Governments and central banks have hurled “the kitchen sink” at the credit crunch over the past few days, as Edward Hadas of Breakingviews.com put it. On Wednesday, Britain part-nationalised its banking sector to avert a collapse. The Treasury’s rescue package is “as big an economic initiative as it has probably ever taken”, said Robert Peston on bbc.co.uk. And while UK and US stocks plunged to five-year lows as the intensifying credit-crunch-fuelled gloom over the economic outlook across the world, the US Federal Reserve led a co-ordinated round of global interest-rate cuts. Along with the Bank of England, the European Central Bank, and the Swiss and Canadian national banks, it lowered rates by 0.5%.
This followed another series of bank bail-outs in Europe, a Spanish €30-50bn emergency fund to provide liquidity to its banking system, and a Russian pledge of around $37bn in long-term loans to its biggest state banks. The Fed also took the unprecedented step of buying commercial paper – short-term debt issued by banks and firms to finance day-to-day operations. The market had frozen as investors, mostly financial institutions, had become increasingly risk-averse and hoarded cash.
Credit crunch: Britain’s banking bail-out
The government is making £25bn of capital available to seven leading banks and the Nationwide building society in return for preference shares, and there is another £25bn on standby. Meanwhile, the Bank of England will provide at least £200bn under its Special Liquidity Scheme, whereby banks can swap illiquid loans for risk-free government securities that can be traded in money markets. The government will also, for a fee, guarantee the money that banks borrow from other financial institutions for up to three years.
This is “the most significant element” of the plan, said Lex in the FT – a “bold attempt to unjam banks’ funding markets”. UK banks needed to repay around £54bn of debt by March 2009, noted Bloomberg.com, but with wholesale markets so gummed up investors have been worried that they will not be able to refinance.
There is little detail on what taxpayers are getting in return for bailing out the banks, but some constraints on executive pay and dividends are “probably inevitable”, said Citigroup. The government will “need to insist on tougher measures” to force banks to change their future behaviour, said Damian Reece on Telegraph.co.uk. “There’s a bit too much carrot at the moment and not enough stick”. As far as the banks are concerned, however, this package should “stop the panic” over whether they are safe, reckoned Terry Smith of Tullett Prebon.
Credit crunch: what next?
This package is hardly likely to be a turning point for the economy. As Citigroup notes, we are “probably less than half way” through the UK house price decline and the recession, which implies further business failures, repossessions and debt write-offs. So banks may well need more capital. The £50bn injection isn’t enough to give lending a boost given the prospect of further writedowns, said Capital Economics, and in any case demand is sliding amid the poor economic outlook. Growth in lending to both firms and households has fallen sharply over the past few months.
Nor are interest rate cuts a silver bullet, although they may provide a temporary confidence boost. The Fed’s reduction in rates from 5.25% last September to 2% before Wednesday’s move did nothing to loosen the credit crunch. The pace of the deleveraging spiral is overwhelming monetary policy, as Hadas points out. Banks lose capital from loan losses, which results in them withdrawing loans, making borrowers sell assets. That lowers asset prices further and causes more losses – and as economies weaken further the cycle will only continue.
In short, there is no quick fix for the credit crisis and the accompanying economic downturn – and the excesses of the past few years are unlikely to unwind in a hurry.