Bailout 2.0 - how will it work?
Updated on 18 January 2009
Our economics correspondent Faisal Islam has had an insight into what the government is preparing to announce.
A parade of banking bosses have been visiting the Treasury offices of Lord Myners to have Bailout 2.0 explained to them. The last time this happened in October, one of the banking bosses likened the government's negotiation strategy to 'a drive-by shooting'.
Three months on, we are back here, but the context is different. The government will argue that Bailout 1.0 worked, because it saved the banking system from a widespread collapse in confidence. Tomorrow's move has been necessitated by a sharp deterioration in the worldwide economy. This is a bailout for the economy rather than for the bankers, it says.
There are likely to be seven initiatives tomorrow, each designed to take out a blockage in the supply of credit to people and households:
- Asset Insurance Scheme. The value of billions of pounds of toxic and toxifying assets on bank balance sheets will be insured by the taxpayer. The government hopes it will increase the transparency of bank balance sheets, renew confidence, and enable a cleansing process that leads to higher lending levels. The precise amount of guarantees and risk transfer to the taxpayer will depend on ongoing negotiations with the banks, but my sense is that we are talking about the banking system's most risky legacy assets. Banks will still take the first loss.
- Extension of the credit guarantee scheme. This was the second part of the original October Bailout, a government guarantee of lending between selected banks for a commercial price. In December the treasury lowered the price they charge for this guarantee. Of the £250bn of guarantees originally estimated, around £100bn is known to have been used. This will now be extended till the end of the year.
- 'New SLS'. The bank of England special liquidity scheme expires next week. But it will be reborn, possibly as a scheme which sits on the public sector balance sheet, rather than the bank of England's. Why not just extend the existing SLS? Did the bank of England say 'No'? This may turn out to be very significant.
- Mortgage guarantees. The treasury is likely to implement the recommendations of former 'Hboss' Sir James Crosby. That would mean £100 billion of guarantees for packages of mortgage debt known as mortage backed securities. These were the magic fountain of mortgage credit in the boom years. MBS enabled banks to lend much more money than they had deposited. But can the government really boost a market that has collapsed around the world? And should it?
The Crosby credit guarantees may also permit borrowing by non-financial companies, such as car manufacturers.
As well as the patchwork quilt of lending guarantees amounting to semi-nationalisation of the lending system, there are other initiatives. - Northern Rock strategic shift in direction
Not quite a U-turn, but nearly. It has been draining up to £17bn of credit from the economy to repay its emergency support loan. That business plan was squared off with the European Union state aid rules. But it became utterly absurd to have one set of state-backed banks being hit over the head by the government in order to lend more, when the bank lending the least was undoubtedly the 100 per cent state-owned Northern Rock (as we pointed out in October). So Northern Rock is likely to turn from a bad bank to a neutral bank.
- RBS and Lloyds have both been having talks with government about redemption of the Treasury preference shares. At the end of this process it is likely that RBS will be 70 per cent government owned (versus 58 per cent now. In theory RBS will have freed up more capital to increase lending to the economy
- Basel II. This is the most technical bit, but possibly the most important. Banking chief executives have been expressing concern (including John Varley of Barclays on this programme) about the 'procylicality' of international regulations on capital. The FSA and the Treasury will tomorrow announce that they are adopting a more flexible, looser approach to these capital regulations. Theoretically this should allow more credit creation.
Critics will say the array of huge proposals are more akin to a scattergun than a driveby shooting. The governments thinks these are laser guided sniper bullets aimed at all the key technical causes of the continuing dysfunction in the supply chain of credit. These measures are about getting lending going and giving the banks confidence in their own balance sheets.
There are three key comments about Bailout 2.0 in my opinion. Firstly there will be little upfront taxpayer injection of cash, as we saw in October. Instead huge contingent liabilities have been created for the future. The government hopes that they will not have to be called upon, but if they do, that this would be better than a continuation of the current corporate credit drought.
Secondly some of these moves are in the vague neighbourhood of 'quantitative easing' type policies. But it looks like the bank of England did not want to fund them. More on this tomorrow.
Thirdly, this array of weaponry is being fired because the government can not be sure which one will work. So unprecedented is the current economic conjuncture, that we really are engaged in experiments.
