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.

"to stem the remorseless contraction of credit that's caused our awful recession.

Peston on BBC:

"A bank insurer, not a toxic bank

• Robert Peston
• 17 Jan 09, 12:04 PM

I don't know why the Government hasn't knocked on the head the idea that it's working on the creation of a bad or toxic bank that would buy our biggest banks' dodgy loans and investments.

What I expect it to announce on Monday (although the timetable could slip a day or so) is the creation of the mother-of-all bank insurance schemes.( GOVERNMENT MUST STEP IN AND GUARANTEE EVERYTHING IN A CALLING RUN. )

By the way, the Treasury is also considering making an offer to Lloyds/HBOS and RBS to convert the expensive preference shares they've sold to the Government into ordinary shares.( GOOD )

If this happens, I would expect RBS to say yes and Lloyds to say no. And the conversion would see the state's holding in Royal Bank rising from 57.9 per cent to around 70 per cent, or a good step nearer full nationalisation( GOOD ) (see below for more on this).

But back to this insurance scheme to give banks and their investors a bit more certainty( A GUARANTEE ) about the losses they would face as the recession undermines the ability of many borrowers to repay their debts.

Our biggest banks would identify their bad( CORRECT ) loans and foolish( CORRECT ) investments. And they would then pay a fee to a new state-backed insurer to protect themselves from losses over a certain level on these stinky assets. ( A PROPOSAL PUT FORWARD IN THE US AS WELL. )

But the banks would retain these bad assets on their balance sheets. They would not be transferred to a new toxic bank. We as taxpayers wouldn't own the stinky loans - though we would be liable for losses on them over a certain level.( TRUE )

Why the urgency of doing this?

Well in just a few weeks we'll see results for 2008 from our biggest banks. As I've already pointed out, Royal Bank of Scotland and HBOS will announce unprecedented, horrible losses.

And the HBOS losses would represent a massive drain on its new owner, Lloyds TSB.

There's a fear that unless the Government has developed some kind of safety net for them by then( A FULL GUARANTEE ), there could be an alarming loss of confidence in the banking system of the sort we witnessed in September and October.( A CALLING RUN )

So next week we'll get the announcement that just such a safety net, in the form of the insurance scheme for toxic loans, is in the process of being designed and built.

In a way, it can be seen as a way of getting capital into RBS and Lloyds/HBOS in particular without fully nationalising them.( THAT'S IT )

That said, the scheme will be open to all( IT HAS TO BE TO STOP THE CALLING RUN ) our very biggest banks. So Barclays too could insure away future losses on certain of its loans and investments if that suited it - although on Friday night it insisted that it had made stonking profits of well over £5.3bn in 2008.

However I don't expect a long and detailed statement on the institutional mechanism by which we as taxpayers will pick up part of the bill for the longest banking blow-out in history.

Nor do I expect, as this stage, the Government to put a number on the likely cost to all of us as taxpayers of putting a floor under banks' losses - although the potential liability would run to tens of billions.( TRUE )

Of course it's entirely possible( TRUE ) that if the new state insurer values the assets properly( THIS IS THE REAL PROBLEM ), taxpayers could end up over the years of the scheme with a profit.

But it seems unlikely that this will be a very popular policy. Readers of this blog have repeatedly asked why we as taxpayers should bail out the banks for the consequences of their greed and recklessness( BECAUSE THE CALLING RUN HAS LED TO A PROACTIVITY RUN ). The question I'm always asked is whatever happened to the old-fashioned idea that we should pay for our mistakes?( NATIONALIZING THEM WOULD DO THIS.)

For those working around the clock this weekend at the Treasury, in Downing Street, at the Bank of England and at the Financial Services Authority, the priority is to restore the strength of the banking and financial systems, to stem the remorseless( MANY PEOPLE ACTUALLY ADVOCATE LETTING THIS GO ON! ) contraction of credit( A CALLING RUN, WHERE CAPITAL MUST BE HOARDED FOR CALLS. ) that's caused our awful recession.

In that context, the Treasury and UK Financial Investments (the institution created by the Treasury to manage its investments in banks) have been preparing to make an offer to Lloyds/HBOS and Royal Bank, to convert £9bn of their preference shares (owned by the Treasury) into ordinary shares.

The reason for doing this would be to remove from them the heavy financial burden of paying the 12 per cent dividend of the preference shares.

In the case of RBS for example, the dividend represents an annual cash outflow of £600m and for Lloyds/HBOS the outflow is £480m.

In theory, if the two banks didn't have to pay this dividend they could lend £27bn more every year (because under FSA guidelines, if the £1080m of dividends were retained by the banks as equity capital, the banks would be able to lend a multiple of that core Tier 1 capital).

My strong sense is that RBS would love to convert the prefs, which it regards as costly debt, into ordinary shares - even though that would see it owned 70 per cent or so by the state.

However Lloyds TSB is less keen, because it's 43.4 per cent owned by the public sector and doesn't want to see state-ownership rising above 50 per cent, which would be the result of converting the prefs.

