How do you solve the banking crisis?

Question:  How do you solve the banking crisis?

Answer: No-one knows.

It’s interesting to ask this question because I was asked this very question on Thursday of last week.  The question was poised in the context of the UK Parliament debating the Banking Bill today in the House of Commons, and I had been asked to write a briefing paper for the debate.

 

My answer? 

 

We need a bank shareholder guarantee scheme to encourage confidence back into the system.  This is a lengthy discussion that, rather than repeat here, appeared in the Parliamentary Brief today.

Here’s a very brief summary:

“The government’s requirement that the banking system return to the lending practices of past years is flawed because it is in direct conflict with the banks’ need to recapitalise. The choice is either nationalise the whole industry and continue to pump endless cash into the system, or create a bank shareholder guarantee scheme, that protects future shareholder funds invested in the UK banks. The latter is the only way to bring back shareholder confidence and allow the banks to build more tier 1 capital based upon equity reserves, rather than just cash reserves …

“This is a classic chicken and egg situation.  The government has been feeding the chicken by giving the banks cash, but now needs to nurture the egg by focusing on the banks’ balance sheets and shareholder confidence. Without the latter, we can feed the chicken as much cash as we want, but it will not make our banking system solvent. And without a shareholder guarantee scheme in UK banks, we may as well nationalise the system …

“A healthy banking system is critical for the economy to return to stability.  The government needs the banks to return to their lending policies of past years in order to maintain consumer and business confidence. However, this is in direct conflict with the needs of the banks to reserve cash in order to recapitalise to cover their solvency requirements.

"Stock market confidence in UK banks is nowhere, as demonstrated by the 0.24 per cent take-up of the recent RBS rights issue. As a result, that rights issue cost the government a further £15bn and effectively nationalises another bank.

“Without a shareholder guarantee scheme in UK banks and specific actions that encourage shareholder confidence in the UK banking system, the government will continue to have to fund further banks’ rights issue and fund recapitalisation. That path may as well be one to full nationalisation.”

All well and good.

I then spot that other people have been asked this question, and come up with totally different answers.

For example, in tonight’s Evening Standard, Jim O'Neill, Chief Economist at Goldman Sachs says that “There is one simple way out of the mess, Gordon: a state bank”.  Jim contends that the government needs to have its own bank to provide lending direct to business, and circumvent current banks completely.  “A reliably financed lender might just be the key to the recovery from the current malaise we all want to see,” he says.

Interesting.

Especially as some regional councils, such as Essex and Kent are already creating their own banks to do just this.

So, State Banks are the answer?

Not according to David Cameron, the leader of the Conservative Party, who announced plans to create a £50 million fund to guarantee bank loans to businesses today.

Three different answers to the same question, and there's probably three hundred more out there.

 

However, I personally don’t believe that either of the latter plans addresses the issue of banks’ Tier 1 Capital requirements.  Whilst banks are dependent on pure cash reserves, rather than cash and equity reserves, we have a problem and neither of the latter plans address this.

For example, the core issue for shareholders is that a £1 investment in a bank such as RBS or HBOS a year ago would be worth less than 10 pence today.

Until banks get shareholder confidence back in the system, we will not revive this system.