THE global banking system has leapt from the fire into the frying-pan. After yet another burst of dramatic interventions, governments are now furiously tackling the twin problems afflicting banks — solvency and liquidity. Their actions briefly pepped up stockmarkets, and, more importantly, stabilised credit markets. But on October 15th and 16th stockmarkets tumbled headlong once again amid concerns that the banks had been rescued too late to stop a slump in the world economy.
For now, at least, a collapse in the banking system has been averted. On October 14th the American government held its nose and announced plans to invest $250 billion of taxpayers’ money into its banks, half of that into a group of nine of the industry’s most celebrated names. Smaller banks have until the middle of next month to apply for a share of the remaining $125 billion. More importantly for confidence, it also extended a sovereign guarantee for new bank debt and once again expanded the terms of its deposit guarantees.
The American moves followed a rare burst of European decisiveness. On October 12th euro-area leaders committed themselves to the same potent mix of debt guarantees and recapitalisation that Britain had unveiled, to much acclaim, the previous week. Governments are not stinting. Germany has set up a €500 billion ($680 billion) stabilisation fund; France has pledged €360 billion; the Netherlands €200 billion. UBS, the Swiss bank, will receive SFr6 billion ($5.2 billion) of state capital to help it shed toxic assets.
Britain itself has wasted no time in putting its cash to work, committing £37 billion ($64 billion) on October 13th to recapitalise its big banks. If ordinary shareholders do not take up their rights to new shares, the government could end up owning a majority stake in Royal Bank of Scotland and close to that in a merged Lloyds TSB-HBOS. Central banks are also spraying money around more liberally than ever. On October 15th the Federal Reserve, the European Central Bank and the Swiss National Bank made available unlimited dollar loans. The Bank of Japan plans to offer unlimited dollar funds from October 21st on.
Asian governments are also scrambling to shore up confidence. Australia and New Zealand have abandoned their purist stances on deposit insurance — they now have some. After slowly peeling back guarantees put in place during the Asian financial crisis a decade ago, Indonesia has expanded its deposit-insurance programme. Hong Kong has moved to full deposit insurance. South Korea will allow greater investment (up to 10%) by the country’s big industrial groups in its banks, but its currency tumbled on October 16th after Standard & Poor’s, a rating agency, said the banks may fail to refinance their debts.
The money markets took a measured view of all this action, but there were signs of improvement. The London Interbank Offered Rate (LIBOR) for three-month dollar loans fell for the third consecutive day on October 15th. Borrowing costs remain very high by historic standards, but the risk that banks will be unable to roll over their short-term funding has receded now that governments are, in effect, acting as counterparties. Credit-default swap (CDS) spreads on banks, a measure of their risk of bankruptcy, have tumbled (see chart).
Saving the banks from collapse is not the same as stopping a credit crunch, however. There is much to resolve before credit is flowing normally through the system. First, funding costs are likely to remain high. Investors’ nerves are shot. The “Ted spread”, the gap between three-month dollar LIBOR and the Treasury-bill rate, and a good indicator of risk aversion, stood at 4.2% on October 15th; it hovered at just 20 basis points (a fifth of a percentage point) in early 2007. Concern about banks’ creditworthiness may yet morph into worry about sovereign risk as the full cost of the various bail-outs becomes clearer, especially if governments decide they also need to boost their economies with a fiscal stimulus. The approach of the calendar year-end, when banks need extra cash to help balance their books, will add to funding strains over the coming weeks.
The costs mount
Governments’ debt guarantees are not free for the banks either. Many of them are rather expensive. Britain is charging 50 basis points plus the median CDS spread for a borrowing bank over the past 12 months. Germany is charging a flat rate of two percentage points. Some observers have expressed surprise that a fee is being levied at all. Despite government pleas that the banks get on with lending, officials may have worried about a splurge in debt issuance if the guarantees had been free. Further cuts in interest rates may help to bring down the cost of credit (and to bolster banks’ earnings by steepening the yield curve, the difference between short- and long-term interest rates). But in the meantime dearer borrowing is bound to have a continuing impact on the spending plans of companies and consumers.
The second reason why credit is likely to remain gummed up is that banks still have reasons to husband capital. The injection of government money into American and British banks has set a new benchmark for capital ratios that banks elsewhere may now be judged by. Analysts at Keefe, Bruyette & Woods, an investment bank, reckon that other European banks would have to raise €70 billion-130 billion to match British levels. That is a disincentive to go on a lending spree.
So little time, so much to fear
In Britain and America, too, there are lots of reasons for caution. Banks remain weighed down by the same toxic assets that sparked this whole mess. The Americans still insist that they will dip into their $700 billion bail-out pot to buy up impaired assets, but the new capital injections will deplete their firepower. Accounting standard-setters have been arm-twisted into relaxing rules that force banks to mark certain assets to market, but in the long run that may hurt confidence in the health of bank balance-sheets, not help it. Bo Lundgren, one of the architects of Sweden’s much-vaunted 1990s bank bail-out, stresses the importance of transparent valuations of bad assets.
In another difference with Sweden, where the economy had already been contracting for seven quarters before the government strongly intervened, the downturn in this economic cycle is still young. That means banks will suffer a new set of credit losses in coming months in areas such as credit cards, car loans and commercial property. Stresses in housing markets impose another constraint on lending: that may be why Sheila Bair, head of the Federal Deposit Insurance Corporation, an American bank regulator, broke ranks with her government and criticised the rescue plan for not addressing foreclosures. Banks may suffer from a crisis of confidence in emerging markets, too.
Companies are perhaps the biggest concern of all, even though firms have borrowed less than consumers. Default rates remain low but are bound to climb as the economy worsens. This wave of corporate failures will add further stress to the battered CDS market. And, as governments focus their efforts on bailing out the banks, non-bank sources of financing are becoming more fragile. The costs of issuing commercial paper, a form of short-term debt heavily used by companies in America, will fall once a Fed facility for purchasing commercial paper is up and running on October 27th. Even so companies may well have to draw on uncommitted credit facilities with banks, expanding the size of bank balance-sheets.
“The idea that there will be a reboot of lending is not credible,” says George Magnus, an economist at UBS. Financial calamity may have been averted, but the world economy is still cooking up something very nasty.