It will be interesting to see whether Lloyds' shareholders would agree that its worth paying out £480m of cash each year to taxpayers to prevent that creeping nationalisation of the bank.

Anyway, as readers of this blog know, there'll be plenty of other initiatives announced next week by the Treasury, most of which can be seen as deploying taxpayers' resources to encourage lending.( THE ONLY WAY )

One of these will be an extension of the timetable for Northern Rock, the fully nationalised mortgage bank, to repay what it's borrowed from the Bank of England and the Treasury. This would put less pressure on the Rock to shrink the amount that it is prepared to lend.

Which at a time when the problem for the economy is a shortage of credit sounds a bit like an outbreak of common sense at the Treasury."

Sorry Bob, this is the only way. Frankly, nationalization would be better. I'm surprised that you don't see that.

"The line between private sector and public sector, which became blurred in 2008, may become almost impossible to see in 2009."

Peston sums the situation up, as per usual on BBC:

"The past 18 months was a story about the collapse of lending to banks and by banks - and about how we as taxpayers came to the rescue by providing £600bn of loans, guarantees and capital to the banks, to keep them afloat.( WE WERE ALWAYS ON THE HOOK WITH A SYSTEM OF IMPLICIT AND EXPLICIT GOVERNMENT GUARANTEES TO INTERVENE IN A CRISIS )

The story of the next year will be about the implications of this continued shrinkage in the availability of credit and about the implications of this massive, unprecedented support given to banks by taxpayers( LET'S NOT DO IT AGAIN ).

As a nation, our fortunes in 2009 will be conspicuously tied to the fortunes of our banks as never before. ( I'M NOT SURE I FEEL COMFORTABLE WITH THAT, GIVEN THEIR RECENT PERFORMANCE )

First, an economic recovery rests on the ability of banks to support viable businesses during what increasingly looks like a severe recession. ( TRUE )

Second, and as important, the balance sheet of the British public sector can be seen as the aggregated balance sheet of some substantial banks - because the state now controls three banks, Northern Rock, Bradford & Bingley and Royal Bank of Scotland, and will have a huge stake in a soon-to-be created fourth, LloydsTSB/HBOS. ( TRUE )

It means that if the perceived credit-worthiness of our banks - with their trillions of pounds of assets and liabilities - were to deteriorate further, that would have an impact on the perceived credit-worthiness of the state( YES ).

As never before, it matters to all of us that the banks run themselves in a prudent way( HEAR HEAR ). In an extreme and highly unlikely case, if the markets viewed our banks as recklessly managed basket-cases, that would have an impact on the value of sterling and on the ability of the government itself to borrow( TRUE ).

So our prospects and welfare depend to a huge extent on an institution that was created a few weeks ago by the Treasury to manage its investments in the banks, UK Financial Investments (UKFI). ( GOOD LUCK BRITS )

It's probably no exaggeration to say that - for the coming year or two at least - UKFI will be as important to all of us as the Treasury, or the Bank of England or the City watchdog, the Financial Services Authority.

UKFI's primary aim is to "protect and create value for the taxpayer as shareholder"( I AGREE WITH THIS POLICY ) - while also making sure that the banks we own provide "competitively priced" loans to small businesses and homeowners "at 2007 levels"( TRUE ).

Those objectives are not quite irreconcilable( IN THE US THEY ARE ) - in that the banks over which it has sway should be capable of providing substantial credit to the housing and small-company markets without chucking good money after bad, even though this is a dire period of economic contraction and proliferating bankruptcies( I AGREE ).

But, for the avoidance of doubt, UKFI has no ability to increase the supply of credit in the economy as a whole.

Remember that the ability of banks to lend is anyway being undermined by losses on the stupid loans they made in the boom years and also by the collapse in the price of houses, property and shares, which slashes the value of vital collateral that backs loans( VERY TRUE ).

So many banks are lending less to big companies, they are lending less for commercial property transactions, they are lending less to City institutions, they are lending less in the form of unsecured personal loans( TRUE. IT MAKES SENSE. ).

Lots of overseas institutions are cutting back significantly on the bounteous credit they provided directly to the real economy in the UK during the preceding few years( TRUE ).

Also many bigger companies that borrow directly on wholesale markets by selling bonds and other securities are finding it much harder and more expensive to raise money( VERY TRUE. A BIG PROBLEM ).

And credit provided between companies that buy and sell to each other is being massively restricted, by a collapse in the availability of insurance for such credit( TRUE ).

All of which can be summed up as "ouch" for businesses and households - and is the primary reason why some companies are going bust, and why those that will survive are reducing investment and cutting jobs( I WOULD ADD FEAR AND AVERSION TO RISK, SINCE THE "OUCH" SEEMS TO BE UTTERED IN TOO HIGH A VOICE ).

So even with £600bn and rising of support for banks from taxpayers, our banks simply don't have the resources to keep afloat real companies - manufacturers, exporters - that are vital to the future of the British economy( SOME WILL FAIL ).

