On 8 October 2008 the UK authorities announced a comprehensive plan to address the financial crisis facing the United Kingdom’s banking institutions. The plan comprises the following elements:
- Recapitalisation - The UK Treasury is making £25 billion available in permanent capital to raise the banks’ Tier One capital ratios, with a further £25 billion available on standby and for other eligible institutions. The banks who may participate in the scheme have agreed to conclude their recapitalisations by the end of the year. The Government will take stakes in participating banks through preference shares or permanent interest bearing shares, and may also underwrite issues of ordinary shares.
- Liquidity - An additional £100 billion is being made available to banks under the existing special liquidity scheme, which allows banks to swap illiquid assets for Treasury bills. The Bank of England will provide liquidity “in whatever way is necessary to ensure the stability of the system”.
- Funding - The Government will, for a fee, guarantee new short to medium-term debt issued by the banks to help them refinance wholesale funding obligations as they fall due. The expected total is approximately £250 billion. This facility means that banks will be able to issue unsecured debt instruments of up to 36 months backed by a government guarantee, and will allow banks to access medium-term wholesale funding in a way they have been unable to in recent months.
Shortly after this package was announced, the Bank of England also announced a cut in its base lending rate of 50 basis points in a coordinated move with the US Federal Reserve, the European Central Bank and others.
Banks accepting this offer of government capital will face constraints on their ability to increase dividends and on executive compensation structures. They will also be expected to make a commitment to continue lending to small businesses and homebuyers. It remains unclear, however, how these obligations will be enforced. It is also unclear what the precise terms of the government capital will be, and in particular what coupon the securities will carry. What does appear, however, is that the Government agreed to drop earlier requirements for equity stakes and/or warrants so as to avoid dilution of existing equity holders. Nor will the Government have rights to appoint directors of investee banks, and there will be no forced changes to existing management teams.
Some banks are unlikely to use the Government facility, while others have suggested that if they do so they would first offer existing shareholders the right to subscribe the required capital.
This is the first comprehensive plan announced by the UK Government in relation to the present crisis. Before this, the Government’s response has been more piecemeal, effectively nationalising first Northern Rock then Bradford & Bingley (two mortgage banks), and then raising the level of the bank deposit protection scheme from £35,000 to £50,000. It has declined to offer an unlimited guarantee to depositors as has been done in Ireland and Greece. It has also declined to approach a rescue on the basis of the US Treasury’s Troubled Asset Relief Program, preferring to provide assistance to banks by directly their addressing capital, funding and liquidity problems rather than simply relieving them of toxic and difficult to value assets.
The plan has been generally well received, putting in place as it does the pre-conditions for stabilisation of the banking system whilst at the same time recognising the longer term interests of bank shareholders—interests which have not been given such weight in the actions of the US authorities.
The cost to the UK taxpayer, however, is potentially enormous (much larger in relation to GDP than the equivalent figures in the United States), and will add materially to government borrowing requirements at a time when the economy (in common with most of the world) is entering into what may turn out to be a severe recession, which will add further to the negative impact on government finances. Whilst the plan will not itself save the economy from recession, the hope is that by bringing to an end the paralysis in the banking system it will avoid a recession turning into a long-term depression. However, the likelihood of serious recession and the rapidly deteriorating position of government finances have meant that the welcome to the plan is not (yet) reflected in equity prices.
Europe has not yet produced a coordinated response to the crisis. Not only is there no clear consensus of approach (for example, Ireland and Greece breaking ranks to offer unlimited government guarantees of bank deposits), but also there is no European Commission-wide regulatory structure under which such a response could be effected. The European Central Bank has rules for monetary policy and the ability to intervene in the markets to provide liquidity. But it cannot bail out bankrupt banks, which is a job for national governments acting unilaterally or multilaterally, the interests of more than one nation are involved. The same is true of prudential regulation. A number of European governments are now said to be examining the UK plan to see if it is appropriate to their circumstances, but as President Sarkozy said of the plan, it is “perfectly adapted to the situation his [Mr Brown’s] country is in”, but that he would not copy it for France.
Impacts on Financial World
Events continue to move extremely fast, and it is impossible to judge at this stage how they will ultimately affect the operation of the financial markets and corporate activity. However, the following issues (amongst others) are being discussed:
The future shape of regulation
How will the financial markets be regulated in the future? It seems that few would now support the proposition that, in the end, markets “get it right” and self-correct. We are likely to be facing a period of tighter regulation but will there be a coordinated international response to what are seen as regulatory failings, and if so will that be led from the United States or Brussels (likely to result in a tighter, rules-based approach), from London (suggesting a continuation of a principles-based approach) or from somewhere else, and would an international response include nations (including the newly wealthy) drawn wider than the G7? Or, as seems possible from the inability of European governments to coordinate a response, will individual countries develop their own solutions?
Sources of capital
Where will the capital be sourced to fund future economic growth? We have seen for some time now an increasingly flow of capital from newly wealthy countries in the Middle East and Asia into western economies, and indeed considerable sums have already been invested to strengthen the capital of a number of western financial institutions. As traditional sources of finance to fund growth and corporate activity remain under stress, the relative importance of the new sources is likely to grow, and with that the pace in the shift of political and cultural power is likely to increase. If there is to be a new international regulatory settlement for financial markets, those nations are likely to want to take part.
Current events are likely to have a dramatic effect on appetite for investment products. Investors are likely to feel safer for a while with investment originating close to home. They will shun complexity and opacity. They will shift away from models in favour of human activity; and there will be an emphasis on experience rather than innovation.
Corporate transaction activity
Highly leveraged transactions are likely to be extremely difficult to execute for some time. Financial buyers are likely to be less influential in the market and transactions will be affected with corporates looking for transactions justified by strategic plans and sector consolidation. These transactions may increasingly be funded by equity. And it will be some time before a flow of these types of transactions start as profound uncertainty remains in current conditions over the underlying value and even the viability of assets and businesses.