsibility for potential very large losses, as well as getting into nightmare territory on how many staff to employ, how many branches to keep open, and who to continue lending to.

What other options are open to governments? There are three obvious ones that warrant discussion.

1. Allow weak banks to go bust, and let the market pick up the pieces. Do this as quickly as possible to get the damage out of the way as soon as possible. There will be a recession anyway. This might deepen and shorten it. The market would then finance the new banks and the banks in the system that are viable. The experience with Lehmans has spooked both markets and authorities, leading most of us to rule out this approach.

2. Support weak banks that we need to continue by government acting as their bank manager. They should be offered sufficient liquidity, short term loans and guarantees so no major bank fails, with a view to their sorting out their balance sheets as quickly as possible under cover of the temporary state banking support. They should pay a fair interest rate and other charges to taxpayers for this assistance.

3. Use regulatory means and the role as bank manager of last resort to banks to force them to raise their own game more rapidly. Banks pay too many employees too much money. They need to slim and cut higher pay. They use too much property and carry other high overheads. These need to be reduced. They have been paying too much out in dividend and bonus. These need to be squeezed. Most banks could pay for their own losses and capital problems if they kept more and spent less of the huge revenues they generate.They should be made to get themselves in shape by astute regulation fo their capital ratios.

A combination of 2 and 3 is recommended. This would force adjustment without major casualties. It would reassure markets that there would not be a sudden collapse, whilst forcing banks to own up to the their losses and to work their way to a stronger financial position. The banks are too large to sort it out by public subsidy. Resorting to public capital takes some of the pressure off banks, delaying them waking up to the new realities and running themselves sensibly.

The authorities should study the experience of Japan. There after the credit explosion of the late 1980s the authorities kept many of the damaged Japanese banks going without forcing them to recognise their losses and to sort out their balance sheets quickly. As a result the Japanese economy suffered from more than a decade of insufficient bank credit and deflation. The West must make the banks sort themselves out more promptly, whilst taking care to avoid system collapse through needless bankruptcies of larger institutions.

Meanwhile the sharp deterioration of the Western economies is ominous for the banks as well as for the rest of society. It means more loan losses ahead on lending to companies and individuals. The governments do need to arrest the nosedive in the economies. Savers will be unhappy about plunging interest rates, but they will be even more miserable if the recession gets out of control and more banks go the way of the Icelandic institutions. In the end savers can only get good returns if borrowers can afford the interest.

The 10% drop in the US Stock market in the two days following the election of the new President is a warning sign for him and his advisers. They cannot delay until January. They are right today to meet to discuss the economy. They need to come up with a plan for how they are going to stabilise the situation. Quietly dumping or modifying the Paulson plan would be a good start. It is too dear and it’s not working well enough. I don’t think Mr Bush will complain if the new team try to control the steering wheel.


  1. Letters From A Tory
    November 7, 2008

    It’s the failure to sort out the balance sheets that worries me. All the problems that helped to start this crisis such as hidden debts appear to have slipped through the legislatory net – for now, at least.


  2. Andrew S
    November 7, 2008

    For banks to spend less they would have to stop doing all the fancy stuff and return to traditional lending against deposits and backing good businesses. They would not need to get into the spiral of paying high wages to financial wizzos.
    But that does mean the UK financial services sector would reduce. Some other country would no doubt want to fill the void so we would have to be ready for that.
    Also do we really want banks and other businesses to continue sending jobs overseas just to cut costs. What real jobs are we going to be doing in this country? Real jobs includes the backoffice work all businesses need to get done.

  3. Lola
    November 7, 2008

    Mr Redwood – I agree with both your cure and with the 'do it now' bit. But how are you going to get Brown Darling to go with this? It would mean them admitting they were wrong. It's just not going to happen is it? Every day's delay will cost us dear.

    IMHO Brown thinks he has go this sorted. I don't mean sorted for the country but sorted for him politically. It has been dealt with. He has achieved his aim of boosting his public image. The matter will now rest until he can either see more political advantage or until we get such a massive crisis (a visit to the IMF?) that he is forced to confront his failures at the ballot box.

    Never in all my life have I been so worried about our country and economy. I am 56 and first voted for Ian McLeod in 1970. I remember Wilson and Callaghan and Heath and all of them. I remember the 1976 ish secondary banking crisis. I remember the three day week, the winter of discontent, the early 80's recession. I remember the Cuban Missile Crisis and the assassination of President Kennedy . All of those 'crises' were minor in comparison to this one. Somehow we knew what to do and what our values were and we knew that we would win this because we could see the results of not doing so and where we would end up.

    Now we have a new world where there is no visible alternative. The victory of liberal capitalism is complete so the residual lefties have to rely on deceit and obfuscation and well, bribes, to gain and keep power. Liberal capitalism is in many ways counter intuitive, yet its success cannot be denied. To counter this the residual lefties are resorting to ever more control and deceit. Appealing to a badly educated electorate with shallow promises (not bread and circuses – but Big Macs and Big Brother) which the bureaucrats do actually deliver.

    And to be clear I am no raving righty looking to hang people for parking in the wrong place. And I am driven in my ire by the knowledge that leftyness destroys wealth for everyone. Especially the less well off.

    So how does one counter the 1984 style newspeak and deceit of the current government? How do we get 'change' that will take us to where we can actually create real wealth by trade and pay our way in the world again?

