Unprecedented move to prop up the UK banking system

London, Thursday 9 October 2008: In one of the most tumultuous and humbling days the UK's banking sector has seen, the government has been forced to ride to the rescue of some of the most august institutions in the industry.

In a bid to definitively break the vicious circle of events unfolding in the banking sector and wider economy, the widely publicised intervention includes a series of measures designed to recapitalise each of the eight largest banks and building societies in the market, as well as to restore life to the interbank lending market. In summary, these are:

• A commitment among all eight players* to raise their Tier 1 capital position by a combined £25bn, with funds made available by government in return for preference share capital or PIBS (permanent interest bearing shares).
• A minimum of £25bn in further support for all eligible institutions as required, on the same terms as above.
• A government guarantee of new short and medium term debt issuance of varying terms up to 36 months. The Treasury expects take-up of this facility to reach £250bn.

Unsurprisingly, this rescue package does not come without conditions. In return for bailing out these banks, the government fully intends to take its pound of flesh for the taxpayer. The strings attached include restrictions on executive remuneration (including bonuses), a suspension of dividend payments, and pledges to continue lending to consumers and businesses.

In order to make the package politically attractive, these conditions realistically had to be attached. In return for bearing risk at a level of around £2,300 per taxpayer, the government has an asset on which it may well make a return in due course. However, with the economy at the beginning of a downturn, it is fair to assume that no government would have wished to be faced with this situation, regardless of the potential pay-off in time. Ultimately, this is about buying economic stability and is therefore very much a “not lose-not lose” scenario than “win-win”.

Indeed, there is no doubt that the government had to act. Today's move by the UK Treasury comes amid a raft of measures introduced both domestically and across Europe.

Against a background of daily falls in banking share prices, the recent failures of Northern Rock and Bradford & Bingley, there was a very real danger that doing nothing would have led to widespread consumer panic and, ultimately, the unthinkable - another run on a UK bank.

Additional measures to boost consumer confidence have come in the form in a 0.5% cut in the Bank of England base rate; a move also mirrored by equivalent falls in the ECB and Fed rates.

Despite calls for a wider cohesive response regarding a bailout for the banking system, individual countries remain intent on unilateral action. Last week Ireland guaranteed to protect 100% of savers' deposits causing discomfort to other European leaders, while some confusion remains over the whether Germany has offered to take the same action. The Spanish Prime Minister has announced a €30bn-50bn emergency fund to provide liquidity to the financial system by buying Spanish bank assets as well as raising savings guarantees to €100,000. In France, Luxembourg and Belgium, the unprecedented “multi-nationalisation” of both Fortis and Dexia have also been necessary as share prices have plummeted.

Meanwhile governments also struggle to deal with the fall out from increasing liquidity issues in other countries. Last week's collapse of the Icelandic banking system has exposed 300,000 UK savers to potential loss of deposits in Icesave. In a move that sets a precedent for protection against future banking failures the UK Treasury has today announced: “We guarantee that no depositor will lose any money as a result of the closure of Icesave". This, coming on top of the nationalisation of Northern Rock and Bradford & Bingley, sends out a clear message to savers that the government will take steps to support their deposits, even if the clarity of a 100% guarantee has not been given.

Despite the scale of the Treasury's move, its success is not guaranteed

Despite the scale of the Treasury's move, its success is not guaranteed. Seeing the FTSE index at 9am GMT yesterday morning one could be forgiven for thinking that traders had not heard the news, as the index fell 250 points on its already low opening value. This is a demonstration of the irrational nature of stock markets in this current climate. Overnight trades account for some of this loss, the very fact that £50bn is needed to stabilise banks is terrifying for the markets; the rumours are true - the banks could not get out of this mess on their own, and have been forced to go on bended knee to the Treasury for assistance.

This week's share price movements will not reveal how successful the bailout has been; rather commentators must look to whether this move encourages banks to lend to each other. Banks are hiding their money under the ‘proverbial mattress' placing up to €100bn with the ECB each night at the punitive interest rates available rather than lending to one another in the normal way. The Treasury's cash injection needs translate into an injection of trust if the bailout is to succeed.

The one serious doubt that overshadows the bailout is whether it will be sufficient. While the numbers being discussed are astronomical for the layman, they are not outlandish in banking terms. For example the six largest British banks have £54bn of debt to refinance by April according to Bloomberg. Adding to this the refinancing commitments of the other large UK banks and factoring in that with falling property prices, banks' asset values will decline still further between now and April, much of the Government's package could quickly be sucked up. However this is not a unilateral scheme that has been cooked up by the Government and offered to banks as a foregone conclusion. This plan has been discussed and developed for weeks, with the banks telling the Government what they believe is required to help them survive the crisis. It is certain that the Government intends this to be a one-off offer as the political ramifications (not to mention the impact on the national debt) would be devastating if repeat action was required. The hope is that this will be enough to buy back trust between the banks.

The HBOS and Lloyds TSB merger will be the first real litmus test of this success. Although there is little doubt about whether the deal will go through - there is too much as stake politically for it to fail - the speed and ease at which it passes is fundamental. There is the risk that shareholders on either side may vote against it, particularly given the huge volatility of the HBOS share price. However, certainly for Lloyds TSB, the long-term view should be that it is acquiring a large proportion of the UK mortgage market, much of which remains healthy, alongside a strong deposit business and a range of insurance providers and distributors for a price that would have been unheard of even six months ago. For HBOS shareholders the choice is rather more stark; either the deal goes through or nationalisation looks like the only option.

Ultimately, the Treasury's rescue package will see the UK taxpayer foot a bill that may rise as high as £300bn. However, when the commodity being purchased is as vital an intangible as economic stability, this should prove to be a price that was worth paying.

Click on link below to view timeline of major events in the financial crisis:

http://info.datamonitor.com/timeline.pdf

Notes

The seven banks that have confirmed their participation in the scheme are: Abbey, Barclays, HBOS, HSBC Bank plc, Lloyds TSB, Royal Bank of Scotland, and Standard Chartered. The largest building society in the market, Nationwide, is also participating.