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.