    Reply: The more of us who want change for the better, the more pressure we can exert to achieve it. You are right to be worried.

  4. Kit
    November 7, 2008

    "The experience with Lehmans has spooked both markets and authorities, leading most of us to rule out this approach."

    Yes, nobody knows which banks would be bailed-out or forced into bankruptcy. The authorities are leaping from one knee-jerk reaction to another without consideration to the consequences. (150bp – I wouldn't be surprised if a provider of tracker mortgages gets into trouble.)

    The authorities seem determined to spook the market. And if the authorities are spooked it is by their own actions.

  5. Bazman
    November 7, 2008

    I would not be surprised if they announced record profits.

  6. figurewizard
    November 7, 2008

    At last someone is suggesting that weak banks should be allowed to go bust. Administration followed by receivership would give the relatively strong banks to become stronger still, which; despite the widespread scorn with which they are currently regarded remains the essential point. This after all is what happened in 1866 when Overend Gurney collapsed after the Bank of England refused to lend support. A small but well run bank by the name of Barclays picked up the pieces then. Given Barclays recent debt free takeover of the US operations of Lehman Bros, it seems that history really could repeat itself if only the governments allowed it to.

  7. m wood
    November 7, 2008

    Very much agree with your analysis and solutions 2 or 3. It has occurred to me that most people have overlooked the fundemental reasons for this financial crash. For years people have been collectively 'inventing' money by overvalueing assets such as houses, loans etc. There comes a time when someone says, the emperor has no clothes, in this case, there isn't enough real money to match debts. The result is a random process that destroys the 'make-believe' money, either by writing off loans or devaluing currencies (another name for inflation). Many people/businesses get hurt in this process of adjustment that the market has to make, who it is is not a logical choice, the market system is too complex for Governments to control

    The real culprites are not the Banks, – they are just mechanics in the system – but those that failed to regulate the invention of make-believe money – mostly Brown and Clinton.

  8. David Belchamber
    November 7, 2008

    The example of Spanish banks must surely point the way forward for the regulatory system that will eventually emerge from our present mess. I believe that dodgy things like SIVs and CDOs are not permitted but the example of Santander surely demonstrates that prudent, tradtional banking does not inhibit expansion.
    Do you think that pre-1997 when the BoE had total oversight over the banking system, failures such as Northern Rock, Bradford & Bingley etc would still have occurred or do you think that an alert BoE would have nipped them in the bud without media publicity and also great cost to the taxpayer?

    Reply: Receiving £18 billion cash from British taxpayers has also helped Santander! The pace of their acquisitions is breathtaking and they need to consolidate them.

  9. mikestallard
    November 7, 2008

    I am in total agreement with all that you say except for just one thing. In 2 and 3 above, is it to be the government of the Bank of England which does the sorting out?
    This government is motivated by just one thing: re election. North British banks – the ones that have the most government now in their internal workings – are affecting the votes. They are affecting the voters who have mortgages and who need money for their businesses. The government is, therefore, very willing to intervene here. Yvette Cooper has made appearances on TV already. Glenrothes was important to the Prime Minister for a number of reasons. He likes, apparently, to be seen as a reliable paid of hands – it gets votes.
    The Bank of England, on the other hand, is motivated by money. This demands expert knowledge, instant reaction to change, sufficient tools to deal with crises and a free hand to deal with whatever is thrown at it. The Bank has been around for centuries and, unlike this government, has a wealth of experience to draw on in finance.
    That is why I should like the Bank manager to be – the Bank Manager! Instead, of course, we get the politicians and the FSA taking the decisions and all falling over each other.
    I very much enjoyed your lucid exposition of a hugely difficult subject: thank you!

    1. mikestallard
      November 7, 2008

      line 2: the government OR the Bank of England.
      line 8: pair of hands.

  10. anonymous
    November 8, 2008

    I believe you and your comrades in Westminster recently received copies of a certain dystopian novel for your reading pleasure.

    May I ask you opinion of that?

    Reply: Need more detail to be able to answer.

  11. Amanda
    November 10, 2008

    This is one of my main sources of economic analysis, so thank you for providing it.

    I am with Lola, I am more worried than I have ever been. The more I look at what Brown and Co are doing the more I can see it is the wrong thing to be doing. Re-election is the only think they care about – but for what purpose when the country will be 'fit for nothing', one can only wonder. Maybe a complete sell out to the EU and a place on the gravy train!!

    However, if we are to stop this, what can we do? What actions do I, as a family woman and small business owner, do to help my country? Apart from not voting Labour – but then I never have. The Conservatives offer me no hope and I, like I'm sure many others, feel very alone and angry.

    Reply: Changing government will be necessary. In the mentime let your MP and the media know of your worries.

  12. Amanda
    November 10, 2008


    My MP is Labour who cares nothing for 'the likes of me', he'd much rather serve his 'public'. I am helping my local conservative PPC, and I write comments on blogs all the time and constantly complain about the BBC. But the media, in the main, are corrupt as far as I can see.

    I also take every opportunity to discuss politics with people I meet, even now in business which would have been a definite faux pas in days gone by.

    And I take time out to help and encourage young people to upskill, be self reliant, and get out of the country if they can.

    However, none of this seems to help very much.

    Reply: Even in this damaged democracy of ours public opinion does matter and we need to keep wooing it.

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