The swiftness of Britain’s transition from the cutting edge of innovation in banking and finance to representing the epitome of the global crisis has left many heads spinning. But in its dramatic demise lie lessons that financial institutions around the world would do well to heed.
For years London’s financial center, commonly called the City, has been held up as the shining example of British excellence, with finance contributing some 20% to GDP and London widely regarded as the financial capital of Europe, if not the world. The deregulation of recent years sparked innovation that further reinforced the image of London being at the cutting edge of international finance.
Such thinking has been turned on its head by the events of September and October 2008, when weeks of near panic about the prospects of Britain’s banks and record falls in their share prices culminated in their part-nationalization by the Labour government on October 7.
In a move that would have been unthinkable even a few weeks ago, the state is to make £37 billion ($64 billion) in public money available to three leading financial institutions, with the option of extending this package as and when it is needed. Royal Bank of Scotland will receive the largest share (£20 billion) with Lloyds TSB and HBOS—which are to merge—benefitting from an injection of £17 billion (Barclays has agreed to raise some £6.5 billion independently). The move means taxpayers will own 60% of RBS (which also owns NatWest) and 40% of the merged Lloyds TSB/HBOS. The chief executives of the affected institutions all resigned with immediate effect. In moves aimed at boosting liquidity, the Bank of England is doubling, to £200 billion, the loan money it is making available to banks. Significantly, the authorities also said a further £250 billion would be made available in loan guarantees to encourage banks to start lending to one another again and thus, by extension, to individuals and companies in the wider economy. This means Britain is gambling money worth more than one-third of GDP—or £16,000 from every taxpayer—on rescuing its banks and helping them function properly again.
“This plan is designed to put the British banking system on a sounder footing,” Britain’s prime minister Gordon Brown told a packed House of Commons on October 8, having secured cross-party support for the bailout plan.
For those who have been following the credit crunch in the United Kingdom, the government’s dramatic moves seemed long overdue. Lack of confidence in the tripartite regulatory system set up by Brown when he was chancellor of the exchequer in 1997 had been contributing to the sense of unease in Britain’s financial sector, with its three players viewed as not facing up to the challenges facing the sector. Although now under a new chairman, Adair Turner, and determined to be more proactive in identifying problems, the Financial Services Authority (FSA) is blamed for having earlier failed to spot the problems at troubled banks Northern Rock and Bradford & Bingley and of underestimating the dangers posed by securitization.
“Britain’s celebrated light-touch regulation, credited with contributing to London’s success as a financial honey-pot, was virtually no touch at all,” says Simon Morris, a specialist in international regulation at law firm CMS Cameron McKenna.
The FSA is now also blamed for failing to warn investors about the problems afflicting Iceland’s banks, all three of which had Internet operations aimed at British savers before they were nationalized during the week of October 6 to prevent them going bankrupt. British public bodies stand to lose at least £1 billion as a result of the collapse of Iceland’s banks.
Inaction Draws Criticism
Until its shock 50-basis-point cut in interest rates on October 8—timed to coincide with similar moves by the US Federal Reserve, the European Central Bank and other central banks—critics had accused Bank of England governor Mervyn King of taking too academic an approach to the crisis, being overly concerned with inflation targeting, its main remit, and moral hazard. Industry players had also criticized the government for dithering, saying dramatic action was needed to restore confidence, which has all but vanished.
Yet the stresses in the banking sector, which first became apparent in September 2007, around the time problems at Northern Rock prompted the first run on a British bank in 141 years, had been becoming increasingly apparent. On September 26 of this year, the Confederation of British Industry (CBI), an employers’ group, warned that profitability had been falling at a record rate, with 99% of banks surveyed saying they expected it would take at least six months before anything like normality returned. Just two days later the government was obliged to part-nationalize Bradford & Bingley and sell its savings division and its 200 branches to the ever-acquisitive Santander group for the bargain price of £612 million ($1.1 billion). It also put aside competitive concerns and waved through a takeover of Britain’s largest mortgage bank, HBOS, by Lloyds TSB, after short selling and a crash in its share price threatened HBOS’s very survival.
Months of crisis have had a strong negative effect on the sector’s international image as well. The latest annual Global Competitiveness Report, published by the World Economic Forum, which viewed British banks as the safest and best in the world in 2006, now puts the sector in 44th place, behind Peru and El Salvador’s banking sectors in 42nd and 43rd position. “When the dust finally settles, Britain’s bank sector will look very different,” says James Bateson, head of financial institutions at the law services firm Norton Rose, who predicts more failures before the crisis passes.
