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Dependence day

Written by: on April 27, 2009

In October 2008, it seemed as though write-downs on assets would wipe out the capital of US banks, leading to insolvency. However, following the bankruptcy of Lehman Brothers, it was judged too damaging to allow such banks to fail so the US government authorised the Troubled Asset Relief Programme (TARP), which provided funding at subsidised rates to deposit-taking US banks. The aim was to give banks enough capital to keep running and generate a profit to write off the losses they had incurred.

The US Treasury funded the banks through preference shares, which pay an interest rate like debt, yet absorb losses like shares. Funding from preference shares counts towards the Tier 1 capital ratio, which was at the time the conventional way of measuring the safety of a bank. But, as well as the preference shares, the US Treasury took warrants, which gave them the option to exchange their preference shares for common stock allowing them some control, as common stock carries voting rights.

In the UK, there was no such organised plan. Starting with Northern Rock, banks on the verge of bankruptcy were taken over by the government, either through insolvency processes or by taking a substantial common stock position in the company. Lloyds Banking Group gave the government a 43 percent stake to finance its acquisition of HBOS and RBS sold the government a 70 percent stake to raise enough capital to avoid bankruptcy. As a result, the only major independent UK bank remaining is Barclays. By avoiding government ownership, they are able to pay their staff as they see fit and so have been luring away talent from government-owned banks. So, as the crisis has run its course, Barclays’ profile has improved dramatically relative to its competitors.

Since the Cold War, western governments have faced a conflict: in societies like the US and UK, the consensus view is that it is inappropriate for the government to run banks, as they are seen as having a conflict of interest between politics and profit which is not present in the private sector. However, on the other hand, governments want to avoid bankruptcies of integral banks, and to direct credit to the economy to promote economic recovery. This has lead to controversy over the British government’s quasi-nationalisation of banks.

In order to ameliorate such concerns, under the American Recovery and Reinvestment Act, passed in February 2009, US banks have the right to repay TARP funds at any time, subject to a consultation with their regulator. After repayment occurs, the Treasury is required to ‘liquidate any associated warrants at the current market price’. In the UK, banks have no legal guarantee that they will be able to buy control back from the government. But Bloomberg recently reported that US Treasury officials were quoted anonymously saying that they would retain the warrants, which afforded them a degree of control over TARP banks, even after TARP funds were repaid. This has sparked fears that the US government will act to nationalise banks, even if they are healthy enough to repay government loans, in order to increase the flow of credit to the economy.

In 1977, the Community Reinvestment Act was signed into law. It required banks to provide credit to their local community, particularly to underprivileged borrowers. The Act was strengthened in 2000 and 2002. Since then, many merger approvals, including for the now-defunct Washington Mutual, required a guarantee that lending to underprivileged communities would increase. Many commentators have suggested that government pressure to make non-economic loans led to the boom of excessively cheap loans and securitisation that led to the current recession. If governments put too much pressure on banks to lend to the economy, they may be laying the foundations for the next bubble and, by proximity, the next economic crisis.

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