restoration

Last Monday morning, we all woke up to the news that the UK Government had put its rescue plan for our large banks into action.  Subject to an unlikely, although possible, take up of the equity issues in HBOS,  Lloyds TSB and RBS by existing shareholders, we will all own part of them – up to 43.5% in the enlarged Lloyds Halifax Bank of TSB Scotland, and 60% in RBS.

At the same time, the authorities are enhancing their already considerable liquity support, by extending the Special Liquidity Scheme and offering up to £200bn in guarantees for bank issues of debt.

Combined, these two strands of the plan were aimed at providing confidence in our (for they now belong to all of us, at least in part) banks and allow the flow of credit around the banking system to recommence.  Crucially, the Government is looking for that restarted flow of credit to also lead to increased availability of debt for home-owners and small businesses, in an attempt to avoid a severe recession.  We are going to have a recession, it’s just a question of how bad it will be.

So, has anything changed?  Well, I am going to sit on a fence and say yes and no.  First and foremost, a large element of fear has been removed, that previously surrounded our banking system.  It is clear that the Government has no intention of allowing a large UK bank to go down – Northern Rock and Bradford & Bingley shareholders may wince at this point – and will continue to everything they can to prevent this while there is still worth in UK plc.  If we ever reach the point at which the country is bankrupt, I’d be more concerned about sharpening up my agricultural skills than mooning over the vanished value of investments.

This fear has also, crucially, been removed within the banks.  Executives and staff alike now have a far clearer idea of what is required in the next couple of years, the uncertainty of the last few months has been removed, though we are resigned to our “total reward” packages being diminished for a while to come.  We are not all going to be as hyper-motivated as the last few years – that is simply a human reaction – but the mere fact of still having a job is a powerful stimuli.

However, as yet, the flow of credit around the banking system – the wholesale markets you will have heard about – has not returned to anything like normality.  It is only when this starts to happen, and banks begin to move from utter reliance on the public resources, that credit availability to the areas identified by the Government will be properly restored.  This is still, obviously, an issue due to the stubbornness of three-month LIBOR rates to budge much.

LIBOR is the rate at which the banks lend to each other, providing a fundamental indicator of their willingness to do so.  Since central banks around the globe made a co-ordinated cut on 8th October, three-month LIBOR, the variation  which is the cornerstone of the wholesale markets, has moved down a little bit, but resolutely remains considerably above 6%.  Given that Bank of England Repo Rate (or Base Rate, as it’s otherwise known) is 4.5%, this shows that the banks are charging an incredibly premium for lending to each other.

Why is this an issue when the Government has effectively guaranteed liquidity to our banks?  The answer is that the wholesale markets are not wholly between our banks.  In fact, the main UK banks are combined net borrowers on the markets, meaning that the cash must be coming from somewhere else.  That mystery source is actually two-fold: non-bank UK financial institutions and overseas investors and financial institutions.  The former is not a source that could recover in the short-term as a lot of these UK institutions will most likely be keeping their cash close to home until the recessionary ramifications are clear.

The overseas sources of cash, therefore, would seem to be key to restarting our wholesale markets.  This has not happened yet because the full international efforts to resolve the gridlock have not worked their way through the system.  While I am reticent to give Gordon Brown too much credit, given that it is arguable that a lot of the particular problems our banking system has encountered are of his doing, it is important to remember that the action taken by the UK government was in effect pioneering.  Put it this way, the particular way our plan has been structured is being broadly followed by other governments.

Therefore, while we think we have “solved” our problems, we must bear in mind that our financial system does not sit in isolation to the rest of the globe and, while other rescue plans are being put in place, we cannot expect normality to immediately return.  The breakdown that occurred last year, which ultimately lead to the credit crunch, spread rapidly via the massively inter-linked global financial markets.  The co-ordinated international solution cannot quickly reverse the damage, particularly as the spillover to the “real” economy has now reached the point of no return.

Recovery is beginning, but ultimately, we can write off the rest of 2008 and most of 2009 before that actually turns into some good news stories.  In the meantime, we need to continue the conversation about how banking will look for the years to come.