The acute phase of the crisis was triggered by the failure of Lehman Brothers. This and the associated confusion in the markets about government policies caused a sharp rise in perceived counterparty risk, which completely blocked the short-and medium-term money markets. The pervasive uncertainty brought a widespread realisation that many commercial banks are undercapitalised and that further dumping of assets at fire-sale prices, with associated marking-to-market, would eliminate their capital base.1
The Paulson plan (US Emergency Economic Stabilisation Act, EESA) focused on creating a market for impaired securities. This is important, although there may be better ways of doing it. But the urgent issues are the recapitalisation of banks and re-liquefying the term funding markets.
Secretary Paulson has emphasised that the EESA does enable the Treasury to “inject capital into financial institutions”. This is the direction that the US and European countries should take. Funds invested in bank equity are leveraged, because bank creditors and depositors are then willing to put more into the bank; this will then reduce by a leveraged amount the excess supply of distressed securities. And recapitalisation with public funds can be tied to underwriting the money markets.
New measures to unblock the wholesale markets include the ECB’s commitment to supply unlimited funding at the fixed policy rate (now 3.75%) in its weekly refinancing operations, and the Fed’s new Commercial Paper Funding Facility, in which a Fed-backed special purpose vehicle will purchase three-month secured and unsecured paper. These are useful but ad hoc measures and unrelated to recapitalisation.
The UK Package: The right policies and hopefully not too lateThe UK proposals announced on 8 October provide a detailed template that links the two urgent objectives. The government has offered to inject equity (as preference shares or PIBS) into a wide range of “eligible institutions”, and the major banks have already confirmed their participation. There are safeguards for the public interest. In addition to the prerogatives of a significant equity stake, there will be specific conditionality in regard to dividend policies, executive compensation, and lending policies. Although taxpayers take a risk, there is an upside risk too. Bank price-earnings ratios are now extremely low, so it is not unreasonable to think the value of the equity will appreciate in the longer term.
Banks that do raise appropriate additional capital either from the government or from other sources will be entitled to a government guarantee (on “commercial terms”) of new unsecured debt issuance “to assist in refinancing maturing wholesale funding obligations as they come due”. This should go far in eliminating the counterparty risk that has frozen the term funding markets.
These are the right policies, finally, and perhaps not too late. Other countries should consider seriously how to adapt them to national circumstances. It would be worse than unfortunate if preconceived ideas or politics were to block similar initiatives elsewhere in Europe – only for countries to find subsequently that they have to reverse themselves yet again or follow ill-designed alternatives.
The dangers facing the European financial system – and the real economy – are now clear and present. They call for a focused strategy rather than the ad hoc, mainly uncoordinated reactions we have seen so far in the UK and elsewhere. The new British proposals provide the basis for a strategy that the G7 and the international institutions should endorse and promote.
Footnotes1 The evidence is clear: TED and Libor-OIS spreads and the VIX at record levels; spikes in CDS spreads, even for the top names; no unsecured interbank lending, even overnight; banks borrowing from the ECB and then redepositing the funds (at a lower rate) with the ECB, rather than lending them on, because they want liquidity above all; plummeting bank share prices.