People's Democracy

Economic Notes

Is The Crisis Transforming  Global Finance?

C P Chandrasekhar

AFTER much dithering, lots of high drama and much effort to avoid the inevitable for fear that it would straightjacket capitalism, governments in the developed industrial countries have taken the first, major, necessary step to begin resolving the financial crisis. They have, effectively, nationalised a large part of the private banking system. The process began in the UK, where the Gordon Brown administration stepped beyond what Bush was willing to do and announced that it would resort to an �equity injection� to buy ordinary and preference shares worth �37 billion in three of the biggest banks in the country: Royal Bank of Scotland, Lloyds TSB and HBOS.

Existing shareholders have the option of buying back the ordinary shares from the government. But if they do not, as seems likely, then the government would have a stake of 60 per cent in RBS and 43.5 per cent in the combined entity that would emerge after the ongoing merger of Lloyds TSB and HBOS. This clearly amounts to State takeover, which brings with it new obligations. The three banks will not be able to pay dividends on ordinary shares until they have repaid in full the �9 billion in preference shares they are issuing to the government. The Treasury would appoint 3 new RBS directors and 2 directors to the board of the combined Lloyds-HBOS to oversee the government�s interests. And there would be restrictions on executive salaries and bonuses that had ballooned during the years of the speculative boom.

The decision to nationalise was forced on the UK government because it realised that the problem facing segments of the banking system was not just one of inadequate liquidity resulting from the �freezing� of credit markets due to fears generated by the subprime crisis. Rather credit markets had frozen because the entities that needed liquidity most were those faced with a solvency problem, because of the huge volume of bad assets they carried on their balance sheets. To lend to or buy into these entities with small doses of money was to risk losses since that money would not have covered the losses involved in cleaning up their balance sheets and yet keeping these banks viable. So money was hard to come by. This is disastrous for a bank because rumours of its vulnerability trigger a run that devastate its already damaged finances.

STATE TAKEOVER

What was needed was a large injection of equity to recapitalise these banks after taking account of losses. Wherever the sum involved was small, a private sector buyer could play the role, otherwise the State had to step in. Thus, in the case of some banks recapitalisation through nationalisation was unavoidable because, as UK chancellor Alistair Darling put it, �this is the only way, when markets are not open to certain banks, they can get the capitalisation they need�. Others such as Barclays hope they can attract private investors so as to avoid being absorbed by the government. It expects to raise �6.6 billion from private investors, but the prospects are not certain given the fact that it has decided not to pay a final dividend in 2008, so as to save �2 billion. That may not be the best signal to send to prospective investors.

What needs to be noted, however, is that nationalisation is not the end of the matter. In addition, the UK government has chosen to guarantee all bank deposits, independent of their size, to prevent a run. It has also decided to guarantee inter-bank borrowing to keep credit flowing as when needed.

Once the UK decided to take this radical and comprehensive route, others were quick to read the writing on the wall. What followed was a deluge. Germany with an estimated bill of �470 billion, France with �340 billion, and other governments with as yet unspecified amounts pitched in, with plans to recapitalise banks with equity injections, besides guaranteeing deposits and inter-bank lending. The banking system was being saved through State take-over, not just with State support.

Finally, the US, which was seeking to avoid State acquisition and had already decided to use as much as $700 billion to address the financial crisis by buying out impaired assets that were seen as choking the financial system, fell in line . It too has decided to use $250 of that money to acquire a stake in a large number of banks. Half of that money is to go to the nine largest banks, such as Bank of America, Citigroup, Wachovia and Morgan Stanley. The minimum investment will be the equivalent of one per cent of risk-weighted assets or $25 billion � whichever is lower. With capital adequacy at a required 8 per cent, this is indeed a major recapitalisation. Further the government, through the Federal Deposit Insurance Corporation, is guaranteeing all deposits in non-interest bearing accounts and senior debt issued by banks insured by the FDIC.

However, the conservative influence has ensured that this intervention is biased in favour of Big Finance. The support comes cheap: banks will pay a dividend of just 5 per cent for the first five years, only after which the rate jumps to 9 per cent. During that time, they have the option of mobilising private capital and buying out the government. Interestingly, the government is not taking voting rights and would be able to appoint directors only if the bank misses dividend payments for six quarters. While there are restrictions on payment of dividends to ordinary shareholders before clearing the government�s claims and limits on executive compensation, the government only reserves the right to convert 15 per cent of its investments into common stock. In sum, the American initiative overseen by Henry Paulson, an old Wall Street hand from Goldman Sachs, has virtually cajoled the banks to accept a government presence, unlike what seems true in the UK and Europe.

DESPERATE ATTEMPT

Whether it occurs in part-punitive fashion or as a sop, the back-door part or full takeover of major private banks is a desperate attempt to stall the financial meltdown in the advanced economies resulting from the decision to allow private financial players unfettered freedom to pursue profits at the expense of all else. That freedom which came with the financial liberalisation of the 1980s and after, spawned new institutions and instruments � collateralised debt obligations, special investment vehicles, credit default swaps and the like � that were all aimed at expanding credit irrespective of risk, packaging such debts into products, and selling the associated returns and risks. The process ensured high returns in the form of fees and commissions, which came to be more important than interest income. The net result of this was a tendency on the part of all players to believe that they were free of the risk, because it had been transferred, even though branches of the same firm had made huge leveraged investments in those kinds of assets. This disease also afflicted the conventional banking system, which was risking the money of depositors, through its involvement directly or indirectly in all stages of the speculation-fed expansion. When the bubble burst, the banks were faced with collapse and depositors� funds together with the all-important role that the banks need to play in a modern economy were impaired, threatening a deep recession or depression in the real economy.

While this threat has forced governments to drop their neo-conservative bias against State ownership and markets that hollered at government intervention in the past have now applauded such action, the threat of recession has not receded. Even if the banks are safe, though there is no definite guarantee as yet, there are many other institutions varying from hedge and mutual funds to pension funds that have suffered huge losses, both from the subprime fiasco and the stock market crash, eroding the wealth of many. The effects of that wealth erosion on investment and consumption demand are only now unravelling, indicating that there is much to be told in this story as yet.