The question, in truth, is not only whether the measures will work, but whether the UK can afford them.

From the FT:

"Are UK banks too big to rescue?

By Martin Wolf

Published: January 22 2009 19:55 | Last updated: January 22 2009 19:55

Is the British government on the right path with its recent package of measures to help the banking sector or, as Mervyn King, governor of the Bank of England, put it this week, “to protect the economy from the banks”? The question, in truth, is not only whether the measures will work, but whether the UK can afford them.( BLIMEY )

Here are two frightening statistics: over the past five years, the balance sheets of many of the world’s largest banks more than doubled; and, according to the Bank, the median ratio of debt to equity in big UK banks is more than 30 to one.

The government faces two challenges: it must eliminate the consequences of these past errors and prevent new ones. These errors go in opposite directions: the past one was lending too much; the present one is lending too little. The legacy of the former is destroyed balance sheets; that of the latter is collapsing lending. ( A SPOT OF BOTHER )

So what should the government be doing in dealing with the legacy of past excesses? The first action must be a brutal worst-case evaluation of balance sheets. The government cannot safely guarantee any conceivable losses( ACTUALLY, IT NEEDS TO. ). The big banks are deemed too big, too interconnected and too important to fail. Yet might they not also be too big to rescue( YOU'D BETTER HOPE NOT )?

This last is the spectre that Willem Buiter has been raising for the UK in his Maverecon blog. He notes that, with balance sheets equal to 440 per cent of gross domestic product, these institutions might imperil the fiscal soundness of the UK itself. I suspect this danger is exaggerated( LET'S HOPE SO. ). A recent analysis from Goldman Sachs suggests that the cost to the state should not exceed 8 per cent of GDP. But it is also true that we do not know what would happen to the value of the global assets of UK banks in a depression. Moreover, we have to add in the costly impact of what are likely to be huge ongoing fiscal deficits over many years.

The government’s policies for dealing with the overhang of bad loans had been recapitalisation. Now we have what Alistair Darling, chancellor of the exchequer, told the House of Commons would be “a new scheme under which the Treasury will insure( REMEMBER PESTON'S POST. ) certain bank assets, for a commercial fee, against losses on banks’ existing loans”.

Meanwhile, the problem for new lending is the departure of foreign financial institutions and capital. The government estimates that about 30 per cent of lending capacity has consequently been lost.

The proposals announced this week include three measures to address the capacity reduction: a £50bn Bank of England fund, financed by the Treasury, aimed at buying corporate assets; a decision to let Northern Rock maintain its loan book, to “support prudent lending to creditworthy customers”; and conversion of the preference shares in Royal Bank of Scotland into ordinary shares.

In addition, “we intend,” said the chancellor, “to negotiate with each bank a lending agreement,” which would be “binding and externally audited”. In return, new support measures are offered: an extension of the credit guarantee scheme introduced in October, which already covers £100bn in loans; an additional £50bn of guarantees, initially on new mortgage lending and eventually on other assets; and, finally, a plan for the Financial Services Authority to adjust capital requirements, to encourage lending in the downturn.( NOTICE THE GUARANTEES )

So what are we to make of these proposals? I have three big worries.( THAT'S IT. AN OPTIMIST. )

My first concerns the potential cost to the taxpayers of guarantees, particularly on past loans. Guarantees on new loans may now be unavoidable. Old loans are a different matter. The idea of offering insurance against extreme outcomes is a superior alternative to buying bad assets at inflated prices( YES ). Yet these loans are bygones – sunk costs. The only question is: who bears the losses? The dangers of letting some losses fall on creditors, via debt-for-equity swaps, are evident. Yet there may be no responsible alternative, particularly in view of the UK’s vast ongoing fiscal deficits.( YES )

My second worry is management. The chancellor says that “we have a clear view that British banks are best managed and owned commercially and not by the government”. Recent performance hardly suggests banks are well managed( TRUE ). Above all, who is taking the risk and deciding what the banks should do? The answer to the former question is taxpayers; the answer to the latter is government. Private management of socialised risks is dangerous( TRUE ). This is why temporary nationalisation is logical. I suspect it is where we will end up.( YES )

My third concern is over the apparent hope of recreating securitised financial markets. I understand the appeal of such markets. But, by offering guarantees( YES ), the government could be subsidising the recreation of a market in lemons.

With international confidence in the UK weak and weakening, the government has to take a realistic view of what it can and must do. It has to come clean on the possible fiscal costs and, in the last resort, it has to focus its limited resources on the future instead."

Too true.