Seeds of the next crisis

It is said that the seeds of the next war are sown in the decisions made in at the end of the last one.  As with wars, so it seems with banking crises.

Last week I broadly welcomed the bailout approach adopted by Brown in contrast to the Paulson Plan in the US which was already failing.  Not that Brown can take a credit for inventing the approach; a very similar scheme was used in Sweden in the early 90s and very recently by Warren Buffet, the world’s most successful investor, to rescue Goldman Sachs so the precedents were clear.  Moreover, he had the experience of Northern Rock some months before giving him time to get his head round the concept (with Vince Cable calling it consistently right).  Now most EU countries and, to a limited extent, the US are moving to adopt schemes based on the ‘British Plan’ in some degree.

The background is, of course, an absolutely monumental failure of the banks themselves, the regulators and the government.  (Which is to say that Brown is doubly implicated in that he both heads the government and, as Chancellor, designed the regulatory framework that has failed so catastrophically).

But all that was last week and it seems that even a weekend is a long time in politics.  For the plan that was being discussed last week has mutated over the weekend in ways that are subtle yet important and fill me with foreboding.  Motives matter, and I am not convinced that the government is as pure as driven snow at this point.  It needs to be.

Firstly, the decision to let Lloyds TSB take over HBOS in flagrant breach of competition rules was just about (downhill and with a following wind!) justified when first mooted on the basis that Lloyds could rescue HBOS without recourse to the taxpayer.  But since it has emerged that both Lloyds TSB and HBOS will need taxpayer help this rationale entirely evaporates.  Labour is acting as midwife to the birth of a very dangerous offspring.  Moreover, the loss of an important plc head office to Edinburgh is no small matter.  The UK as a whole would be healthier if more public companies had head offices outside London.  I would like to see this deal stopped or, failing that, a Lib Dem commitment to break up Lloyds/HBOS.  Let it not be said at some later date that Lloyds/HBOS didn’t know the risk.

Secondly, the original rescue plan envisaged that government help would be in the form of preference shares with various conditions attached.  While these were not precisely spelled out it is clear that they would include restrictions on executive pay and bonuses.  What we are actually getting seems to have mutated to a small number of preference shares with most of the money injected in the form or ordinary stock with directors on the board to match.

Now this distinction matters, not so much because of the mechanism per se, but because it seems to herald a shift in government thinking over the weekend.  For, despite the name, ‘preference shares’ are nearer to loans than to ordinary shares.  Under the original proposals the government effectively gives the banks concerned a loan at an interest rate somewhat higher than the government itself pays (so making a profit on the difference), not taking management control as such except via the conditions linked to the purchase of the preference shares.  Under the revised proposals the government is very much involved as a ‘player’ – with ongoing involvement in day-to-day decision making. 

These two approaches are subtly but importantly different.  The first is rather similar to the way the Bank of England operates in setting exchange rate targets – government sets the target at the outset in the full glare of democratic accountability but then stays firmly hands off.  The second is, at first sight, more democratic but in reality it’s classic Labour, hands-on-the-levers-of-power.  However much Brown insists that the government-appointed non-exec directors are just that – not executive – they will have a disproportionate influence in transmitting Brownian wishes into routine management decisions at a level that stays far below any Parliamentary radar.  If Brown says (or even thinks), “jump” the board will have to be exceptionally strong-minded not to ask, “how high?”.  And Parliament will never know, not even that some issue was in play.

Under the preference share approach government has to make its mind up about conditions now then stick to them.  Key decisions are not difficult – the premium over the government’s cost of borrowing, director’s pay and bonus capped at, say, £250,000, until the preference shares are redeemed (Germany has imposed a cap of 500,000 Euros).  This would give directors a powerful interest in giving  taxpayers their money back ASAP so minimising risk.  This giving the money back ASAP is the approach taken with Northern Rock where over half has already been repaid.

Under the ordinary share purchase approach the government will find itself facing a ‘difficult’ election while enjoying massive de facto influence (if not outright control) of a huge pile of assets.  If Brown judges that a quick boom will improve Labour’s chances then a hint here and a nudge there will ensure that there is one by pouring these assets into schemes whose merit may be more political than financial.  And if these schemes can be spun to have wider social benefits then so much the better.  House building would seem to be the obvious way to tick all the boxes.

Already the government is showing its prediliction for political objectives in telling the banks that they must lend to house buyers and small businesses at the same rate as they lent to them in 2007 at near the height of the boom.   Government spokesman have been doing the rounds of the media trying to deflect criticism on this point by saying that they still expect the banks to be prudent lenders.  But that’s not what the government said earlier.  They could just as well have left this to the banks themselves; after all banks make their living my making loans to people and businesses so they can’t and won’t stop just like that.  There are still other banks out there who would be more than happy to pinch their best customers.

Brown needs to get this sorted quickly because, although necessary, this plan is not sufficient to get us out of this mess.  We need to be moving on fast to get ahead of events, and not trailing in their slipstream.


4 responses to this post.

  1. Interesting that comment at the end about house-building. It was of course HBoS who set themselves a target to become Britain’s biggest housebuilder as well as bank. As a sector, construction is currently shot to pieces. If you can stage a “rescue” of the “real economy” exemplified by a big investment into house-builders you just would, wouldn’t you! As you say, it ticks all the boxes.


  2. […] suggest that the bailout: (a) should involve only preference shares (not ordinary shares – see this earlier post for reasons), (b) the interest rate should be as low as possible (e.g. 2% above the […]


  3. I suspect there is a better change of stiffer new bank regs in the EU than in the US.


  4. […] From the web site, Liberal Eye, Power to the People: […]


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