The Irish government just nationalised the third largest Irish bank, Anglo Irish Bank. Even an Irish government guarantee of all the liabilities of the Irish banks was not enough to keep Anglo Irish afloat. Bank of America has just received a second injection of capital from the US government - $20bn this time. It has also received a guarantee from the US Treasury, the FDIC and the Fed on all but the first $10bn of $118bn of potential losses on toxic assets.
Governments all over the world (including the British government with Northern Rock and Bradford & Bingley, the Dutch government with ABN-AMRO) seem to resort to full nationalisation only after everything else has been tried and has failed. Looking ahead it seems likely that all British high street banks, RBS, HBOS, Lloyds Banking Group, Barclays and HSBC will end up in (temporary) public ownership within the next year or so. RBS is already 57 percent government-owned and the soon-to-be-merged HBOS and Lloyds Banking Group are 43 percent publicly owned. All three need additional capital. None of the three is likely to be able to get it from the market.
Barclays has so far avoided a public capital injection, but has raised additional capital at a much higher financial cost to the shareholders (although presumably not to the management) than the cost of an equal size state-funded capital injection would have been. HSBC may seem to be in a different league, because its share price has fallen by ‘only’ 43 percent over the past two years because it has raised very little new capital, and all of it from the market. I believe that this view is too optimistic. HSBC’s writedowns have been about the same size as that of the other four banks combined. During the early stages of the crisis it has managed to offset a disastrous performance in the US with a strong performance in emerging markets, especially the Far East. With the emerging markets now suffering very badly as a result of the global credit crunch and global economic slowdown, the prospects for profitability over the next few years are dismal. Barclays too is heavily exposed to the economic fortunes of the emerging markets. So, incidentally, is Santander, the Spanish owner of Abbey and of Alliance & Leicester.
Even if you do not share my view that all UK high street banks are dead banks walking, held up both by actual government financial support (directly through capital injections and indirectly through such facilities as the Special Liquidity Scheme and the Treasury’s guarantee on new bank debt) and through the anticipation of future government financial support, these banks do act like zombie banks. They have enough capital to stay on their feet and stumble around a bit, but they are doing rather little of what banks are supposed to do: lending to the non-financial private sector – households and non-financial enterprises.
There are many factors contributing to this reluctance of the banks to engage in new lending.
Normal, sensible commercial prudence in the face of a severe cyclical downturn is one reason. In a recession, lending is riskier.
Irrational fear and near-panic, resulting in excessive caution and risk aversion is another reason for low volumes of new lending, for higher interest costs and for more stringent loan conditions. The balance of power inside banks has shifted dramatically to the risk controllers and bean counters. Loan officers are being kept on a very short leash. ‘When in doubt, don’t lend’ is the motto above the employee’s entrance at our high street banks.
Contradictory messages from the authorities are a third reason. The Treasury and the PM shout ‘lend, lend!’. They also shout ‘pass on all rate cuts fully to the borrowers’ thus ensuring that new lending won’t be profitable. The FSA admonishes: ‘reckless lending is part of what got you into trouble! De-leverage and raise your capital ratios. And if you have any money to invest, put it into Treasury Bills and Bonds, to ensure adequate liquidity in the future‘.
But I believe that costly partial state ownership and the fear of future state ownership (partial or complete) are themselves discouraging banks from lending. To minimize moral hazard, capital injections into the banks by the state and other forms of financial assistance by the state should be priced punitively and have other conditionality attached to it that is unpleasant for current shareholders and management (the dismissal of the incumbent top executives and the board; restrictions on dividend payouts and share repurchases until the state has been repaid; restrictions on executive pay and on bonuses etc.).
But if the state’s financial assistance is priced punitively or has other painful conditionality attached to it, existing shareholders and management will do everything to avoid making use of these government facilities. If a bank has no option but to take the government’s money, it will try to repay it as soon as possible – to get the government out of its hair. Such a bank will therefore be reluctant to take any risk, including the risk of lending to the non-financial private sector. Such a bank will hoard liquidity (sometimes in the form of deposits/reserves with the central bank) to regain its independence from the government. Still independent banks will hoard liquidity to stay out of the clutches of the government.
