Business Standard

Percy Mistry: Acquiescing to unbridled state power!

Percy Mistry  |  New Delhi 

The Brown rescue package amounts to usurious extortion.

To call the last month ‘extraordinary’ would be the understatement of the incipient 21st century. In four weeks a US/EU financial crisis has turned into a global economic slump. Recession in the US and EU is certain. So is a growth recession in India and China. The uncertainty is how long both will last. The Rubicon was crossed with a gross misjudgement. The US authorities thought the global systemic implications of allowing Lehman Brothers to fail could be contained. LB was abandoned to assuage the sacrificial instincts of moral hazardistas and the US Congress.

But Lehman’s bankruptcy dislodged a keystone of the global financial system. It led to a cascade of institutional failures across the US and EU. The effect has been profound. The world’s nervous breakdown has been accompanied by a sudden and alarming acquiescence to exertion of unbridled power by the state (men in white coats) as saviours of last resort. Suddenly, there is no restraint in opening every public monetary and fiscal spigot available to avert financial distress and recession. Resort to massive neo-Keynesian, or Brownie intervention may seem comforting for the present. But it bodes much ill for the future.

Stock and bond markets did not react as expected after the passage of the Troubled Asset Relief Programme (TARP) by a reluctant US Congress, and the Brownie (i.e. the Brown-Darling Rescue Plan ) announced by the UK. The Brownie was a better template than TARP for financial system rescue. Adding fuel to a raging fire, an unnecessary crisis of confidence in the euro as a currency was triggered by a “beggar-thy-neighbour” announcement of unlimited guarantees of deposits in Irish banks. The Irish authorities did this without any consultation with their euro-partners. That elicited a reaction from larger EU countries, which thought they would end up paying the bill. But, within days, those countries did a U-turn. When Hypobank failed, the German chancellor did not know what she was guaranteeing when reassuring her electorate about the safety of their deposits! European collectivism ceded to nationally driven inter-governmentalism. That unleashed a flight from the euro to the dollar, which has since defied gravity.

The rescue package eventually put in place by the euro-zone has limited some of the damage. Since then there have been a cascading series of similar bank-rescue initiatives by countries around the world. The consensus now seems to be that a flood of half-baked “Brownies” are indispensable for the world to survive. But governments have not had the luxury of time to think them through. They have been formed in a pressure-cooker of compulsion and panic. Hence they are imperfect. But the perfect may be the enemy of the good.

The Brownie recipe was copied from a Swedish cookbook of the early 1990s. Its intellectual property has been appropriated by Brown and Darling. Amazingly, these descendants of Laurel-and-Hardy are basking in the glow of world adulation for having secured the western front of global finance. That is like being grateful to habitual arsonists for suddenly becoming part-time firemen. What Bro-Dar particularly liked was global congratulation for being cleverer than their trans-Atlantic cousins. TARP focused initially on extracting toxic assets from banks, thus freeing up capital to restore lending and confidence. Brownie tackled several co-terminous problems (solvency, liquidity and confidence) plaguing the financial industry while TARP focused on putting dirty private laundry in a new public laundry bag. Since then, of course, the trans-Atlantic cousins have baked their own Brownies, using TARP resources to capitalise banks and guarantee lending, but on different terms.

The Brownie miracle food merits closer examination. Its micro-details militate against its broader objectives. That confirms the dictum that when governments do things like nationalise assets under pressure, they risk tripping over their tongues and being too clever by half. Realising that there was more gumming up global finance than toxic sub-prime assets, the Brownie incorporated three ingredients: (a) bolstering bank capital through the purchase of common and preference shares; (b) providing more liquidity throughout the financial system; and (c) ensuring new bank lending in the inter-bank market through guarantees.

