Economist Intelligence Unit comments on concerted action by policymakers to restore confidence in the financial system.
OVERVIEW
The size and comprehensive nature of the UK government's rescue package for banks reflects a belated attempt by authorities in the developed world to find solutions to the financial crisis rather than responding to events on an ad hoc basis. This more proactive stance was evident in this week's co-ordinated 50-basis-point interest rate cut by influential central banks.
Amid continued sharp declines in global stockmarkets and concerns about counterparty risk stemming from the collapse of Lehmann Brothers, a US investment bank, the UK rescue package has not had an immediate effect on the willingness of UK banks to lend to each other. The sterling 3-month Libor rate remained little changed at 6.3% two days after the package was announced. But the interbank market may respond in the coming days.
In the US, the Federal Reserve is now accepting unsecured commercial paper from corporate borrowers. This move is intended to stem outflows from the US commercial paper market and alleviate upward pressure on US rates. Further measures to support the banks and relieve financing stresses are likely to be announced at the IMF and World Bank meetings this weekend. These may include additional emergency cuts in interest rates by central banks.
The UK rescue package
The three-part UK bank rescue package is large, with a notional value of £400bn (28% of GDP), and seeks to address the undercapitalisation of the banking system and the seizure of the interbank market. The government has committed to restore banks' solvency by injecting up to £50bn of fresh equity through preferred shares or by underwriting issues of ordinary shares. At least some banks will accept the offer of an infusion of state capital. The government has guaranteed up to £250bn of new medium- and long-term bank borrowing, a measure designed to inject liquidity and ease concerns about counterparty risk. The Bank of England has made an additional £100bn available to banks under its short-term lending facility, doubling the total.
On the same day the Bank of England joined the Federal Reserve, the European Central Bank (ECB) and some other central banks in a co-ordinated 50-basis-point rate cut. This is certain to be followed by further cuts, possibly in short order. Cuts in short-term rates will assist banks by steepening the yield curve.
While the UK package is coherent, its success in restoring the functioning of the interbank and credit markets is not assured. If interbank markets remain dysfunctional elsewhere, this would work against a return to normal in the UK's globalised financial system. Banks in the UK are particularly exposed to external conditions given a large gap between their deposits and loans, which has to be covered by external wholesale funding.
Further measures to support the financial system in the US
Elsewhere, policymakers are facing up to the need for a more far-ranging approach. In the US, the Paulson plan, which in its initial form was restricted to swapping banks' bad assets in return for US Treasuries, has been broadened to enable the government to take equity stakes in banks. Also, the Federal Reserve is attempting to address liquidity constraints by accepting unsecured commercial paper from large corporates. The US authorities are wary of guaranteeing interbank loans because of the risk that such a step could drain liquidity from the non-bank financial sector, including money market funds, which play a critical role in the US financial system.
In the euro zone, the lack of a federal political, fiscal and regulatory authority precludes a unified approach to the recapitalisation of banks, which will be conducted at national level. The extent of state involvement in this process will vary. If the UK scheme is seen to succeed, it may prompt other countries to follow its lead so that they do not lose competitive advantage. The lack of a provision for the ECB to guarantee interbank loans could prove an obstacle to bringing Euribor spreads down from current elevated levels.
The success of the UK rescue package in unfreezing the interbank market and preserving the payments chain will be apparent within days. Its impact on medium- and long-term credit markets will take time to emerge. A recovery in bank lending from current depressed levels is likely, but credit will remain rationed and expensive.
Banks face further writedowns
Even banks that raise fresh capital will need to continue deleveraging their balance-sheets well into 2009. Capital adequacy ratios will be eroded by further writedowns on residential and commercial property, and corporate loans. The latter will pose a renewed threat of counterparty risk, given the enormous growth of the credit default swap market, which is only now beginning to be tested by an increase in defaults.
The excesses of the UK's credit boom—reflected in record levels of household indebtedness, a low savings rate and house price-to-income levels well above historical norms—will have to be worked off over several years. Other countries where growth has been driven by excessive indebtedness will face a similar painful adjustment as households rebuild savings.
THE BOTTOM LINE
The far-reaching measures now being taken by policymakers have a reasonable chance of stemming the loss of confidence and stabilising the financial system. However, they are unlikely to prevent a recession in the developed world in 2009. If they fail, the outlook is bleak. The payments chain would rupture, and large-scale bankruptcies and job losses would be in prospect.
