Extraordinary actions by central banks, finance ministries, and governments in the last few days have failed to contain, let alone diminish, the financial crisis, note Citigroup analysts. In particular, trust among banks is so depleted that the interbank market remains virtually paralyzed, as highlighted the persistent high level of three-month LIBOR rates, even after the coordinated policy rate cuts.
Accordingly, media reports suggest that the U.S. Treasury soon will use its new authority under the TARP legislation to make direct capital injections into the U.S. banks and to provide other support, as needed, to restore effective intermediation. A rise in bank capital would reduce the risk of interbank lending. Moreover, a rise of aggregate capital in the banking system is probably necessary to halt the vicious cycle of fire sales, asset price declines, capital depletion, loss of lending capacity, and economic decline.
The UK’s bold banking system reforms instituted this week provide a basis for assessing the actions of governments that wish to jumpstart intermediation. The UK program has the following characteristics:
1) It makes available preference share capital to a group of banks that have committed to boost their capital, and offers assistance in raising ordinary equity if requested. It also makes available preference capital (or, if requested, as “assistance to an ordinary equity fund-raising”) to any eligible institution. A preference share provides a fixed interest rate and is senior to common equity, but confers no voting rights. The GBP50 billion announced in the program is about 28% of the capital UK banks had outstanding as of June 30, 2008.
2) It promises “decisive action to reopen the market for medium-term funding for eligible institutions that raise appropriate amounts of Tier 1 capital.” To do so, it makes available (at a price) “a Government guarantee of new short- and medium-term debt issuance to assist in refinancing maturing, wholesale funding operations as they fall due.” The Government expects to guarantee GBP250 billion of credit. To be eligible, institutions also will have to raise their capital.
Two key facts are notable: First, the U.K. program did not wipe out existing shareholders, although it charges a fee for the services that taxpayers provide. Second, it links any public guarantees for new debt (also available for a fee) to a promise to raise capital.
Until very recently most governments in the affected countries have been reluctant to provide direct support to financial institutions without imposing a very high price on existing shareholders. In this respect the UK program is an important departure, note Citi analysts. This change is an indication of just how negative and risk-averse investor sentiment has become, and how difficult it may be exit the crisis.
At this stage, it remains to be seen how effective the UK program will be. Like the three-month rates on dollar and euro LIBOR, today’s rates on sterling LIBOR have not receded. However, it is not clear how effective any UK program, by itself, could be to reduce interbank lending risk on such an international stage. The program’s
announcement does not appear to have diminished the market value of existing UK bank equity, despite the dilution.
Initially, the price of default protection on UK banks that have announced their participation in the program came off sharply. Consequently, if the banking sector proves successful in raising capital, as some institutions have committed, the effect should be to facilitate trust among UK banks, a prerequisite for restoring effective intermediation.
Naturally, financial systems differ and this will have to be reflected in other countries’ plans. The U.K. banking system, for example, is significantly more concentrated than the U.S banking system. Implementing such a scheme in the United States will pose more substantial challenges, note Citi analysts.
Nonetheless, Citi analysts suspect that key features of the UK program – including capital injections and the provision of guarantees for some bank liabilities — will be relevant for policymakers in the United States and elsewhere as they seek to promote financial stabilization. Given the intensity of the crisis, and the ineffectiveness of the extraordinaryactions already taken, Plan B probably will not be long delayed. In the United States, Treasury Secretary Paulson promised yesterday that “we will use all the tools we’ve been given to maximum effectiveness, including strengthening the capitalization of financial institutions of every size.”
The Troubled Asset Relief Program (TARP) law appears to allow Treasury to acquire capital in intermediaries. The definition of troubled assets includes “any other financial instrument that the Secretary… determines the purchase of which is necessary to promote financial market stability.”
Creative use of the TARP program, or other legal authority, may allow the U.S. government to mimic other aspects of the UK program, i.e., the provision of guarantees for new bank debt.
Ultimately, the success of any new emergency policy actions will be measured by the extent to which they arrest the slide of financial conditions. The Citi Financial Conditions Index (FCI) for the United States had already reached the extraordinary level of minus 5.2 standard deviations at end-September, and likely has deteriorated further. If past relationships between the FCI and economic activity are a guide, the U.S. economy is headed for a deeper recession than in the previous two decades. Such cyclical considerations are not the key question at this stage. If the slide in financial conditions is not halted and reversed, if effective intermediation is not restored, the threat to the economy would become structural, rather than cyclical, fundamentally altering growth prospects over a period of years.