The biggest losers have been the building societies that demutualized to become banks in the late 1990s: Northern Rock, finally—and belatedly—nationalized this March; Halifax, part of HBOS, now being subsumed into Lloyds TSB; Alliance and Leicester, bought for £1.2 billion in July, also by Santander. Too small to compete with the larger institutions, most found business in areas, such as buy-to-let, that the credit crunch and the housing market downturn revealed to be fundamentally unsound and then found themselves unable to finance themselves through an all-but-collapsed wholesale borrowing market.
Royal Bank of Scotland is also unlikely to emerge unscathed. Its share price has been hammered over concerns about over-gearing, reflecting its purchase last year of part of ABN AMRO, and it looks to be first in line for the bailout package.
The winners include HSBC, with its huge but well-diversified international operations, and Spain’s Santander, whose boss, Emilio Botín, famously eschewed securitization generally and derivatives in particular on the grounds that he would never buy something he did not fully understand. Santander’s Abbey National—the demutualized building society it bought in 2004—looks set to become one of Britain’s top-five banks. Lloyds TSB is also patting itself on the back for its conservative approach to risk: Once it has absorbed HBOS, it will be Britain’s largest financial lender, with some 30% of the population as customers.
Further consolidation seems all but inevitable, especially within the City. Walking through the Square Mile in October 2008 was an almost eerie experience, with bars and restaurants almost empty. “I’ve never seen it like this in 20 years; it feels like Armageddon,” says Richard Fraser of headhunting firm RJF Global Search. “Lots of people are looking for work, but no one’s hiring.” Little wonder Capio Nightingale, the City’s only mental health hospital, is reporting that requests for relief from anxiety and depression—what it terms “Square Mile Syndrome”—are up 33% since July.
The truth is that British banking— buffeted first by its exposure to the US subprime crisis and then by the falling domestic housing market and the concerns now hitting European banks—has to get through the biggest crisis of confidence and trust in its recent history. Two days before the government’s bailout, the CBI’s deputy director general, John Cridland, argued that a “circuit breaker” was needed to halt the downward spiral. “There are three separate but related problems: a continued lack of liquidity in money markets, the erosion of bank capital resulting from the devaluation of their assets, and the loss of confidence among depositors that their money is safe. Action is now needed to address each of these,” he said.
The bailout package certainly addresses the first two, but what of the last?
For Jenny Hicks-Beech, an antiques dealer, the sense that nowhere seems safe for her savings is a fundamental part of the sense of fear now gripping ordinary Britons. “The fact that you feel you cannot trust the banks with your money is terrifying; we’ve never been in this situation before,” she says.
To the irritation of his many critics, who say he has been on the back-foot throughout the crisis, responding to events rather than appearing to have a plan, chancellor of the exchequer Alistair Darling has refused to make the government’s implicit support of savers explicit. There has been talk about moral hazard and the potential cost, which could run to £800 billion. Darling also says the recent increase in the amount covered by deposit guarantee from £35,000 to £50,000 covers 98% of depositors. The problem, though, is that the remaining 2% hold 40% of the total retail deposits in British banks, which they can readily withdraw and deposit in the increasing number of countries that have extended 100% guarantees on deposits. This increased risk for British banks is the last thing they need in the current climate.
In the immediate days after the announcement of the government’s unprecedented package, Britain’s banking community seemed almost stunned at the course of events that had seen the most avowed proponents of free markets turn cap in hand to the state. The general consensus, though, is that the package is brave, far-reaching and well constructed; it was well received, despite the continued slide in the FTSE index after its announcement. Many regard its focus on bank recapitalization and encouraging the restoration of normal interbank lending as an improvement on the $700 billion plan by US Treasury secretary Henry Paulson, which instead focuses primarily on the complex task of identifying and buying up toxic debt and thus, arguably, runs a greater risk of failure.
The general consensus though is that the package is brave, far-reaching and well-considered; reassuringly it has been well received, with the US and EU launching similar schemes and Nobel Prize winning economist Paul Krugman lauding Gordon Brown as capitalism’s savior.
The key question, though, is whether it will at least slow the seemingly inevitable slide toward recession? The International Monetary Fund is now warning that the world faces the most challenging economic environment since the 1930s and predicts Britain’s GDP will contract by 0.1% in 2009, a major revision downward from its August forecast of 1.1% growth. However, if Brown’s £500 billion gamble encourages Britain’s banks to actually start behaving like banks again, the future could begin to look less scary.