A week is a long time in politics, Harold Wilson, UK prime minister in the 1960s and 1970s, once famously said. Current UK prime minister Gordon Brown’s capital, like the rest of the world’s banks, was rock bottom by early October. That is until he became a man with a plan. A plan that has been mimicked – some might say improved upon – by the world’s biggest financial superpower, the US.
Mr Brown, heavily criticised for his handling of the failure of British bank Northern Rock in early 2008, has come some way to repairing his tarnished image. On Sunday October 12, the chiefs of the UK’s biggest banks met in Downing Street to thrash out the details of a strategy that would eventually see the UK government become the major shareholder in the cream of British banking.
Yet just 12 months ago, when the government was forced to take over Northern Rock, nationalisation was a dirty word. Mr Brown and his government suffered a barrage of criticism for their actions, with some heralding a return to the financial dark ages.
It seems now, however, that the world faces little choice. The US government announced plans to inject $250bn into its beleaguered banking system the day after the UK’s decision, and across Europe, governments have been desperately propping up their financial systems.
In the UK, the government announced on October 13 that it would pump £37bn ($64bn) into the banking system. This will take the form of a $20bn stake in Royal Bank of Scotland (RBS), accounting for 60% of the bank, and a 43.5% stake in a post-merger Halifax Bank of Scotland (HBOS) and Lloyds TSB entity. Of those shares, £9bn-worth will be preference shares paying the government a fixed interest payment of 12%.
Price to pay
All this comes at a price. Under the terms of the deal, RBS, HBOS and Lloyds TSB will be prevented from paying dividends on ordinary shares until they have repaid in full the total of £9bn in preference shares (although this aspect is currently being argued by the banks). The banks will also be forced to curb executive pay, accept government appointees to the board and commit to carry on lending to small businesses and home buyers.
No sooner had the UK government finalised its plans, than the US put its own stabilisation programme into place. The US government, however, went easier on the banks. Treasury secretary Henry Paulson, who labelled the US bail-out “objectionable”, pumped $250bn into the US banking system. Of that, $125bn will be poured into nine banks – Bank of America, JPMorgan Chase, Wells Fargo, Citigroup, Merrill Lynch, Goldman Sachs, Morgan Stanley, Bank of New York Mellon and State Street. Unlike the British plan, however, the US banks will be able to carry on paying dividends and face only mild curbs on executive pay. The banks will also only have to pay 5% on the US government’s preference shares, compared with 12% in the UK.
At what cost?
As The Banker went to press, it was too early to say whether either the UK or US stabilisation plans had been a success. All that can be said is that they were, in Mr Brown’s words, “unprecedented and essential”. But when the dust settles, what will be the true implications of state ownership of such vital economic assets? The government has been at great pains to stress that the move is merely temporary and that it intends to take an arm’s-length approach when it comes to the day-to-day running of the banks.
Not everyone, however, places much faith in such assurances. Eamonn Butler, a director at the Adam Smith Institute, a free market think-tank, agrees that the government had no choice when it came to nationalisation, but is also highly sceptical.
“I am not sure politicians are up to the job of running a bank,” he says. “My feeling is that by putting people on the board of these banks, that means that whenever anything happens, and [British tabloid newspaper] The Sun declares there is a scandal in a particular bank, the government will then have to intervene because they will say: ‘you [the government] have people on the board, why don’t you fix this problem?’ My feeling is the government will get drawn in more and more and more into the everyday running of banks, and that is not good.”
For some, the mere fact that the government has already imposed such draconian measures on the banks is proof it will find it hard not to get involved in the future. The restrictions on executive pay and dividends are a case in point. Roger Barker, head of corporate governance at the Institute of Directors (IoD) in London, fears a Financial Services Authority-style regulation of pay structures.
“We want the shareholders of the company to put pressure on banks to design pay structures,” he says. “In this case though, the government is the shareholder. Therefore it has the right to determine how executives should be paid. One can’t argue with that. These people are, in effect, becoming like civil servants.”
Fear of interference
Many fear the government will be inextricably drawn into interfering with the banks’ affairs, driven by political rather than commercial motives. Dr Butler views the restriction on executive pay and bonuses as the government merely ‘playing to the gallery’.
“Bonuses have got precious little to do with this problem. People have this idea that bankers get bonuses for doing nothing. Actually, the bonus system is a way in which the banking system effectively keeps its fixed costs down,” he says.
“Here you’ve got politicians immediately rushing in and as part of the price of their support they’re doing a political act, rather than a commercial or economic one. If they’re doing that on day one, I am not very confident about what they will be doing on day 1000.”
The IoD’s Mr Barker also points out the unprecedented size of the government stakes. Normal institutional investors don’t tend to have stakes bigger than 2% to 3% in any one company, but the government’s stakes are significantly bigger than this, both in the UK and the US.
“Clearly the government is going to dominate the board,” he says. “The concern of having someone like the government takeover in a way is akin to the concern you might have over a sovereign wealth fund taking a large stake.
“Is the government going to exert pressure on the company to operate for non-economic reasons? Or does it go to the opposite extreme and have a completely hands-off approach and doesn’t participate in boards at all? This can cause equal problems because it leads to a governance vacuum.”
Dividend concerns
The government’s restriction on dividend payments has also caused concerns. Nick Hill, a banking analyst at rating agency Standard & Poor’s, believes the government is sincere in its promise not to interfere, but that the dividend policy could be counter-productive.
“If banks really can’t pay dividends until the government preference shares are repaid then naturally they might be tempted to hoard cash in the short term so they can pay the government back and then start paying dividends again,” he says.
If banks do decide to hoard cash, it is even less likely they will be prepared to lend to small businesses and the mortgage market – the impetus for the plan in the first place. Mr Hill believes, however, that this scenario is unlikely.
“The UK plan was intelligently considered, in that it addresses the three issues that were really hanging over the sector: capitalisation, funding and liquidity,” he says. “The only way out was by comprehensive, decisive and massive action by the government and pretty much that is what we have seen over the past few days.”
The other area of concern for the IoD’s Mr Barker is the banks’ obligation to carry on lending to small businesses and the mortgage market. While it is undoubtedly a sensible measure, he believes the government’s proposal is vague and poses more questions than it answers.
“How is that going to be managed? Are government directors going to push that through? Is it appropriate that lending should continue at bubble levels? Is it desirable and is it possible? How will it work on an economic basis?” he asks.
Exit strategy unclear
One of the most fundamental unanswered questions, however, is what the government’s exit strategy will be. In many ways the situation is a microcosm of the war in Iraq. Intervention was the easy part, getting out the other side might prove to be far harder.
“It’s not clear what the government wants to achieve yet,” says Mr Barker. “Does the government want the banks to continue as they have done? In other words, wait until we get out of the current crisis, whereupon the government sells its shareholdings and we’re back to business as usual. Or might the government be tempted to convert the whole behavioural approach of these institutions and take them back in time to more of a mutually run organisation, which has a much simpler model?”
The Adam Smith Institute’s Dr Butler is blunt. “I fear that if things continue to go badly then the government won’t be able to get out, and if things go well, it won’t want to,” he says.
Most observers agree, however, that the government has no intention of becoming a long-term stakeholder in the British banking industry.
“Ideologically speaking, even a Labour government is not in favour of the state owning institutions – we haven’t gone back to that. It’s very much an emergency measure and I believe [the UK government] when it says it wants to get rid of its stakes at the earliest possible moment,” says Mr Barker .
