Last week’s deepening financial and economic crisis has brought forward new policy measures in Europe over the weekend. Here is a recap prepared by Citigroup analysts.
Euro Area: Is this the ‘Super Bazooka’? Yesterday, heads of euro-area member states and ECB President Trichet agreed on an action plan to stabilize financial markets. As we expected last week, the Heads of State action plan is a template for national government action rather than a single euro area measure.
The euro area plan has many similarities to the UK bailout program: measures to recapitalise banks, provide extra liquidity and improve medium term funding of banks. However, we do not have details of the program yet, as it is up to the 15 member states to set up national programs. The major countries will present their programs today, but note that the parliamentary approval process will take some while, e.g. measures in Germany will not be approved before the weekend.
o Liquidity: As well as welcoming the ECB’s expanded liquidity injections, the plan advocates some measures to mobilise illiquid assts on banks’ balance sheets: “to facilitate medium term funding of banks notably through purchase of high quality assets or through swaps of government securities”. It is unclear if this really would aim to allow refinancing for ‘high quality’ assets, or would become a sink for ‘toxic’ assets.
o Guarantees for new debt: “Governments would make available … a Government guarantee, insurance, or other similar arrangements of new medium term (up to 5 years) bank senior debt issuance.” This proposal is similar to the UK bailout plan and is a guarantee for new bank debt rather a guarantee of (interbank) loans. These measures will be temporary, ending in December 2009.
o Bank recapitalisation for financial institutions: “each Member State will make available to financial institutions Tier 1 capital, e.g. by acquiring preferred shares or other instruments including non dilutive ones.” And for banks at risk in particular “to avoid the failure of relevant financial institutions, through appropriate means including recapitalization.” However there are some restrictions: “Financial institutions should be obliged to accept additional restrictions, notably to preclude possible abuse of such arrangements at the expense of non beneficiaries.” and “Emergency recapitalisation of a given institution shall be followed by an appropriate restructuring plan.”
o Some relaxation of mark-to-market accounting. “financial and non-financial institutions should be allowed as necessary to value their assets consistently with risk of default assumptions rather than immediate market value which, in illiquid markets may no longer be appropriate.”
Since the Heads of State agreed on coordinated national action plans rather than a single euro area solution, there are no details and so far no solid numbers for the size of the measures. However, the two largest states, Germany and France will present the details of their plans today, with press conferences at 2:00 pm UK time by the German Chancellor Merkel and the French President Sarkozy. According to press reports, the German plan will have an amount of EUR 470 billion, including EUR 400bn of guarantees for part of banks’ liabilities, plus EUR 70 bn to recapitalize banks. Germany will set up an external fund (financial market stabilization fund) to implement the national action plan. To fund the scheme, the Finance Ministry will get approval for additional lending of EUR70 bn. The government measures will have a significant impact on general government balances for most euro area governments this year and in coming years. Indeed, the German Finance Minster already admitted “Germany will not meet the target of a balanced central government budget in 2011”. For France, press reports suggest that the government will offer a package to EUR 40 billion to recapitalize banks. Italy will also present an action plan today. However, according to Prime Minister Berlusconi there would be no need for recapitalization in Italy after having already made a capital injection to the countries biggest financial institution. Of course, for some of the smaller states with large banking systems, the extent of government support may be constrained by worries that the costs will destabilise government finances.
ECB President Trichet joined the heads of states at the summit this weekend and the statement suggests that the ECB supports the national government initiatives. As discussed in the latest Euro Weekly, the current collateral framework seems to constrain the provision of liquidity. To address that, the summit statement suggests that the ECB will ease the eligibility criteria of collateral: “in considering to further improve its collateral framework with regard to the eligibility of commercial paper.”
UK: Bank Capital-Raising
Major banks have announced a capital raising exercise of about £43.5bn in total, through a mix of ordinary shares and preference shares, of which about £37bn will be underwritten by the UK government (£20bn for one bank, £17bn for two more that are merging with each other). For example, one bank is raising £15bn of ordinary shares underwritten by the UK Government, plus £5bn of preference shares issued direct to the UK government. If the government does (as underwriter) take up these shares then it would have a majority stake in one bank, with a large minority stake in the merged bank as well. A fourth bank is raising £6.5bn through ordinary and preference shares, apparently without the government acting as underwriter. Two other foreign-owned UK banks are having extra capital injected through their parent companies.