I believe that this mechanism is at work in a powerful way both in the UK, the US and in continental Europe. Hans Werner Sinn in a recent Financial Times OpED piece pointed out that the German rescue package for banks was fatally flawed for precisely this reason: the acceptance by banks of an injection of public sector capital brings with it a cap on managerial salaries. Rather than accepting a cap on their salaries, managers would prefer to totter along with an under-capitalised bank and restrict the scope and scale of their lending operations.
There are two ways of resolving this problem and of incentivising the capital-deficient banks to lend again. The first is to make the capital cheap (gratis, in the limit) and to minimize the onerousness of the rest of the conditionality. This is the road taken in the US. The US Treasury injected capital into Goldman Sachs at less than half the cost to Goldman Sachs of a capital injection by Warren Buffett a few days earlier. AIG got a tough deal from the Fed and the US Treasury at first, but obtained much sweeter terms less than a month later. The latest capital injection into Citi by the US Treasury (preferred stock with a dividend yield of eight percent) is very cheap.
By throwing cheap money with little conditionality at the banks, the Fed and the US Treasury may get bank lending going again. By subsidizing new capital injections, they reward bad porfolio choices by the existing shareholders. By letting the executive leadership and the board stay on, they further increase moral hazard, by rewarding failed managers and boards that have failed in their fiduciary duties. All this strengthens the incentives for future excessive risk taking.
There is a better alternative. The alternative is to inject additional capital into the banks by taking all the banks into full public ownership. With the state as sole owner, the existing top executives and the existing board members can be fired without any golden handshakes. That takes care of one important form of moral hazard. Although publicly owned, the banks would be mandated to operate on ordinary commercial principles. Managers could be incentivised by linking remuneration to multi-year profitability. The incentives for excessive liquidity accumulation and for excessively cautious lending policies that exist for partially nationalised banks and for banks fearing nationalisation would, however, be eliminated.
In addition, full public ownership of the banks would greatly facilitate the creation of a ‘bad bank’ that would hold on its balance sheet all the toxic assets (illiquid assets of highly uncertain value) currently held by the high street banks. The key problem with any bad bank proposal is the price it pays for the toxic assets it acquires from the banks. If all the banks, and the bad bank, are publicly owned, this problem goes away. The toxic assets are simply moved to the balance sheet of the bad bank. They could be valued at anything from zero to their notional value or historic cost (or even higher). It would be a redistribution of wealth from one state-owned entity to another state-owned entity.
Note that the guarantee component of the Bank of America package (like the earlier insurance of/guarantee for $300bn worth of Citigroup toxic assets provided by the US Treasury) does not avoid the problem of valuing the toxic assets. The problem of determining a price or value for the illiquid assets stopped the TARP from being used as originally intended – for buying toxic assets from banks and in the process becoming a price and value revelation mechanism for illiquid assets. There is a valuation embedded in the guarantee or insurance offered to Bank of America and Citigroup: the state will compensate the banks if the value of the securities falls below a certain level. But the valuation is rather well hidden, and may not be revealed unless the guarantee is actually invoked. Also, guarantees are off-balance sheet, and politicians, like bankers, like that.
The bad bank would hold the toxic assets and collect the cash flows associated with it until a liquid market for these assets is re-established. This may never happen, in which case the bad bank would hold the toxic assets to maturity.
The publicly-owned banks would be reprivatised when financial markets stabilise and the economy recovers. It would be good if a better regulatory and supervisory regime for banks and other highly leveraged entities were in place by that time.
Ironically, by partially nationalising some of the banks, by making this injection of public capital expensive financially and as regards other conditionality, and by holding the threat of possible future (partial) nationalisation over the remaining banks, the authorities created an incentive structure that is biased strongly against bank lending, and against bank risk taking generally. The best escape from this unfortunate halfway house is to go to temporary full public ownership of all the banks. It would be cheap. It should not cost more than £50bn for the state to buy the rest of the UK high street banks. It could wait a while and get them even cheaper – possibly for nothing. But time is more precious than money in this case.