The commanding heights (part 4)

Personally, I thought Gordon Brown was going to make a good prime minister. The only concern I had was working tax credits, a Gordon Brown thang that's an over-engineered, overly complicated, confusing and horrendously inefficient means of using financial stimuli to change attitudes and behaviour. Here hang on did I say working tax credits? I meant to say the Asset Protection Scheme (APS) now being rolled out across British banking.

Lets start with the basics and the fact government really, really, really, really, really doesn’t want to nationalise another bank. I mean it really doesn’t. Politically, given the Northern Rock share value experience, doing so would alienate a lot of voters as in how much are your shares in “Was Private-Now-Public-Bank” PLC worth? Diddlysquat!

Politically 2Xs it opens up whole cans of worms, I mean if banks can be nationalised why not any other business as the unions in the car and engineering firms currently queuing up for more aid might say.

It’s also morally complicated, I mean big UK banks lend to all sorts of people across the globe, so should their lending decisions be subject to additional political and/or foreign policy criteria? To use a practical example when RBS acquired Natwest it inherited Huntingdon Life Sciences (HLS) as a customer. Following anti-animal testing protests, to quote HLS, RBS “pulled the plug” (1). Now that government has a majority stakeholding in RBS will it start lending to HLS again given it’s a perfectly legal business or consider pulling the plug on other legal businesses that also pose a reputational risk? On a smaller scale if a nationalised bank repossesses a house is that Gordon Brown’s fault?

Government also wants to hold the banks at arms length because of what another nationalisation might mean for the national debt given the EU has just issued a warning to other European governments about their debt levels even if the French example signals we’ve another year or two before anyone might give a monkey’s. There again with some rating agencies (aye rating agencies, you know, the experts that said sub-prime RMBS was the bees knees) already discussing the potential for downgrading Britain’s credit rating this could have more immediate, financial consequences given government borrowing is set to reach new heights.

So that’s just some of the reasons why government really (5x) doesn’t want to nationalise another bank, it’s just I’m not convinced current policy towards banks takes this into account due to “moral hazard”.

Bank bailouts of the kind seen in the US create a moral hazard because they see profits privatised (as in mega bonuses and dividends) and losses socialised (e.g. a government bailout on the cheap if things go wrong). This is a bad thing because it removes any incentive not to behave badly in future, in fact it leaves intact the mentality of sure we’ll lend to anyone, its not as if government won’t bail us out if it all goes wrong because we’re too big to fail.

Don’t confuse this aspect of moral hazard with the kind of matronly chastisement Mervyn King’s speech to the BBA a while back dished out when he talked about taking away the punchbowl at a party. Nah, feck that, moral hazard isn't about punishing bankers for bad morals, it’s about discouraging stupid behaviour that could damage us all.

How has this concept been translated into actual policy? Via the APS of course where in exchange for a one off fee paid to government banks can place a cap on the potential losses attached to whatever bits of their portfolio they throw at it. The idea is this removes the uncertainty over how much a bank might eventually lose and by removing this uncertainty other financial institutions regain their confidence in British banks and start providing them with the liquidity they need to finance their existing and future lending books.

That’s the theory as I understand it, and dear god uncertainty matters right now what with it being a major cause of the credit crunch as when everyone realised the rating agency assessment of sub-prime asset losses was garbage, but had no idea what the eventual losses might be (and without which had no idea of assessing the solvency of the banks that invested in it).

When you put it like this the APS sounds perfectly reasonable, quite smart even except subprime was primarily a US phenomenon European banks invested in via sexy treasury departments. Over here UK and European banks never generated the same type of debt via their branches (give or take self-cert liar loans) and have already been writing down their exposure to the US mortgage market.

Besides if the provisioning and/or write down policies of the UK banks are worth a damn (or are all the accountants who do the annual accounts fibbing?) they already allow for future losses. Ahh, says the realist, but we’re in such an uncertain environment who can possibly estimate future losses? Fair point said the pragmatist, but following that same logic we pretty much need to underwrite entire portfolios rather than bits of them, I mean why just 10, 20 or even 50% of a bank’s lending book, why not 90 or 100%? In the meantime the APS looks an awful lot like a belt added to an existing set of braces. And man oh man what an expensive belt given current estimates see RBS paying £8bn to participate in the scheme, which is almost as much profit as it declared before tax, amortisation and what not for the full, BOOM year of 2007.

And see that’s the problem. Given we’re just entering what I think will eventually be regarded as a depression, charging banks so much to participate in the APS will potentially wipe out their profits for years. On an individual basis this clearly avoids any moral hazard, which is a very, very good thing, but at an industry level it could prove deeply counterproductive because banks will be so busy paying APS fees they won’t have any cash to lend let alone pay the dividends that would restore their (our pension fund) share values.

So the APS involves some dirty great inconsistencies, possibly enough to undermine the entire process. In fact the way it currently stands (will RBS trade further equity in lieu of paying APS fees?) it places nationalisation very much back on the agenda by itself along with the post-nationalisation good bank/bad bank split advocated by Willem Buiter.

My personal contribution to this debate is more straightforward; punish the guilty to avoid moral hazard in future. Sack all the chief executives, divisional CEOs and their direct reports who helped formulate and implement the strategies of the banks currently being bailed out by government. This could easily be done via existing company HR policies what with the losses currently being declared providing clear evidence of gross incompetence and for another no executive can claim to be irreplaceable due to the emphasis placed by the FSA for years now on succession planning i.e. an irreplaceable executive is by definition an incompetent executive.

This approach offers loads of benefits. First, it's easy to implement, second, it feels good in a morally-right-morale-restoring kinda way, third, it saves loads of cash what with executives being expensive creatures, and finally, it sends a clear message about the old way of doing things being no longer acceptable.

Oh dear I've just realised this would involve government stepping beyond the current arms length bollocks and intervening in the banks it has major shareholdings in. Even worse it would see government back-tracking on the existing arrangemnts that see it proclaiming no one is getting a pay off at the same time as senior boys are already becoming consultants on fixed term contracts that approximate their pay offs. Hang on a mo 2 Xs, given the RBS bonus fiasco isn't government intervening already? And shouldn’t the non-execs being doing this kinda house clearing stuff anyway without any government prodding? What would Gordon say I wonder?

Postscript to the above - (as of 20th Feb) my understanding based on various financial journals is that RBS can defer payments. This kinda suggests policy is being made on the hoof i.e when the consequences of what was being proposed became obvious, shit done changed.

On a different note the Times today reported that RBS's deputy head of its corporate division is taking early retirement. Yeah, that'll teach him a lesson that will.