Hector Sants picked up the phone late on Friday, October 10, to make the first
of a series of difficult calls. After a torrid day in the markets that saw
shares in Britain’s banks mauled again, the chief executive of the Financial
Services Authority (FSA) had been reviewing his sums.
Sants decided Britain’s banks would have to raise even more capital than he
had imagined less than 24 hours earlier. And it had to happen immediately.
From a meeting room in the Treasury - flanked by Tom Scholar, a senior
Treasury civil servant, and Andrew Bailey, chief cashier of the Bank of
England - he began breaking the news to Britain’s bank bosses.
Sir Fred Goodwin at Royal Bank of Scotland (RBS) was first to get the call,
followed by John Varley at Barclays, Andy Hornby at HBOS and Eric Daniels at
Lloyds TSB. All were furious.
Over the course of Saturday all the banks were forced to go through a
line-by-line analysis of their accounts. Sants wanted to know what would
happen to their books if a main product line, such as a mortgage book,
suddenly lost a significant chunk of its value.
He was also concerned about what would happen if foreign subsidiaries suddenly
stopped making money, and how new capital rules would damage their balance
sheets as recession works its way through. Sants then asked to see what
would happen if all the banks’ profits from Britain were wiped out by the
downturn. To cap it all, they were asked to model what would happen if all
of these things happened at once.
It was this final, worst-case scenario, that formed the basis of the £37
billion bailout scheme that was announced last Monday.
The banks were in disbelief at the amount of capital they would have to raise
but the figures were nonnegotiable, even for those shunning government
investment. The result is that Britain’s banks will be the best capitalised
in the world - against their wishes.
“Everyone knew this recapitalisation process could only happen once,” said one
source. “You couldn’t have banks coming back to the government for anything
else further down the line. Hector wanted to be sure the banking system was
absolutely bombproof.”
That may sound like a good thing, but some in the City are beginning to
question whether the scheme goes too far. Longer term, it may even damage
London’s status as the world’s financial centre, heaping further woe on the
economy.
“Armageddon may have been averted for now, but at a price,” said James Eden,
an analyst at Exane BNP Paribas.
“By forcing UK banks to run with higher capital ratios than their
international peers, they have potentially been placed at a competitive
disadvantage because they may be unable to match prices offered by European
competitors and still earn a commercial return.”
In practice, being better capitalised means that for every loan a bank makes,
it has to store away more of its capital.
“There is a risk that the FSA is throwing a net over the hole once everybody
has already fallen into it,” said one veteran bank adviser. “In previous
downturns the way to get through the problem has been to relax capital
criteria temporarily, and for the banks to give their problem customers a
little more breathing space.
“There is a lot of clamour for a return to old-fashioned banking, and
old-fashioned lending criteria. That’s exactly what needs to happen, but you
can’t start applying those rules now.
“If you ask the real grey heads of British banking, who know what a downturn
looks like, past experience has always shown that now is a time to be
lenient.” WHEN the London Stock Exchange opened for trading on Monday
morning, shares in the three banks involved in the rescue started to tank .
Although the FTSE 100 closed the day up 3.2%, shares in HBOS, Lloyds TSB and
RBS fell.
Barclays, which talked its way out of signing up to the government’s scheme,
was the day’s biggest gainer, climbing more than 14%.
The concern in the market was about the changed terms of the new deal. The
first draft of the bailout plan had involved preference shares. The deal now
agreed involved the state buying ordinary shares, meaning existing investors
would see their interests diluted.
Worse still, a new condition appeared to have been imposed by the Treasury -
any bank agreeing to be recapitalised by the state had to agree to stop
paying dividends for five years.
When news of this hit trading screens, some investors took fright. In recent
years banks have accounted for about 25% of all the dividend income produced
by the FTSE 100. A number of pension schemes, investment trusts and
insurance companies had been holding on to bank shares for one reason only -
dividends.
Public reactions were guarded. Peter Montagnon from the Association of British
Insurers stressed the importance of making banks attractive to investors and
said he was “keen to talk to the authorities further about how such
arrangements would look in practice”.
The National Association of Pension Funds offered only grudging acceptance.
“Pension funds recognise that these are unprecedented circumstances and that
government intervention is necessary,” it said.
But it added: “It is important that as much flexibility as possible is built
into the terms of the funding package and we encourage government to engage
with boards to determine appropriate drivers of dividend policy over the
medium term, including whether payouts should be stopped temporarily and
what indicators should be considered to determine when they might start
again.”
Tim Breedon, the Legal & General chief executive, weighed into the debate
on Friday, warning that the dividend block was “counter-productive” and that
it “raised the barrier for both private and institutional investors to
invest alongside the government in recapitalising the banking sector”.
Treasury officials insist that the only condition it put on the banks was to
stop them paying dividends for a year, not five years, and that markets had
got hold of the wrong end of the stick. But this apparent clarification
failed to lift uncertainty.
While Britain is receiving plaudits for devising a bank bailout scheme that
the rest of the world has copied, nobody else has taken such a hard line
with the banks. The Treasury is charging a whopping 12% interest rate on the
preference shares it is offering the banking sector. The American scheme
offers the same thing for 5%.
The costs being charged to Britain’s banks for the guarantees on their bonds
and money-market investments are also higher than they are under the
American scheme. The US scheme offers these guarantees free for the first 30
days, after which a charge of 0.75 pecentage points will be made. In Britain
a floating fee is being charged for this service from the start, which is
expected to cost between 1.1 and 1.7 percentage points.
On the surface, this looks like good news for taxpayers. Yet if the point of
the exercise was to save banks from collapse and ensure they can keep the
economy afloat, it could become self-defeating.