These announcements raise the scale of capital-raising by these banks above that announced in the Bank bailout last week, which envisaged £25bn of initial capital-raising by eight major UK banks, plus an extra £25bn for other banks or as top-ups for the eight major banks. Moreover, the new capital raised is more heavily weighted to ordinary shares rather than interest-bearing shares. This gives more scope for banks to enhance capital by suspending dividend payments. Indeed, the two banks for which the government will be underwriter and investor in preference shares have said that no dividends will be paid in ordinary shares while the preference shares are outstanding.
The capital-raising exercises will ensure that all these UK banks will have Tier 1 capital ratios of at least 9%, the level which the UK FSA now seems to view as appropriate, rather than the 6% norm previously (it is unclear if this is a formal Tier 1 capital target applying to all banks, or just guidance for these particular lenders). In turn, this extra capital will allow these banks to qualify for the government guarantee for new debt issuance announced as part of the Bank Bailout last week. The government is expected to organise its purchases through a special new Bank Reconstruction Fund, funded by a large rise in gilt issuance (details of the DMO’s new remit will be announced tomorrow).
New Liquidity injections. The ECB, BoE and SNB announced this morning extra liquidity injections of USD, of fixed interest rates at unlimited amount. Previously, liquidity injections have been of fixed amounts at a rate determined by auction. Now the taps are on more strongly. The Norwegian government announced over the weekend that it would offer its commercial banks up to $55.4bn in (Norwegian Krone) government bonds in exchange for mortgage debt.
Will They Work?
These responses follow key ingredients in the IMF’s template for policy responses in banking crises:
o Crisis containment policies such as regulatory capital forbearance, emergency liquidity support, government deposit guarantees, and (an issue that is not really appropriate in Europe) suspension of convertibility of deposits.
o And, crisis resolution policies, for example, recapitalizating financial institutions, using asset management companies (AMCs) to resolve distressed loans, offering debt forgiveness, and providing incentives for loan loss writeoffs.
In particular, it is encouraging (in terms of securing the longterm survival of the financial system) that policy makers have moved from seeking to downplay the severe financial and economic crisis, and instead are now producing unprecedented measures that reflect the seriousness of the situation. Moreover, given the global nature of the crisis and widespread financial interlinkages, a coordinated and concerted approach is more likely to succeed than a patchwork of different measures. This does not mean that all countries have to do the same thing, but key elements of liquidity injection, recapitalisation and guarantees for some bank liabilities are important. In addition, there seems to be a healthy ‘competition for ideas’, in which countries show willingness to adopt measures proposed by other governments (e.g. the UK approach) rather than champion only their own ideas.
As we do not know how large the euro area packages will be, it is too early to say if the measures are enough to stabilize financial markets and to prevent economic disaster. Euro area heads of state will meet again on Wednesday to present details of the member state action plans. In the UK, it is encouraging that UK banks are raising large amounts of new capital and (by suspending dividend payments in some cases) seeking to hoard their capital, hence gaining some protection from inevitable future losses during the recession. This probably offers a pointer to the next stage across the rest of Europe as well.
The aim of these measures is to try and avert a widespread financial collapse that could trigger economic depression, and ensure that there is a functioning financial system even once the recession ends. Of course, it is futile to expect these measures to totally prevent the recession that is unfolding across Europe and the UK. The widespread debt-fuelled boom in asset prices and spending has left a legacy of high private debts in many countries, deteriorating credit quality, plus overstretched and falling property prices. In these circumstances, widespread retrenchment is probably inevitable. Banks will seek to cut back on new lending and shrink balance sheets to reduce further losses and reduce the need for future capital-raising. In the UK, the government has said that banks that obtain public sector capital will have to give “a full commitment to support lending to small businesses and home buyers”. But, in practice, banks that have partaken of public sector capital probably will also curtail new lending, to speed the return to private ownership and repayment of public sector funds (especially if, as with the UK, public capital comes with constraints on dividend payments). At the same time, households and businesses across Europe will cut back on spending and save more, and leveraged investors will (because of reduced credit availability) continue to deleverage and seek to sell assets.
In the UK, some might say that the country is leading the way in terms of the appropriate policy responses to the crisis. But, any sense of self-congratulation among UK policymakers must be tempered by acknowledgement that the UK also is more vulnerable than most countries to the financial crisis, as the result of the massive debt-fuelled boom of recent years. The UK is among those “leading the way” into recession, housing collapse and soaring unemployment.
Even with these measures, european central banks are likely to cut policy rates markedly in coming months in response to prospects for severe economic weakness and reduced inflation risks. Indeed, depending on market developments, another round of coordinated and concerted central bank easing is possible in the next few days (with, like last week, 50bp cuts by the main central banks, or perhaps even more).
