First the Government bailed out Northern Rock, then it was Bradford and Bingley.
Now, with nearly every other bank looking as nervous as a turkey on Christmas Eve, the Government has announced a £50 billion rescue package. However it could end up costing us taxpayers up to £500 billion!
The key points of the plan are:
- Banks will have to increase their capital by at least £25 billion and can borrow from the government to do so.
- An additional £25 billion in extra capital will be available in exchange for preference shares.
- £200 billion will be available in short-term loans from the Bank of England, up from £100 billion.
- Up to £250 billion in loan guarantees will be available at commercial rates to encourage the banks to lend to each other.
- To take part in the scheme, banks will have to sign up to an FSA agreement on executive pay and dividends.
Which banks are included?
It seems likely that five of the eight institutions listed in the announcement will participate in the equity raising; Royal Bank of Scotland, Barclays, HBOS, Lloyds TSB and Nationwide - while HSBC, Standard Chartered and Abbey will be more likely to take advantage of the money market operations. Other banks and building societies would be able to apply for inclusion in the plan.
In return for all our taxpayers money, the government insists it has extracted a price from the banks; no more big bonuses, no dividends to shareholders and a pledge to keep lending money to small businesses and would-be homeowners. But, whether this is adhered to, remains to be seen.
How on earth did we get here?
In a nutshell, banks got careless and loaned too much money to people who just couldn't pay it back. If a lender makes too many bad loans, they go bust. But because these lenders are so vital to the economy, the government has decided we can't let them go bust; hence the bailout.
How do banks borrow money?
They borrow it from you and me (through savings deposits), or from commercial lenders (through the wholesale money markets), or through issuing bonds. So say the bank has £1 in shareholder equity. It then borrows £9 on top of this. It then writes £10-worth of loans based on this.
There are two serious flaws to this. Firstly, you have to make sure the people you lend to will repay you and secondly, if everyone you've borrowed from wants their money back at the same time, you're in trouble, because you've loaned most of it out. So you have to keep an eye on when your payments are falling due.
Most bank lending is done over the long-term (like a 25-year mortgage) and banks charge more for this, as it's taking a bigger risk. Most bank borrowing, however, is done short-term, via instant access deposit accounts and 30 or 90-day loans from the money markets. This borrowing is cheap, because it's only short-term.
What went wrong?
All this is fine as when a short-term loan comes to an end, the bank just rolls it over, which the lender is usually happy to do.
Notice the word ‘usually’…
When the US sub-prime mortgages started going wrong, it was clear that the loans that banks had been writing were worthless. Would you be keen to fund a bank giving out bad loans? If it doesn't get its money back, maybe you won't either. More to the point, many of the people doing the lending are banks themselves. So they realise they're going to need that 'spare' money, and hang on to it.
So the money markets dry up as institutions hoard their cash and that is what the central banks have been trying to deal with. This is the liquidity problem, which is what scuppered Northern Rock. It relied too much on wholesale markets, couldn't repay its debts when they fell due and couldn't be rolled over, so it went to the wall.
Northern Rock; more of your money down the drain
What does all of this mean?
It means we've acknowledged that UK banks are broke. But by offering extra capital and vast liquidity to the banks, this may unblock the money markets, reduce inter-bank interest rates, and encourage banks to lend to each other again.
In this scenario, credit for businesses and individuals should become cheaper and more widely available. For now, this should stop the immediate panic about the security of British banks, but how will things be in a year’s time? What about 5 year’s time?
The Government can play a very long game, holding these assets for years, or even decades, until they recover in value.
For instance, Sweden bailed out its banks in this way in 1992, and made a profit for Swedish taxpayers. So, while this plan may be a short-term lemon, it could prove to be a long-term cherry.
How much will it cost all of us?
With about 25 million UK households, the £50 billion rescue plan works out at £2,000 per household added to our national debt.
What it also means that the part nationalisation gives us all a stake in these lenders; hence we mustn’t allow them to take our money and then lend it back to us at high rates of interest!
Though they may be recapitalised, banks can't return to rampant lending. None of this will be over until the property crash ends, because as long as property markets continue to tumble, the asset side of banks' balance sheets remains under question.
PS: One piece of good news: the government has guaranteed all £4.5 billion of savings in failed Icelandic bank Icesave (and plans to sue the Icelandic government for withdrawing its savings safety-net).
What do you think of the Government’s decision?
Should they be bailing out the organisations who should have known better or are they not left with much choice?
Why not let us know what you think in the comments below?
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