This piece was prepared for the Guardian’s excellent Comment is Free (CiF) site, and appears there under the title “Risky business”.
The phrase “Swedish model” must have a special resonance in the Treasury. The former Swedish finance minister has made a whistle-stop tour urging other countries to adopt a plan similar to the one credited with saving the Swedish financial system after their banking crisis in the early 1990s. Never mind that, soon after they had been rescued, the Swedish banks invested heavily in the Baltic countries, where they are now running into new difficulties. The UK is now to adopt a similar plan to inject taxpayers’ funds into several of its banks, in return for preference shares, seemingly because it’s the only idea we can come up with for recapitalising the banks. But several commentators have suggested an alternative scheme that would put far less taxpayers’ money at risk and treat bank shareholders more fairly.
Compared to ordinary shares, preference shares are trumps. They are first in line for dividends. Depending on the precise terms, preference shareholders receive proceeds from the sale of a business, or from the liquidation of the assets of a failed company, before ordinary shareholders. But they are still just shares.
The plan to issue preference shares does nothing to reduce taxpayers’ exposure to losses on banks’ assets, because it doesn’t bring a penny of additional private capital into the banks. In fact, the taxpayer’s explicit risk will increase, because the preference share issues are equivalent to guarantees (up to the amount paid for the preference shares) not just to retail savers but to all the banks’ creditors. The point is that, in the event of liquidation, ordinary shareholders are wiped out first, then preference shareholders and only then bond-holders, depositors and so on. Why would we want to put the taxpayer in the firing line like this?
The problem for shareholders is that the government is likely to demand very favourable terms for its investment, in the hope of making a handsome profit for the taxpayer (at the expense of private pension holders and other investors) or in its anxiety to avoid a loss. But the more the government takes, the more difficult it will be for the banks to raise private capital should conditions deteriorate further. The result could be that even more taxpayers’ money ends up being poured into the banks.
Of course, it’s unlikely that any of the banks receiving taxpayer funds will have to be liquidated or even sold at a loss for the taxpayer, but an alternative scheme could put much less taxpayer money at risk.
Darling has said that the banks have agreed to increase their capital, but rather than take up the government’s offer to take preference shares, they could raise new funds themselves. In present market conditions this would be very difficult. However, the government could help simply by offering to underwrite deeply discounted rights issues by the banks. If this is what is meant by the clause in the Treasury’s announcement that the government “is also willing to assist in the raising of ordinary equity if requested to do so”, then Darling may have covered all the bases.
In a rights issue, each existing shareholder receives rights to put more money into a company by buying new shares at a price less than the prevailing share price. Such rights can be sold, but to allow them to lapse is to leave money on the table, since shares could be bought at a discount by exercising the rights and then immediately sold at a profit.
Recent rights issues by banks such as HBoS and Bradford & Bingley failed, because the share price fell below the rights issue price, taking away the incentive for holders to exercise their rights. There are various reasons why share prices tend to decline during the rights issue process. The ability to short-sell shares can amplify the price decline; in fact it is asking for trouble to permit short-selling during rights issues. The ban on short-selling financial stocks which is currently in force would give rights issues at a large discount to the current share price a good chance of succeeding.
Because recent rights issues have failed, the belief has developed that there are no holders of private capital willing to invest in UK banks. This is nonsense. It is true that large investors prepared to inject billions are yet to come forward. But the shares are being traded in the market every day; there are buyers as well as sellers. The problem is simply one of organising a successful fund-raising exercise and discovering a price at which investors will buy into the banks. Rights issues are a possible solution.
At present, underwriters for rights issues by banks are very thin on the ground. Normally, underwriting would be done by other financial institutions, but in the current conditions such organisations are likely to be wary and charge a great deal for their services. Especially as the Bradford & Bingley underwriters may have taken large losses. The government, though, could take on the underwriting role. To avoid later accusations of having provided state aid, the government could charge a reasonable (but not fire-sale) fee (e.g. 1%, raising a figure in the £100s of millions) for its underwriting service. Perhaps the fees, after costs, could be given to the Financial Services Compensation Scheme (FSCS) fund, which is currently short of £14 billion after the B&B nationalisation and will require further funds to compensate Icesave account holders. Only shares not taken up by existing shareholders (or those to whom they sold the rights) would end up owned by the taxpayer and these would be very cheap. It might even be possible to stipulate that any shares left with the underwriter (the government) would have preference status.
The announcement of a scheme for the banks to raise funds by rights issues could immediately improve confidence in the banking system, especially if rapidly followed by (pre-arranged) statements of support by major shareholders. The market would know the banks would definitely receive the funds, because the government would be underwriting the share issues.
The worst case for the public finances is that one or more of the rights issues fails and shares end up with the government, as underwriter for the issue, but nothing would be lost compared to the other option on the table, partial nationalisation by issue of preference shares, as long as the rights issue price is less than the government would have paid for a stake anyway.
Going down the preference share route could seriously backfire for the taxpayer. If the economy deteriorates further (e.g. credit conditions are slow to improve, interest rates remain high, house-prices fall by 50% and unemployment rises dramatically), the market may eventually judge one or more of the “rescued” banks to be worth no more than the preference shares (especially if the government is greedy), and the ordinary shares could be effectively worthless. Raising private capital by rights issues or otherwise would then become next to impossible, and the taxpayer would be left holding the baby, i.e. effectively guaranteeing the bank’s creditors up to the value of the preference shares. The government could be forced to put even more than the initial £50bn at risk, by buying more preference shares.
In contrast, if capital is initially raised through rights issues, it would be possible to repeat the exercise should the economy deteriorate badly. One presumes Alistair Darling wants to avoid being recalled in the same breath as Denis Healey as a Chancellor who had to go cap in hand to the IMF for a loan to bail out the UK’s public finances. Perhaps before committing taxpayers’ billions for preference shares he should satisfy himself that all possible alternatives have been exhausted. An informed parliamentary debate on the issue might reassure the rest of us.