NEWSFLASH: UK announced bail-out plan for banks

Darling to the rescue
Alistair Darling, Chancellor of the Exchequer, announced a bail-out plan of at least £400 billion yesterday, inclusive of £25 billion committed to help banks recapitalise. The plan is designed to be comprehensive enough and large enough to tackle the core challenges facing the UK banking system. Summary of the UK Bailout Package
1. £25 billion to be used as equity injection to shore up banks’ Tier 1 capital (expected to be preference shares or Permanent Interest Bearing Shares known as PIBS), with the possibility of £25 billion more
2. £250 billion as guarantees for new bank debt
3. £200 billion offered through the Bank of England’s special liquidity scheme

The UK bank support package is applicable to banks and building societies incorporated in the UK as well as UK subsidiaries of foreign institutions, which have a substantial business in the UK. With the package, the UK government has taken steps to provide sufficient liquidity in the short-term; avail new capital to UK financial institutions to strengthen their books and through the guarantee scheme, the banking system is ensured of funds needed to keep lending going in the medium-term. What the UK government has done is effectively to part-nationalise some of the largest banks. As of yesterday, there were eight banks who have indicated they will participate – Abbey, Barclays, HBOS, HSBC, Lloyds TSB, Nationwide Building Society, RBS, Standard Chartered. Barclays, Standard Chartered and HSBC have declined the offer of government equity but will participate in the remainder of the scheme.

Challenges Ahead The government must now exercise diligent control of these financial institutions to make sure that the banks do not take undue risks or to abuse the government-backing. This will be a difficult balancing act. The banks may be too restrained in its daily operations if the government imposes too many conditions on the lending criteria, compensation scheme of banks executives or dividend policy for shareholders. Yet, if the banks become too conservative and do not resume lending, it would defeat the point of the bank support package. Financial Market Reaction The markets do not seem to be offering any signs of immediate gratification. The UK FTSE 100 fell a further 5.18% yesterday to close at 4366.69. Across Europe, markets closed down between 5-8%, amidst the flurry of rate cuts by various central banks in Europe. Regardless, what the UK government has done is a positive step towards shoring up investor confidence. UK government is signaling to investors that it is willing to take stakes in her financial institutions, and to prevent the financial crisis from spilling into the real economy.

Fundamental Difference between the US & UK Bail-out Packages In the US, the bailout plan promises to buy the toxic assets owned by financial institutions. This provides a market for the dumping of toxic assets, so that the banks can get on with their normal business. However, this does not inject liquidity or fresh capital directly into the banks – it simply provides a lifeline for banks to dump their toxic assets, which are difficult to be priced. In the UK, the government is taking equity stakes and directly injecting liquidity into financial institutions, also facilitating medium-term funding. This is to restore confidence in the banks so that over time, these banks can work out their excesses and emerge stronger and more transparent. In addition, banks could also swap the toxic assets they have with UK government bonds, thus ridding the toxic from the banks’ books.

From the IPPFA Investment Division