THE dithering has ended. After a week in which the financial system almost ground to a halt, governments of the industrialised world seem at last to have found the right tools to get credit markets moving again. At the weekend and early on Monday October 13th officials in Europe, America and Asia announced unprecedented and comprehensive plans to prop up failing banks, guarantee their loans and flood the world with cash by providing unlimited dollar funds through central banks. At first blush — and in contrast to previous failures after half-hearted efforts — the new plans seem to be working. Stockmarkets rose around the world on Monday, although the real sign that the situation is improving will come in the credit markets this week.
All the actions are aimed at dealing with the three related problems that have blocked credit markets and the banking system. These are that banks have been unable to raise enough money in the frozen short-term money markets; that banks are unable to take out loans for three-to-five years to make up the shortfall between deposits and lending, because markets for longer-term borrowing are also shut; and, last, that they are struggling to win the trust of lenders because they do not have enough capital as a cushion against losses.
To provide liquidity the Federal Reserve, acting with the European Central Bank (ECB), the Bank of England and the Swiss central bank, will provide banks with as many dollars as banks demand in a bid to reduce borrowing costs, which soared to record levels last week. The move follows a similar promise by the ECB to flood the market with euros. The provision of unlimited dollars to the Swiss central bank is especially important, as the country has a banking sector with foreign-currency liabilities that tower over its domestic economy.
Steps are also being taken to address problems of bank capital and longer-term borrowing. In Europe, the 15 countries that share the euro have now promised to guarantee new bank debt and to inject capital into ailing banks. The European plan draws on the main elements of a British programme, announced last week, that that will immediately see some £37 billion ($63 billion) injected into three of the country’s biggest banks. This will rebuild their capital cushions, or so-called Tier-1 capital ratios, to above 9 percent. Almost all of the extra capital is likely come from the government. Additional money will also be needed by other banks such as Barclays, although they are hoping to raise it themselves without help from the government.
The bank most in need of extra capital is Royal Bank of Scotland, which rashly bought ABN Amro at the top of the market last year. It needs some £20 billion and is unlikely to raise much of this in the market. The government, if it provides all that is needed, may end up owning over half the bank. HBOS and Lloyds TSB, two banks that are about to merge, need another £17 billion between them.
The British government is demanding a pound of flesh in return. Banks that take capital from the government have to agree to limit executive pay. They also face a potential government veto on the payment of cash dividends to shareholders and must promise to help struggling homeowners stay in their homes. More worrying, however, are signs that the government may also interfere in lending decisions by banks in the programme. The banks have to promise to make as much available in loans to homeowners and small businesses for the next three years as they did in 2007 at the height of the credit bubble.
Details are yet to emerge about how countries in the eurozone intend to guarantee bank loans or to inject capital into their banks, although early indications suggest that the scale of their action will be similar to that taken in Britain. The German bail-out, for instance, may be worth about €400 billion ($540 billion).
Despite all this activity, two weaknesses remain. The first is that the ECB is unable to buy commercial paper, the loans that companies issue, which may limit its ability to bypass frozen credit markets to get money directly to struggling companies, as it has been able to do with banks.
A second disappointment was the G7 meeting in Washington, DC. Its officials went into their gathering knowing that ad hoc responses of the prior week had hurt confidence and that they needed to deliver a co-ordinated message detailing what concrete measures would be taken. They promised to “support systemically important financial institutions and prevent their failure,” apparently indicating that no large banks would be allowed fail.
But to many market participants the statement lacked the necessary specificity to restore confidence and left open the question of whether smaller countries that are not part of the G7 or European Union would be included. Nor was it clear how countries that break ranks would be handled. Some governments still face a tough political sales job at home where voters are as upset as Americans about being asked to bail out wealthy bankers.