Saturday, 27 September 2008

We need a UK bailout strategy.

I've been surprised by the UK banks. In contrast to their American cousins, banks here have been noticeably quiet about the need for a generous tax payer financed bail out.

I wonder why? Perhaps, our banks have already quiet received assurances from the government that when the time comes, the taxpayer will be there for them. Both the government and the banking sector have good reason to keep quiet. A bailout will be extremely contentious and won't be an easy sell.

However, silence is the last thing we need right now. Instead, we need a serious debate about the appropriate circumstances when the government should intervene in a failing financial institution. If the Americans have taught us one thing this year, it is that an ad hoc, "take it as it comes" strategy simply doesn't work. The uncertainty about who gets bailed out only makes matters worse.

Nor is it tenable to say "we'll have no bailouts here". The consequences of a full scale bank run is just to horrible to contemplate. Besides, whether we like it or not, governments always come to the rescue of failing banks. The key question is how they bail out the banks.

Since a UK bailout is all but inevitable, here is my simple guidelines for the upcoming financial rescue of our largely insolvent financial system. The overriding idea is that the government should provide financial assistance generously, but brutally punish any bank who dares ask for it.

Principle one - All deposit taking institutions get bailed out. Everything else goes down in flames. So, hedge funds, SIVs, and the rest of the shadow banking system should understand that there are no government guarantees. They are on their own.

Principle two - Any deposit taking institution that asks for emergency liquidity should provide high quality collateral and pay an above market interest rate for any cash. If, in the opinion of the Bank of England, the bank would have difficulty paying the penal rate, the government should immediately nationalize the troubled institution.

Principle three - The shareholders of all nationalized financial institutions get wiped out. The value of shareholder equity goes to zero.

Principle four - The board of directors, the CEO and the CFO of any nationalized firm are fired immediately without compensation.

Principle five - The assets of all nationalized firms are sold only where the maximum value to the taxpayer can be reasonably assured. In some cases, this might mean holding onto assets for a very long time.

Principle six - Banks are nationalized before their net worth is zero. Every bank must keep a minimum capital adequacy ratio of 2 percent. Any bank falling below this threshold is immediately nationalized.

Principle seven - The head of the FSA is automatically fired if any bank fails with assets greater than 0.5 percent of total UK bank assets.

I hate speculating about the future of particular institutions. Bank failure is a nasty business. Judging by press reports this weekend, the UK government might need to think about a coherent bank resolution strategy very quickly.

The failures could start coming thick and fast.



I like the sound of your rules.

Anonymous said...

It will be handled just like Britain handled the war on terror: in a sneaky, sniveling fairy sort of way. The British, with their fat arses and bloated bellies, will just stare slack-jawed at the pantomime before them. They have proven themselves to be both stupid and greedy and totally incapable of holding the government of crooks called New Labour to account.

dearieme said...

1) You would rescue a bank even if it is not systemically important. Why?
2)Principle three: doesn't that ensure that no-one else will put capital into banks from now on? Doesn't that make collapse likelier?

Mark Wadsworth said...

There is no need to invent new rules.

We have a perfectly adequate set of rules for insolvency situations, that might need tweaking slightly:

1. Depositors and normal trade creditors, employees get repaid in full up front.
2. Short term bond holders get paid next.
3. Long term bond holders get repaid so many pence in the £ of what can be realised*, and are then given shares in a new company that is in charge of chasing long term arrears, bankrupt and defaulting borrowers and BTLers etc.
4. Shareholders get nothing.

* Borrowers with sensible loan-to-income and loan-to-value ratios will have no trouble remortgaging (even if that is with the new company), others will have to remortgage as much as they can and take the shortfall on the chin.

The actual 'business' of running the accounts and mortages, the physical branches and computer systems and employees as an existing team are of significant value and get sold to the highest bidder. The going concern value is far higher than the break up value minus costs of making everybody redundant.

Or, if you want me to edit that; a slightly simpler and less painful version of what happens is,

1. Banks are forced (at gunpoint if necessary) to be honest about their write downs and ...

2. ... issue long term bondholders with new shares in exchange for part-forgiveness of debts (a sneaky way of recapitalising banks and diluting down existing shareholders), the part-forgiveness is a formality anyway - the long term bonds of threatened banks are only trading at 50p or 80p in the £ anyway - i.e. the bondholders get given new bonds with a face value of 50p or 80p and the balance in new shares.

Problem solved, lessons learned.

QG said...

Nice try Alice but I'm inclined to agree with dearime and mark wadsworth. Aside from the obvious difficulties facing the government, there is another aspect of this problem that comes to mind.

You're not gonna like this.

You're really not gonna like this at all.

We have to trust that the government has a strategy but the government must keep its mouth firmly shut on the matter. In other words, we have to trust Gordon Brown's government. Any public communication on the subject of bank rescues risks spooking depositors and investors more.

Wile E. Coyote must not look down.

Anonymous said...

Trust Gordon Brown?

* packs passport, turns off lights *

When they do the next sequel to 28 Weeks Later they won't need to empty Canary Wharf. Deserted will be it's natural state.


aSteve said...

I see a big problem both with the UK and US bailouts. While I don't disagree with the direction of your rules, Alice, I think there's a bigger issue.

How long can banks continue to be run with government support? This single question raises a massive problem as it poses uncertainty both for existing banks not receiving state aid - and for any new banks which might be thinking of forming. Our nationalised banks need an orderly run-down... I remain to be convinced that this is what our government is attempting to do.

Mark Wadsworth said...

Re my comment above, I am pleased to report that David Cameron said much the same on Andrew Marr this morning. Our likely next PM is in fact not a total moron. Cool.

dearieme said...

But, Mark, that will make it harder for him to get elected, won't it? People were entirely happy to vote for Tony-nice-but-dim.

Mark Wadsworth said...

No it won't.

These bond holders have been taking a wild gamble on property prices rising for ever, which was clearly stupid.

And for every bondholder who holds £100,000 nominal of such bonds and is forced to realise a loss of £20,000 (or whatever), there are tens of thousands of taxpayers who will heave a sigh of relief that their taxes aren't going to go up to bail out banks and BTLers.

Now, if you want me to draw up a lo-o-ong list of totally stupid things that Dave C has said, you'll have to give me a few weeks to make sure it's all there.