Which is why early in the new year, the Treasury will announce details of yet more taxpayer lending, this time to ensure that credit is provided to viable and strategically important companies - such as the more efficient carmakers( THAT'S ABOUT IT. JOBS.)

The line between private sector and public sector, which became blurred in 2008, may become almost impossible to see in 2009."

I disagree. We both have Hybrid Systems, in which the public and private commingle. All that's changed is the mix of the mingling, so to speak.

"who has admitted that interest rates are only a "blunt instrument" with which to control the economy."

A banker speaks. From the Guardian:

• Julia Kollewe
• guardian.co.uk, Monday 22 December 2008 11.29 GMT
• Article history

The Bank of England underestimated the severity of the current financial crisis, according to its deputy governor, who has admitted that interest rates are only a "blunt instrument" with which to control the economy( I AGREE WITH THIS, WHICH IS WHY OPPOSE ITS USE TO STOP BUBBLES ).

Sir John Gieve told the BBC's Panorama programme, to be screened tonight, that new tools were needed to complement interest rates. He also admitted that the Bank knew "crazy borrowing" was taking place and the price of houses and other assets was rising unsustainably, but did not fully understand the problem( IT SOUNDS LIKE THEY DID. WHAT WAS UNDERESTIMATED WAS THE SEVERITY OF THE CRISIS AND INEFFECTIVENESS OF GOVERNMENT INTERVENTION. I BELIEVE THAT HIS STATEMENT LENDS CREDENCE TO MY THESIS ).

"We didn't think it was going to be anything like as severe as it's turned out to be( BINGO! )," said Gieve, who is in charge of financial stability at the Bank. "Why didn't we see that it was so serious? I think that's because we, perhaps, we hadn't kept pace with the extent of globalisation. So the upswing here didn't involve the big increases in earnings and consumption and activity which we saw in previous booms. We saw the credit, we saw the house prices, but we did see a fairly stable pattern of earnings, prices and output."

Tim Besley, another member of the Bank's monetary policy committee, was quoted in the Daily Mail as saying there was "no quick or easy fix" to deal with the fall-out from the credit crunch and that measures other than monetary policy were needed( VERY TRUE ).

Sterling fell to a fresh record low against a trade-weighted basket of major currencies after the comments, hit by worries that British interest rates need to come down much further as recession bites( THEY WILL ). The euro climbed 1.5% to 94.72p, taking it close to its recent record high of 95.56p, which has led to the expectation that the two currencies will soon reach parity.

More powers needed

Explaining why the Bank did not raise interest rates to curb the lending and house price boom, Gieve said: "If we'd used interest rates to try and address this asset-price credit growth, we would have been holding down the level of activity elsewhere in the economy, in manufacturing, in other services, holding down the level of employment at a time when consumer price inflation and earnings were stable and reasonably low. And people would have said, you know, 'this is a wilful reduction in the prosperity of the country'."( WHAT HE JUST SAID IS WHAT I'VE BEEN SAYING )

The Bank could not rely only on interest rates to control the economy, Gieve argued. "One of the main lessons from this is that we need to develop some new instruments which sit somewhere between interest rates, which affect the whole economy and activity, and individual supervision and regulation of individual banks," he said. ( I AGREE )

"Maybe we need to develop something which bridges that gap and directly addresses the financial cycle and prevents the financial cycle and the credit cycle getting out of hand... I think we need to complement interest rates, which are a blunt instrument – you set one interest rate for the whole economy – with something which is more financial-sector specific."( I PREFER SUPERVISION OF THE INVESTMENT INSTRUMENTS, AND A STRICT FOLLOWING OF BAGEHOT'S PRINCIPLES )

Philip Shaw, chief economist at Investec, said the comments suggested that the "authorities recognise that more needs to be done to restrain borrowing booms because they are potentially destabilising." He noted that there had been numerous comments by Bank officials previously stating that interest rates could not be used to rein in borrowing because they were mainly designed to keep inflation on target.

Among the measures being considered by the government – to be adopted once the economy recovers – is a requirement for banks to hold more capital during good times( THIS MAKERS SENSE IF GOVERNMENT GUARANTEED ). Other measures could include legislation or guidelines on lending to households, Shaw said.( NO SPECIFICITY )

Gieve defended the Bank's performance in the crisis, which he called "a major storm we haven't seen the like of for 100 years". ( WE COULDN'T HAVE BEEN EXPECTED TO SEE IT COMING OR BEEN PREPARED TO DEAL WITH IT )

"It would be very surprising( SURPRISE ME ) if we weren't learning lessons from it and we are," he added.

Gieve also cast doubt( WAS REALISTIC ) on whether the Treasury would get all of the money back that it had poured into the banking sector, pointing to a "level of defaults" in the books of nationalised lenders Northern Rock and Bradford & Bingley, which were now held by the taxpayer.

Speaking on the same programme, John Varley, the chief executive of Barclays, predicted that consumers and businesses would struggle to get access to credit for the next one to two years."

There are some good points made here.