"This wasn't supposed to happen," sang Bjork, while still a member of Icelandic pop group The Sugarcubes, on their 1991 record ‘Hit'. She could easily have been singing about and, by extension, its entire economy. By far the most dramatic collapse of the current credit crisis, Iceland's boom and almighty bust is a neatly packaged example of the reckless leverage that has pervaded the world's economies and sent its financial institutions into a near-unrecoverable tailspin.
The sentiment of Bjork's lyric has been echoed far and wide – banks are simply not supposed to go bust, how could this happen? Yet for over a month now, the worldwide banking sector has been standing at the edge of the abyss. One by one, major institutions have lost their footings on the slippery slopes of illiquidity, to be left dangling precariously from the edge or having toppled in altogether. And only around the world has prevented the catastrophic collapse of the entire system.
The end of the party
The banking boom of recent years is widely seen as a product of Thatcherist free-market thinking; give the banks near-absolute freedom and the spoils will follow. That doctrine has worked for many years, as a splendid splurge of massive profits and eye-watering bonus payments ensued. Not too many people sat back and wondered if it was all too good to be true.
Unsurprisingly, it was. Banks have found themselves saddled with gargantuan piles of steaming, toxic debt they will have little chance of recouping. Light touch regulation – and the relentless pursuit of double-digit profit growth - encouraged risk-taking on a scale never before seen. Many believe that even the interests of the shareholders played only second fiddle to the interests of the executives, and that the self-serving pay schemes of leading financial institutions may have been in no small part responsible for their downfall. The Financial Services Authority has explicitly said it believes that "in many cases the remuneration structures of firms may have been inconsistent with sound risk management".
So, because of their, for want of better words, let's call it greed and negligence, banks now need to boost their reserves to meet requirements set out by the FSA – their capital adequacy ratios - to ensure they have sufficient funds to ride out a recession. Banks have carelessly run down their reserves in economic boom times – on the bizarre premise that these boom times would never end. But what was once a virtuous spiral of lending-upon-lending has morphed, suddenly, into a vicious unwinding. With the spectre of debt default from householders and consumers alike rising, banks have looked dangerously low on the funding they desperately need to absorb the heavy write-downs they're likely to incur.
The key metric used by regulators to assess the financial well-being of banks is the core tier one ratio – the ratio of shareholders equity (including preferred stock) to its total risk-weighted assets. The average core tier one ratio in the UK stood at just over 6 per cent before the bailout, and the regulators want to see a figure of nearer 9 per cent, "well above international minimum standards and at a level that should put them on a strong footing for the future", according to the Treasury's statement. If a bank's tier one capital ratio is too low, a significant drop in the value of its assets could wipe out its equity – in the past, that would have been unthinkable, but massive exposure to worthless sub-prime related assets is a very real risk that governments around the world are now desperately manoeuvring to avert.
The Dynamic Duo – Brown & Darling
For the many accusations aimed at the current Prime Minister and his Chancellor, Gordon and Alistair have appeared to move quickly to avoid an outright, systemic collapse of the very fabric of the financial system. And they've certainly not been shy about blowing their own trumpets over their "decisive and extraordinary action." Our dynamic duo will no doubt wallow in the satisfaction that their bailout has provided the blueprint and impetus for rescue plans around the globe. France and Germany have followed suit with €360bn and €500bn of capital injections and credit guarantees respectively, with the US expected to follow suit imminently.
Troubled UK banks have been quick to sign up to the system – after all-night talks last weekend, it seems they are to receive an immediate £39bn capital injection, a move which could see the government taking a significant equity stake in some high street banks. The new money will come through a recapitalisation involving the issue of additional shares, and is designed to recharge banks' reserves. Only banks considered to have sufficient capital will be allowed to take advantage of government plans to guarantee around £250bn of bank debt, announced last week.
Under the terms of the new agreement, banks will issue new ordinary shares. Existing shareholders will have the opportunity to buy these first, but if they decline - which seems likely - the government will purchase whatever is left, in essence a partial nationalisation of much of the UK banking sector and leading to a significant dilution in shareholder value.
Where a significant stake-holding is taken by the government, it will also be demanding a representation at board level, which would almost certainly lead to the government having a say in dividend payments, acquisitions and disposals. However, Yvette Cooper, chief secretary to the Treasury, stressed that it is not the government's intention to have a long term involvement in running the banks. But it seems that a full return to private ownership will depend on a resumption of normal trading conditions in the financial sector, and that could be many years away.
The timing of the latest capital injection caught most of the banks off guard. Only last week they were breathing a sigh of relief after the government's plan to bail out the country's largest financial institutions. But they failed to realise at the time the need to present a plan to boost their reserves. And the timetable suddenly took on a greater urgency as evaporating confidence saw banks' share prices hammered. Given the total absence of appetite from investors for fundraising, it became clear that the government would have to provide the funds to boost reserves.
For the banks there are several weighty strings attached. Bonus payments will come under strict scrutiny ("rewards for failur" will disappear), and participating banks will need to commit to continue lending funds to small businesses and homeowners in return for the government's support. In effect, the government is giving taxpayers' money to the banks so that they can lend it back to the taxpayers. However unpalatable this may appear, the alternatives would risk the breakdown of the financial system.
Thawing the big freeze
Arguably the most painful effect of the banking crisis has been the seizing up of the all-important wholesale money markets. The benchmark Libor – The London Inter-Bank Offered Rate at which banks lend to one other – has risen to 6.3 per cent, well above the Bank of England base rate, with banks reluctant to lend money to each other because of worries over counter-party risk and their own need to hoard cash to cover potential losses they face from bad investments, particularly their credit default swap liabilities.
The effects of this have had a damaging effect on the real economy. Interbank lending is the lifeblood of the financial system - without it as a source of funding, banks are unable to continue with the day-to-day business of lending money to the business world. Almost 50 per cent of the UK's corporate lending – around half a trillion pounds worth of loans - is pegged to Libor, so the sudden spike in rates is also having a punitive effect on the real economy, with corporate cash flows eroded by the sudden rise in the cost of servicing debt.
Rumours suggest that, having sorted out the banks' tier one capital ratios, the government may be on the cusp of stepping in to save the money markets. So far, the £250bn special liquidity scheme it launched - allowing banks to trade illiquid mortgage–backed assets for more liquid government bonds – has done little to get money markets moving.
This is by far the most important of the steps it must take. "The Bank will continue to take all actions necessary to ensure that the banking system has access to sufficient liquidity," said the Treasury's statement. Now is the time for it to put its money where its mouth is as far as the money markets are concerned, perhaps by offering its services as a direct guarantor of interbank loans, as European governments have already done. Their latest actions already appear to be having an effect, as Libor rates began to fall after details of the European plans were heard. "Guaranteeing interbank lending is crucial to improve financial market conditions," said analysts at BNP Paribas.