In meeting these objectives, however, Brownie has caused severe indigestion. Public bolstering of bank capital in the UK requires that no dividends be paid on common equity for five years. Preference shares command a dividend of 12 per cent, ostensibly to protect taxpayer interests, and have to be paid back within five years. The no-dividend policy caused an instant revolt. Extant shareholders like pension funds (of taxpayers) threatened mass exit. That would have driven share prices down further and made bank recapitalisation more difficult. It would have led to a total private shareholder exit from three major banks, forcing the government to nationalise them completely.

The 12 per cent dividend on preference shares will be ripped out of the top line. That will not permit banks to rebuild margins or their capital base. If those terms were offered to private investors, there would be no need for the government to provide funds for preference shares. Essentially, the UK government is engaging in usurious extortion. It is floating gilts at 4-5 per cent and putting the proceeds in bank preference shares, from which it is extracting 12 per cent regardless. A 700-800 basis point spread for that neat little trick is nice work if you can get it! But does it make sense when you are trying to rebuild the financial structures of banks, which you now own substantially anyway?

So, is Brownie good for banks to be force-fed with? Barclays is moving heaven and earth to avoid imbibing that poison. If Lloyds had any sense it would abandon the merger with HBOS and recapitalise itself (it does not really need to) in the private market. The US has been more reasonable in fine-tuning its shareholding terms to enable broader objectives to be achieved, rather than be vitiated by the micro-detail. Yet, the US and the UK — and for that matter the EU — have NOT dealt with the most urgent problem of all.

National guarantees for new lending in the unsecured inter-bank market are sub-optimal instruments. That market is global. It needs a global solution involving direct participation by global central banks in that market to: (a) suffuse it with as much liquidity as is needed for the market to function through all kinds of ructions; and (b) pool national guarantees in a way that lubricates the market, rather than acting as yet another impediment that gets in the way of who can lend to whom and still be assured of guarantee coverage. It does not take rocket scientists to devise a solution to this conundrum. But it may take people smarter than 21st century Laurels-and-Hardys who are posturing and preening as global financial statesmen when, the week before, they knew they were well past their sell-by dates.

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Percy Mistry: Acquiescing to unbridled state power!

The Brown rescue package amounts to usurious extortion.

The Brown rescue package amounts to usurious extortion.

To call the last month ‘extraordinary’ would be the understatement of the incipient 21st century. In four weeks a US/EU financial crisis has turned into a global economic slump. Recession in the US and EU is certain. So is a growth recession in India and China. The uncertainty is how long both will last. The Rubicon was crossed with a gross misjudgement. The US authorities thought the global systemic implications of allowing Lehman Brothers to fail could be contained. LB was abandoned to assuage the sacrificial instincts of moral hazardistas and the US Congress.

But Lehman’s bankruptcy dislodged a keystone of the global financial system. It led to a cascade of institutional failures across the US and EU. The effect has been profound. The world’s nervous breakdown has been accompanied by a sudden and alarming acquiescence to exertion of unbridled power by the state (men in white coats) as saviours of last resort. Suddenly, there is no restraint in opening every public monetary and fiscal spigot available to avert financial distress and recession. Resort to massive neo-Keynesian, or Brownie intervention may seem comforting for the present. But it bodes much ill for the future.

Stock and bond markets did not react as expected after the passage of the Troubled Asset Relief Programme (TARP) by a reluctant US Congress, and the Brownie (i.e. the Brown-Darling Rescue Plan ) announced by the UK. The Brownie was a better template than TARP for financial system rescue. Adding fuel to a raging fire, an unnecessary crisis of confidence in the euro as a currency was triggered by a “beggar-thy-neighbour” announcement of unlimited guarantees of deposits in Irish banks. The Irish authorities did this without any consultation with their euro-partners. That elicited a reaction from larger EU countries, which thought they would end up paying the bill. But, within days, those countries did a U-turn. When Hypobank failed, the German chancellor did not know what she was guaranteeing when reassuring her electorate about the safety of their deposits! European collectivism ceded to nationally driven inter-governmentalism. That unleashed a flight from the euro to the dollar, which has since defied gravity.