“Can you rescue and punish banks at the same time? I doubt it, which is why I
am less optimistic about the success of the UK banking rescue plan than its
US counterpart,” said Simon Ward, economist at New Star Asset Management.
Ward believes the UK plan could even prove an incentive for the banks to
continue winding down their balance sheets and cutting off lending to the
real economy. FUTURE historians who look back on the point when the crisis
switched from being about the banks and the financial system to worries
about global recession may pinpoint Wednesday, October 15.
The day before, Hank Paulson, US Treasury secretary, had bowed to market
pressure and announced a $250 billion (£140 billion) recapitalisation of
America’s banks, something he had rejected two weeks earlier and which he
admitted he was doing with a heavy heart.
Paulson blitzed the American television networks last week to defend his
revamped bank rescue, admitting it was “objectionable” for the government
to own stakes in a private bank and he regretted having to make the decision.
As a firm believer in free markets he said it was tough for him to make the
decision to buy a piece of nine of the country's largest banks, including
Goldman Sachs, the Wall Street firm he headed before joining the Bush
administration.
“It’s always difficult when you come from a country like ours that’s based on
markets to be in a situation where intervention is necessary,” he said.
“This is only about the American people, only about Main Street."
Any relief over the announcement on Wall Street or Main Street was, however,
short-lived. Figures showing the sharpest rise in UK unemployment since the
recession of the early 1990s had already unsettled the London markets when
data released in Washington showed a 1.2% drop in retail sales last month,
apparently confirming that the world’s biggest economy is heading into a
deeper recession.
Wall Street, which had reacted with euphoria to the weekend agreement by
leading economies to put their own versions of Britain’s bailout plan into
effect, turned tail. The Dow Jones industrial average slumped by 8% and the S&P
500 by more than 9%, the biggest one-day sell-off in percentage terms since
the October 1987 crash.
After so many wild weeks on Wall Street even big players are chary of looking
to it as an indicator of what is happening in the wider economy.
Christopher Boies, head of corporate practice at the top New York law firm
Boies, Schiller & Flexner, said: “Part of the question is what are you
looking to the Dow to indicate? Libor is probably the best indicator because
until banks start lending to each other we are never going to get through
this backlog. We are in paralysis right now. The credit markets need to
start to function.”
Boies, Schiller & Flexner is advising on the $11 billion takeover of Wells
Fargo by Wachovia. It is one of several multi-billion dollar deals in the
pipe-line. General Motors and Chrysler are in talks about a merger,
Microsoft boss Steve Ballmer is expressing an interest in Yahoo again. But
Boies cautioned that corporate activity would remain sluggish as long as the
credit markets were frozen.
Figures on Friday showing a slump in the University of Michigan’s
consumer-confidence index and what analysts described as an unprecedented
tumble in housing starts and building permits added to the gloom. Though the
stock market stabilised, economists are braced for more bad news.
Mark Zandi, chief economist at Moody’s Economy. com, said the American job
market was pointing to severe problems ahead. Weekly jobless claims have
averaged 483,250 over the past four weeks, a seven-year high, and two weeks
ago reached 499,000, a level not seen since the aftermath of the 2001
terrorist strikes. “If they go over 500,000 that’s a severe recession,” said
Zandi.
“All the signs suggest we have a long way to go,” he added. “In terms of the
financial panic I am hopeful that we are near the bottom. But in terms of
the broader economy there is a lot more to come.”
Robert Dye, senior economist at PNC Financial Services, agreed. “Even with the
heavy artillery aimed at the financial markets right now we see a continued
downdraft in the wider economy,” he said. “We think we will see a
three-quarter recession in the US extending through the first quarter of
2009,” he said.
A month ago PNC was predicting a short and shallow recession, but as financial
markets continued to fall and employment numbers and other indicators
worsened , PNC downgraded its forecast. “There are very few safe industries
right now,” said Dye. “In the early part of the year the recession seemed to
be centered in construction and durable-goods manufacturing. Some industries
seemed to be adding jobs. Those industries have now gone into the negative
column as well. And even in 2009 we are not expecting a rapid rebound. This
is a complex and profound event that is going to take time to work through.”
That is also, increasingly, the view in Britain. Though a strict definition of
recession requires two quarters of falling GDP, third-quarter figures this
week are likely to be taken as evidence that the UK economy has already
slipped into its first recession since the early 1990s. After a flat second
quarter, GDP is expected to have dropped by 0.3% in the third.
A report from the Ernst & Young Item Club, published this weekend, has the
title “Out of the financial frying pan, into the fires of recession”. It
predicts a 1% drop in GDP next year followed by an anaemic 1% pickup in 2010.
“Gordon may have won plaudits for stopping the systemic meltdown of the
banking system over the past few days,” said Professor Peter Spencer,
economic adviser to the Ernst & Young Item Club. “But we now have to
face up to the reality of an economy that has been seriously weakened by
recent events. The effects of the credit crisis are spreading out from the
financial and housing sectors and impacting every part of our domestic
economy.”
He warned that the new forecast of a mild recession by past standards was
conditional on further interest-rate cuts by the Bank of England, and on the
authorities’ readiness to take further steps, if necessary, to bolster the
financial system.
Michael Saunders, UK economist at Citi, also warned that the focus was
shifting to the real economy. “The massive bank bailouts probably will
succeed in averting the complete disintegration of the financial system,” he
said. “However, that still leaves the UK facing a severe recession. Most of
the economic pain - with a large rise in unemployment - still lies ahead.”
On Friday the heads of the leading European business organisations, plus the
US Chamber of Commerce, met in Paris to discuss the crisis. In a statement,
the business bodies said: “The financial upheaval is spreading to the real
economy” and called for further coordinated interest-rate cuts by central
banks. Many in business will endorse that.
