Darling, maybee I could come to love you?

Posted by Morgan on 8th Oct 2008
I have not had a great deal of respect for Alistair Darling since I met him in early 2007. He had breakfast with a group of bankers, of which I was one, and openly invited questions from the room. When I asked the Chancelor how he would deal with a UK recession? He answered that there was little need to consider such an eventuality as it was not going to happen....

Ok, so planning ahead and reading the signals were not be his strong point but I think he has finally got something right. In proposing to provide capital to the UK banks in exchange for preference share or a substantial stake we are adopting a far more robsut approach that the US governments poorly defined $700bn bail out or the blanket gurantee of its banks provided by Ireland.

The banks have two problems. Firstly, they can not fund their day to day activities as banks do not have the confidence to lend to one another. Secondly, their balance sheets are too weak to absorb the losses that they need to take before rebuilding their businesses.

By taking a stake in the banks, the government provides a bank with signifcant additional capital and an implicit guarantee that it will provide further funding if required to keep a bank solvent. This should help to create confidence around the UK banks, allowing them to borrow on the inter-bank markets to fund their activties.

The longer term fix is that the government cash injection will give the banks the capital base required to rebuild thier businesses. The first step will be to properly address the value of their assets (loans and investments.) These are currently in the books at artificially high levels, many of the loans and investments made in 2005, 2006 and early 2007 are not worth the paper they are written on but this is not refkected in the accounts. Without the fresh capital a bank could not admit to this as it would threaten its solvency and probably lead to its demise.

The government cash injection will allow this process to begin. Assets must be marked down and sold, this will create short term pain but it is the only way for a bank to re-emerge as a credible entity that can once again go about its business of lending to make a profit.

If the government can help create a group of well capitalised healthy banks they can then focus on their key function. Bank are the essential cogs that provide credit and finance to the UK economy. The failure of the banking system (which is where we were heading) would in turn destroy the economy. It is not good that each tax payer is putting £2,000 in to the banks but this is certainly better than the alternative.

The devil will be in the detail but hopefully Mr Darling supports his £50bn investment with suitable conditions. Banks must be compelled to restore discipline, to write down their assets, dispose of the bad loans and rebuild the bank in a manner that drives forward the UK economy in a sustainable way.

If Mr Darling succeedes in doing this his legacy may be more than his incredible eyebrows?

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