The British government has announced the most comprehensive rescue package yet for any banking system in the world. The government will inject up to $88 billion of new capital into major British banks such as Barclays (BCS), Lloyds TSB (LYG), and HBOS (HBOS.L). And in an effort to ease fears that have reached near panic levels, the government will guarantee short and medium term bank funding. It estimates that the takeup of this offer could run to $440 billion.
The whole package amounts to some $880 billion or more in new and old money—an even greater sum than the recent $700 billion U.S. rescue package. "This is beginning a process of un-bunging a big problem where banks won't lend to each other for long periods," said Chancellor Alistair Darling. Investors were relieved but not entirely swayed: The benchmark FTSE 100 stock index stayed flat most of the day and then turned sharply downward in mid-afternoon.
The government's announcement was coupled with a one half percentage point rate cut by the Bank of England, to 4.5%. The rate reduction was coordinated with other central banks, including the European Central Bank and the U.S. Federal Reserve, which also dropped key interest rates by 50 basis points (BusinessWeek.com, 10/8/08). The BOE, led by its brilliant but sometimes overly abstract Governor, Mervyn King, has been slow to recognize the fast-mounting dangers to economic growth—focusing instead on inflation and the need to teach a lesson to those who made and accepted foolish loans.
The rescue package will come at a price: The government will have a say in executive compensation and dividend policies at the banks participating in the bailout, and will require a "full commitment to support lending to small businesses and home buyers." Shareholders also are likely to see their equity stakes diluted.
The giant bailout is the clearest sign yet of how much the financial environment has changed in Britain and London in recent weeks. Britain benefited hugely from the credit bull market, with house prices soaring and City financiers and traders reaping lavish compensation. Now, with everything going into reverse, the government is proposing what amounts to a partial nationalization of the banks. Similar moves have occurred in the past tumultuous week in other European countries including Iceland, Belgium, and the Netherlands (BusinessWeek.com, 10/6/08).
It's not clear yet which banks will take advantage of the bailout. Eight of the major banks have agreed to raise a collective total of $44 billion in capital by yearend. But how this number will be shared, and which banks will take taxpayer money has not been revealed. Some may raise the money from private sources.
Royal Bank of Scotland (RBS), whose stock plummeted almost 40% on Oct. 7, has said it will participate in some form. While welcoming the government package, HSBC (HBC), the largest British bank, says it won't take government funds. HSBC sources say the bank doesn't need new capital—and it's already grabbing market share from other institutions as savers and business clients seek the safety of its large balance sheet.
In a research note, banking specialists Keefe, Bruyette, & Woods (KBW) estimate that Barclays, Lloyds TSB, and HBOS likely will accept the largest slugs of capital. Barclays insists it doesn't need public money but is keeping its options open. One banking source said the government has made a mistake by not forcing all of the banks to take public funds. That way it would have avoided stigmatizing as weak those that accept taxpayer money.
The British move was prompted by chaotic conditions in the financial markets on Oct. 7, as investors slammed British and other banks. RBS and HBOS (which is in the process of being taken over by Lloyds) came under the most pressure. The 41% plunge in HBOS shares raised questions about whether the merger, for which Prime Minister Gordon Brown has taken part of the credit, actually would go through. After the government announced its rescue package Oct. 8, bank shares rallied with HBOS up 59% and RBS up 21% from dangerously low levels.
As comprehensive as these measures are, notes Citigroup (C) economist Michael Saunders, they probably won't fully restore confidence in a financial system that is so tightly linked to the rest of the world. They also won't likely be enough to prevent what looks like a nasty recession in Britain. "Much of the economic pain still lies ahead," Saunders notes, with house prices falling and job losses and business failures just beginning.
But after months of keeping their heads in the sand, British policymakers along with colleagues elsewhere are quickly waking up to how dangerous a situation their economies are in. That is a very good sign.
Rushing to Avert Panic
All over Europe, governments are scrambling to put out fires in the banking system. There is little time to waste on devising grand European solutions. Markets sniff out weak banks, and worries about their solvency quickly translate into plunging stock prices and liquidity cutoffs. Panic isn't far away.
More government intervention seems certain elsewhere in Europe, and it's likely that the rescues will combine a mélange of measures. Denmark, Germany, Greece, and Ireland already have guaranteed deposits. The Netherlands has taken operations of Fortis (FOR.BR)—a victim of the toxic ABN Amro deal—under its jurisdiction. Some of the actions will be coordinated, but more will probably occur at the national or regional level, as with the rescues of Fortis, Dexia (DEXI.BR), and Germany's Hypo Real Estate Holding (HRXG.DE) in recent days.
Paying back depositors and guaranteeing debts would be extremely expensive—more than the gross domestic product. But governments are counting on their guarantees preventing actual runs on the banks. Stephane Deo, an analyst at UBS (UBS) in London, figures that recapitalizing the banks would be the more cost-effective solution. In the case of Germany, adding another 1% to Tier 1 capital (the most widely followed measure of a bank's financial strength) would cost 3.2% of GDP, he calculates—expensive but much cheaper than the guarantee route. "The endgame of this financial crisis must include recapitalization, including nationalization," Deo says.