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Authors: Vincent Cable
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which
investors were no longer willing to trust banks overnight. At this point the whole financial system was close to total collapse
– leading, potentially, to an economy dependent on barter. The Governor of the Bank of England has said that the UK was literally
24 hours from such a collapse. In previous generations that crisis point would have led to a run on the banks by depositors;but, apart from a nervy weekend when Ireland offered all its depositors unconditional guarantees, there was a common-sense
understanding (helped by earlier interventions, such as the nationalization of Northern Rock in the UK and AIG in the USA)
that, whatever happened, depositors would be protected. It was clear, though, that piecemeal action was no longer enough and
that a comprehensive, and coordinated, approach was required.
A key step was to recognize – based on long-established, nineteenth-century practice – that banks should have whatever liquidity
is necessary from the central bank (albeit at a penalty rate and secured against sound collateral). In an effort to prevent
a crippling squeeze in credit the US administration pumped $180 billion into money markets to offset the hoarding of cash
by frightened institutions, and other central banks followed. Short-selling was banned so as to take the immediate pressure
off bank shares; short-selling had been threatening the system by driving down bank shares to the point of disabling the banks’
ability to raise capital themselves.
But the crucial step was the recognition that, if the banks were to return to their central role as financial intermediaries,
they would need help in adjusting to the large losses that they had made. Writing off losses required capital. Capital could
no longer be raised, unaided, from the markets through the normal mechanism of rights issues to shareholders, and new sources
of capital (such as sovereign wealth funds) were wary or very expensive. There was a danger that banks would try to realize
capital by drastically cutting their lending, with profoundly damaging effects on the real economy (or else try to conceal
the problem, as the Japanese banks had done in the 1990s, which would perpetuate the lack of confidence). The issue, then,
was how best to help restore the banks’ balance sheets to health.
The first attempt to grapple with this problem was the Paulson plan in the USA, to set up a fund of $700 billion to buy up
‘toxic’mortgage-related securities from the banks. It soon became clear that market confidence generally – as reflected in a highly
volatile and collapsing stock market – hinged on getting the plan accepted by Congress. It was, however, a badly conceived
and politically unpopular plan. If the purchases of bad debts were at current market prices, there would be no relief. If
they were on more generous terms, then the banks were being bailed out without any obvious benefit to the taxpayer, and irresponsible
lenders were being rewarded. Nor was there any guarantee that the buy-out programme would make more than a marginal impact.
There were, in addition, many practical questions about how the mechanism would work. Congress baulked at the package and,
at the first time of asking, rejected it, fuelling ever more uncertainty. A compromise proposal was then passed, with some
protection for the taxpayer, and the hope was that if toxic debt could be valued – notwithstanding its considerable complexity
– this would create a liquid market for mortgage-backed securities. Once that happened losses could be valued and written
down in an orderly way.
At this key moment, however, the UK government came up with an alternative proposal for injecting money into the banks more
quickly, by advancing capital directly through a form of partial nationalization. The state agreed to invest £37 billion in
leading banks that sought funding to repair their balance sheet in ordinary and preference
investors were no longer willing to trust banks overnight. At this point the whole financial system was close to total collapse
– leading, potentially, to an economy dependent on barter. The Governor of the Bank of England has said that the UK was literally
24 hours from such a collapse. In previous generations that crisis point would have led to a run on the banks by depositors;but, apart from a nervy weekend when Ireland offered all its depositors unconditional guarantees, there was a common-sense
understanding (helped by earlier interventions, such as the nationalization of Northern Rock in the UK and AIG in the USA)
that, whatever happened, depositors would be protected. It was clear, though, that piecemeal action was no longer enough and
that a comprehensive, and coordinated, approach was required.
A key step was to recognize – based on long-established, nineteenth-century practice – that banks should have whatever liquidity
is necessary from the central bank (albeit at a penalty rate and secured against sound collateral). In an effort to prevent
a crippling squeeze in credit the US administration pumped $180 billion into money markets to offset the hoarding of cash
by frightened institutions, and other central banks followed. Short-selling was banned so as to take the immediate pressure
off bank shares; short-selling had been threatening the system by driving down bank shares to the point of disabling the banks’
ability to raise capital themselves.
But the crucial step was the recognition that, if the banks were to return to their central role as financial intermediaries,
they would need help in adjusting to the large losses that they had made. Writing off losses required capital. Capital could
no longer be raised, unaided, from the markets through the normal mechanism of rights issues to shareholders, and new sources
of capital (such as sovereign wealth funds) were wary or very expensive. There was a danger that banks would try to realize
capital by drastically cutting their lending, with profoundly damaging effects on the real economy (or else try to conceal
the problem, as the Japanese banks had done in the 1990s, which would perpetuate the lack of confidence). The issue, then,
was how best to help restore the banks’ balance sheets to health.
The first attempt to grapple with this problem was the Paulson plan in the USA, to set up a fund of $700 billion to buy up
‘toxic’mortgage-related securities from the banks. It soon became clear that market confidence generally – as reflected in a highly
volatile and collapsing stock market – hinged on getting the plan accepted by Congress. It was, however, a badly conceived
and politically unpopular plan. If the purchases of bad debts were at current market prices, there would be no relief. If
they were on more generous terms, then the banks were being bailed out without any obvious benefit to the taxpayer, and irresponsible
lenders were being rewarded. Nor was there any guarantee that the buy-out programme would make more than a marginal impact.
There were, in addition, many practical questions about how the mechanism would work. Congress baulked at the package and,
at the first time of asking, rejected it, fuelling ever more uncertainty. A compromise proposal was then passed, with some
protection for the taxpayer, and the hope was that if toxic debt could be valued – notwithstanding its considerable complexity
– this would create a liquid market for mortgage-backed securities. Once that happened losses could be valued and written
down in an orderly way.
At this key moment, however, the UK government came up with an alternative proposal for injecting money into the banks more
quickly, by advancing capital directly through a form of partial nationalization. The state agreed to invest £37 billion in
leading banks that sought funding to repair their balance sheet in ordinary and preference
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