The Prime Minister Gordon Brown and the Chancellor, Alistair Darling recently announced a £500 billion bailout package in attempts to restore confidence in the UK banking system. In a desperate and dramatic move, the Chancellor announced a comprehensive rescue package that includes £50 billion to help recapitalise the balance sheets of banks via share purchases, £250 billion to underwrite guarantees at commercial rates and a further £200 billion injection into the frozen money markets. In effect, the taxpayer will take a potential major shareholding in the high street banks, in exchange for providing billions of pounds to assist their operational activities. The impact of the cash injections will mean a dramatic increase in the UK national borrowing. The government says that taxpayers will earn a "proper return" based on commercial terms. £25 billion will be made available immediately for banks to optionally sell preference or priority shares to the government; an additional £25 billion will be made available if necessary in the future. This is equivalent to £2000 for every UK taxpayer. The £250 billion is aimed at underwriting medium-term debts of the banks. The additional £200 billion is an extension of the Special Liquidity Scheme set up earlier in the year, which aims to to enable banks and building societies to swap temporarily assets that are currently illiquid in exchange for UK Treasury Bills.
Eight banks have confirmed that they would like to participate in this government rescue package. These include Barclays, Abbey National, HBOS, HSBC, Lloyds TSB, nationwide, RBS and Standard Chartered. There has been general political consensus that the plan is the right thing to do. The Conservatives said that the banking recapitalisation and provision of loan guarantees the right thing to do. The government will buy the shares in banks, which means that taxpayer will be the first in line for any dividend repayments. Downing Street announced that they would "strings attached and conditions to be met" with regards to the loan guarantees and recapitalisation. If there is a run on a bank or a banks shares collapse, the taxpayer could lose out if loans go bad or shares become worthless as investors panic sell shares.
The underlying problem of fear, uncertainty and doubt between the banks is stopping them from lending money to each other and hence into the wider real economy. In particular, small business survival and business investment depends upon obtaining banking overdrafts and business loans which are rapidly freezing up in the credit crunch. Recent surveys have revealed that business sentiment is down amongst owners and the quantity of business debt and the number of bankruptcies is rising.If businesses cannot get credit when they need it, many will need to rationalise or go through a process of business debt consolidation. The government has intervened to try and reverse the level fear, panic and lack of confidence in the money markets, which pundits are now comparing to the Great Depression.
The collapse of Lehman Brothers, the nationalisation of Bradford and Bingley and the failure of many other financial institutions, has demonstrated that no bank is safe from a 'run' on its reserves. Following the Government announcement there was a only marginal change in the interbank overnight and three month lending rates, indicating that the market still perceived continued future uncertainty and volatility. The collapse of shares in the following days since the 8th of October has gripped millions of small investors as much as major financial institutions. Logic, common sense and financial policies have been replaced by panic and desperation. It appears that the global economy is entering a recession unlike any thing businesses have seen for generations.
The financial rescue plan announced, a dramatic half percentage point cut in interest rates by the five major central banks around the world provided a co-ordinated attempt to soothe nerves and restore confidence in lenders. The half per cent cut in interest rates is showing the market that the authorities are prepared to do whatever it takes to restore confidence. Unfortunately, some lenders have failed to pass this saving on to its customers. Recently the Abbey National disclosed that its tracker mortgage would continue to attract the old higher percentage rate and not reflect the half point drop announced by the Bank of England. If lenders feel there is too much potential bad debt or the money markets are too expensive, they will price the products accordingly. The interest rate cuts are also aimed to bring relief for the four million homeowners who have tracker rate mortgages. Many house holders are already under pressure from huge increases in fuel and food prices causing a rise in personal debts. It is unclear whether lenders will pass on interest rate savings for borrowers on a standard variable-rate mortgage. Some lenders have yet to make any announcements such as nationwide and Abbey National.
The rescue plan is likely to push overall government debt above the 40% of GDP, (breaching the Prime Ministers economic golden rule). The liabilities from the nationalisation of the Northern Rock bank last year, coupled with the bond swap programme, now means that United Kingdom net debt is already 43.3% of GDP, equivalent to £633 billion. To make matters worse, the credit freeze appears to be bringing the economy into recession as businesses both large and small are cutting back on costs such as staff and advertising.
The emergency measures will force a transformation in the attitudes and behaviour of major banks. The boom years of excessive profits and unrealistic gearing are well and truly over. Instead, it is likely that the old traditional boring banking model of acting as a middle man between depositors of capital and borrowers who want to invest in the business or buy property. To make sure of this there are strings attached with taxpayers money... The announcement represents a major recapitalisation with the government taking conditional stakes. These conditions include the use of policies set down by the Financial Services Authority, who will provide a more rigorous focus on banking excess. For instance, capital ratios will now be agreed with major institutions based on judgements of the level of risk associated with their business model. The last 10 years of banking expansion through excessive lending has now come to an end.
In addition, the huge bonuses of the so-called 'fat cats' banking bosses will be curtailed. The huge risk taking taken by hedge fund managers, share traders and banking bosses in the US, City of London and elsewhere, have been blamed for creating the conditions that have caused the credit crunch. Executive pay will be managed by a new FSA code. The scrutiny of executive pay is one of the associated strings attached of the £50 billion the government is providing to UK lenders. The FSA do not plan to determined individual executive bonus packages but will get involved where banks are not realistic about employees pay structures. Banks have traditionally argued that to retain and attract the top people they must incentivise them accordingly.
The International Monetary Fund (IMF) has recently recommended that the UK government create a "toxic waste fund" before recapitalising the banking sector (similar to the Paulson USA plan). In contrast to its recommendation one year ago (in which prescribed a deliberate lack of intervention), the IMF in its Global Financial Stability Report recommends the setting up of a special fund similar to that of the US. It says that politicians must act on a more fundamental basis to prevent global meltdown. It recommends that the UK and other governments should pay two trillion dollars of taxpayers money buying up toxic and tradable assets which have caused the credit freeze. This figure includes the US treasury secretary's £700 billion Asset Relief Programme.