What exactly will the re-capitalisation of banks mean?
On the 13th of October, the UK Government announced their intention to release close to £37 billion to ‘re-capitalise’ British Banks. The announcement was accompanied by a stern promise from the chancellor, Alistair Darling, who stated that:
…we were prepared to make up to 50 billion pounds available. And if we need to go further than that I'll do it. Because my priority at the moment, as I say, is to stabilise an extremely difficult position, to strengthen the banks' position, so we can move forward.
This statement, along with the money injected into the financial system, represents the most significant departure from a pure liberal-capitalist banking system in the history of modern banking. Its impact has already been felt on credit markets, through falls in the overnight and three-month London Interbank Offer Rate (LIBOR). LIBOR represents the rate that banks lend to each other.
It is hoped that this move will oil the machinery and hopefully encourage banks to start lending to each other. If this does not happen then the repercussions on the real economy could be huge.
Why was re-capitalisation necessary?
The ‘credit crunch’ has been a worldwide phenomenon. Re-capitalisation of banks is not now a phenomenon particular to the UK (although they arguably took the lead) and has now occurred, or has been suggested, in a number of developed and developing countries including the US, UK, France, Netherlands, Iceland, and even South Korea.
The UK arrangement is actually only one element of the wider European re-capitalisation process. Estimates have shown that this process will cost the European Union’s 27 states close to £1.52 trillion.
The re-capitalisation is distinct from the plans proposed by the US to remove toxic assets and the two, whilst complementary, are very different proposals.
There are several reasons for the re-capitalisation but the main technical reason hinges on what is called the “Tier 1 capital” ratio. The Tier 1 ratio measures the relative strength of a bank. There are numerous ways that a bank can finance itself but the Tier 1 ratio primarily consists of shareholders' equity, preferred stock (stock that must pay a dividend before normal shareholders can be paid), and retained earnings (the proportion of net income that a company earns which isn’t distributed to shareholders).
The problem was therefore ultimately circular. The Tier 1 Capital of the banks was falling because they became unable to lend to each other and do business like usual. As a result of the Tier 1 Capital falling, banks became more nervous about lending to each other. Mervyn King, head of the Bank of England, has now gone on record saying that the UK Banking system was the closest it has come to collapsing since the first world war.
What are the details?
The basis of the current proposal is focussed upon the precedent of recent transactions made by Warren Buffet (until recently the world’s richest man). Warren Buffet is widely hailed as one of the most successful investors of all time.
On the 23rd of September 2008, Buffet invested approximately $5 billion in preference shares of Goldman Sachs. His argument for doing so was that the recent turmoil had hammered the share price of Goldman Sachs so much that it offered a good value opportunity. The sweetener was that the preference shares will guarantee Buffet dividends before all other stock investors. The UK proposal is very similar to this arrangement.
The UK government has asked 7 UK Banks and one building society (Abbey, Barclays, HBOS, HSBC, Lloyds TSB, Royal Bank of Scotland, Standard Chartered, and the Nationwide Building Society) to issue ordinary shares which they will buy.
The issuing of these shares will raise around £15 billion of core Tier 1 capital. The government has also agreed to purchase approximately £5 billion of preference shares. The idea behind this is that with improved capital ratios, confidence in the system will be restored and banks should start lending to each other again.
The investment will ultimately mean that UK taxpayers own around 60% of the Royal Bank of Scotland Group (RBS) and 44% of the merged Lloyds HBOS bank.
However…
The banks cannot just use the capital as they see fit. The government has supplemented the proposal with a series of rules and obligations. These include the following:
- Banks must re-instate the 2007 lending levels for the next three years to homeowners and small businesses. This is meant to stimulate spending within the economy and reduce the severity and onset of a UK recession. However, given that over-zealous borrowing and indebtedness is one of the fundamental reasons behind this entire debacle, this condition will need to be developed more if it is to bring any realistic benefit.
- The institutions must also offer support to homeowners who are unable to make mortgage payments and also support the expansion of financial capability initiatives. The first point seems to have been missed by the press, especially in the light of the nationalised Northern Rock coming under criticism from Credit Action, who reported that out of the 19,000 homes repossessed this year, Northern Rock were responsible for approximately 3,800 of them. The second point is arguably at odds with restoring levels to 2007 given the proliferation of self-certification mortgages, ultra high loan to value and income multiples for mortgage applicants.
- Remuneration of senior executives: the government has stressed that board members should not receive cash bonuses for 2008.
- As a major investor, the government will also be able to take a seat on the banks' boards and play a role in the governing of the institutions. The impact of mixing politics and business in such a way has concerned some but the government intends to create an independent review panel that will manage the holdings in the banks based upon commercial factors.
- Dividend policy: in order to ensure value for taxpayers, the government has stated that no ordinary dividends will be paid until the government's preference shares have been fully redeemed. This has caused chaos in the City, as long term investors have demanded that their shares are honoured (particularly those who have been in this for the long haul).
Criticisms
Despite the necessity, the scheme has come under scrutiny from the media, financiers, and the opposition party.
The first major criticism has been that the government has failed to act until now. On this point, the actions of the Monetary Policy Committee (MPC) and their apparent disregard for growth in a stagflationary environment can perhaps be viewed as more concerning, especially given their recent musings on the possibility of nil inflation.
The recent boom in commodity prices, which has driven inflationary pressure was, after all, bound to subside in more difficult credit conditions. It should also be remembered that the UK government has been one of the first to re-capitalise, although only after substantial alternative plans were unveiled and approved in the US.
The second criticism has come from extant shareholders within the banks. The restriction on the payment of dividends for 5 years, which RBS and Lloyds TSB/ HBOS have been obligated to sign up to, has angered many.
The criticism, which is arguably completely valid, is that the government will be forced to buy more shares as they will be so unattractive to other investors and will therefore compromise their position. This will obviously be detrimental for the taxpayers.
The existence of the re-capitalisation package is also, to an extent, circuitous. There is an indubitable stigma attached to a capitalist institution seeking money from the government. In France, the revelation of a similar package has been largely disregarded by French banks for this very reason.
Market sentiment has been so inflammatory that the share prices of the banks have plummeted following the mere rumour of institutions seeking capital. If some banks are openly seeking this capital whilst others are not, the price of the government's investments may fall.
Another criticism has been that the government’s investment will dilute existing shareholders. Arguably, a more appropriate solution to this problem could have been found through a variety of means. For example, debt could have been used rather than equity investments. Debts could have taken the form of subordinated loans or fixed charges where appropriate. These would have resolved some of the issues surrounding diluting the equity of the shareholders.
There is also an argument which states that the government could have subsidized the sale of troubled institutions to healthier institutions, although this may have led to further asset contamination.
A third alternative would have been to engage in a more piecemeal re-structuring. However, these solutions may not have done enough to restore investor confidence in the short-term.
Finally, the impact upon the taxpayer of having to rescue institutions which have effectively made their own beds needs to be assessed. The National Statistics Bureau has estimated net debt at £645.3 billion at the end of September. The figures on the 30th of September 2007 amounted to £514.5 billion.
The impact of recent events will only exacerbate this position. Full details of the funding of the re-capitalisation were issued by the Debt Management Office (DMO). For details of the proposals, click here.
There is a compelling argument which states that replacing private debt with public debt fails to acknowledge the over-zealous borrowing and cheap credit which has caused this problem.
An acknowledgement by the government that it was ultimately their drive to introduce housing for all, a move which was merely facilitated by the banks, would be appreciated. The government condition that lending must be restored is perhaps the greatest fear surrounding the plan since the sociological and cultural materialism which has driven this crisis will not disappear.