The rescue package eventually put in place by the euro-zone has limited some of the damage. Since then there have been a cascading series of similar bank-rescue initiatives by countries around the world. The consensus now seems to be that a flood of half-baked “Brownies” are indispensable for the world to survive. But governments have not had the luxury of time to think them through. They have been formed in a pressure-cooker of compulsion and panic. Hence they are imperfect. But the perfect may be the enemy of the good.

The Brownie recipe was copied from a Swedish cookbook of the early 1990s. Its intellectual property has been appropriated by Brown and Darling. Amazingly, these descendants of Laurel-and-Hardy are basking in the glow of world adulation for having secured the western front of global finance. That is like being grateful to habitual arsonists for suddenly becoming part-time firemen. What Bro-Dar particularly liked was global congratulation for being cleverer than their trans-Atlantic cousins. TARP focused initially on extracting toxic assets from banks, thus freeing up capital to restore lending and confidence. Brownie tackled several co-terminous problems (solvency, liquidity and confidence) plaguing the financial industry while TARP focused on putting dirty private laundry in a new public laundry bag. Since then, of course, the trans-Atlantic cousins have baked their own Brownies, using TARP resources to capitalise banks and guarantee lending, but on different terms.

The Brownie miracle food merits closer examination. Its micro-details militate against its broader objectives. That confirms the dictum that when governments do things like nationalise assets under pressure, they risk tripping over their tongues and being too clever by half. Realising that there was more gumming up global finance than toxic sub-prime assets, the Brownie incorporated three ingredients: (a) bolstering bank capital through the purchase of common and preference shares; (b) providing more liquidity throughout the financial system; and (c) ensuring new bank lending in the inter-bank market through guarantees.

In meeting these objectives, however, Brownie has caused severe indigestion. Public bolstering of bank capital in the UK requires that no dividends be paid on common equity for five years. Preference shares command a dividend of 12 per cent, ostensibly to protect taxpayer interests, and have to be paid back within five years. The no-dividend policy caused an instant revolt. Extant shareholders like pension funds (of taxpayers) threatened mass exit. That would have driven share prices down further and made bank recapitalisation more difficult. It would have led to a total private shareholder exit from three major banks, forcing the government to nationalise them completely.

The 12 per cent dividend on preference shares will be ripped out of the top line. That will not permit banks to rebuild margins or their capital base. If those terms were offered to private investors, there would be no need for the government to provide funds for preference shares. Essentially, the UK government is engaging in usurious extortion. It is floating gilts at 4-5 per cent and putting the proceeds in bank preference shares, from which it is extracting 12 per cent regardless. A 700-800 basis point spread for that neat little trick is nice work if you can get it! But does it make sense when you are trying to rebuild the financial structures of banks, which you now own substantially anyway?

So, is Brownie good for banks to be force-fed with? Barclays is moving heaven and earth to avoid imbibing that poison. If Lloyds had any sense it would abandon the merger with HBOS and recapitalise itself (it does not really need to) in the private market. The US has been more reasonable in fine-tuning its shareholding terms to enable broader objectives to be achieved, rather than be vitiated by the micro-detail. Yet, the US and the UK — and for that matter the EU — have NOT dealt with the most urgent problem of all.

National guarantees for new lending in the unsecured inter-bank market are sub-optimal instruments. That market is global. It needs a global solution involving direct participation by global central banks in that market to: (a) suffuse it with as much liquidity as is needed for the market to function through all kinds of ructions; and (b) pool national guarantees in a way that lubricates the market, rather than acting as yet another impediment that gets in the way of who can lend to whom and still be assured of guarantee coverage. It does not take rocket scientists to devise a solution to this conundrum. But it may take people smarter than 21st century Laurels-and-Hardys who are posturing and preening as global financial statesmen when, the week before, they knew they were well past their sell-by dates.

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