An Elegant Proposal from the Brits

It’s long seemed obvious to me that without large injections of fresh capital, all the other efforts to deal with the ever unfolding financial crisis would prove inadequate. Or even counterproductive. The official debate has finally swung in this direction but the question of how best this might be achieved remains a tricky one.

Of all the approaches I’ve seen so far, I’m most taken with that put forward by the Brits. Things may change, since negotiations are still very much underway, but at the core of their proposal is this elegant solution:

The way in which the money will be raised has also been simplified. The government may have to underwrite an issue of ordinary shares. This would give pre-emption rights to existing investors, and those shares not taken up will be owned by the government. These could be placed in a new bank reconstruction fund that would hold them until conditions improve.

Not only are the property rights of current shareholders respected, it sidesteps any need for the existing capital base to be wiped out before new capital can be supplied. This dire prospect was a serious drawback of many other recapitalisation schemes since it pretty much guaranteed that private capital would, in a climate of such extreme uncertainty, simply sit on its hands.

Under this plan, that’s no longer the only rational approach; instead it becomes a matter of deciding whether the proposed capital structure is sufficient to weather the storm. In principle, this is no different to the kind of decision capital always has to make. At the same time, existing shareholders would pay a heavy price through dilution if they chose not to take up their entitlement. Together with the damage already done to the value of their shares, this ensures a decent balance is maintained between risk and reward.

Should a first round of recapitalisation prove inadequate (as seems to me likely given the scale of the underlying problems), precisely the same approach can be used again. And again.

Much can, and probably will, go wrong and I have little doubt exceptionally difficult times lie ahead even with the very best of plans. Still, if something like this does become the new black for financial officialdom, the odds on a truly catastrophic outcome will have lengthened a good deal.

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john r walker
john r walker(@annesanders)
13 years ago

Why do I think so differently to everyone else?

Why do I not think this idea is anything more than a pretty way of part-nationalising a bank? Which is necessary. But still not the real issue.

Which is *drum roll* how do you give executives entrepreneur-like responsibility over the companies they run?

It seems to me that they get all the rewards without the risk.

And that is where the fundamental problem lies.

Which investors know.

And so, if you’re going to regain their confidence (the investors that is), you have to make sure executives have some ‘skin in the game’.

What think thou, esteemed Troppodillian?

john r walker
john r walker(@annesanders)
13 years ago

No doubt it is worthy of comment, and interesting besides.

Its just that I have not seen mention of the lack of balance between reward and risk – either in the media or in the blogosphere – yet there is much discussion of ‘confidence’.

This has annoyed me because I cannot understand a more important contributor to ‘confidence’ than knowing that if a company goes down, that those who made the poor decisions didn’t get paid.

For a start, you might see fewer ‘chainsaw’ execs and more interested in historical curiosities like training and research.

ellenbroad
ellenbroad(@ellenbroad)
13 years ago

On the issue of bailouts, I’m curious what those with better grasp of the issues than me make of this:

ellenbroad
ellenbroad(@ellenbroad)
13 years ago

ok I’m not sure why that link didn’t appear. I’ll try again http://brontecapital.blogspot.com/2008/10/how-to-make-bailout-work.html

Bingo Bango Boingo
Bingo Bango Boingo
13 years ago

Looks pretty light-on, TH.

BBB

JC
JC(@jc)
13 years ago

Ingolf
I’m not sure how or why people think the recaps are a better idea than buying the junk sitting in these balance sheets if the strategy is to clean up the books.

At least I’ll premise that by saying that I’m not sure the equity will be enough to cover the losses.

So the question than becomes will the equity be enough to cover the write downs and losses?

And how about the newest moral hazard being created by the Aussie government insuring all deposits… bi-partisan by the sounds of things.

JC
JC(@jc)
13 years ago

Ingolf:

Let’s hope the bank recaps don’t end up like this.

http://www.break.com/index/clumsy-best-man-knocks-bride-into-pool.html

rog
rog
13 years ago

It looks as if the bull market is well and truly finished and no government can stop that

Patrick
Patrick(@patrick)
13 years ago

The best part of the British proposal as I understood it was the bit where they explicitly required participating banks to resume lending, since that addresses the Main Street problem.

This also seemed to be the worst part because government-inspired lending sounds oddly like what got us into all this!

I certainly agree that the recapitalisation method seems very elegant.

JC, what do you mean by ‘being created’? First, almost the whole OECD does this. Secondly, it is strongly arguable that this was always implicit and they have merely made it explicit – like the US and the GSEs. I imagine you agree that explicit is better than implicit in the case of government guarantees, because the implicit ones are always denied until called!

Patrick
Patrick(@patrick)
13 years ago

Also I would require each bank borrowing from a central bank to post to LIBOR not just its theoretical interbank rate but also the actual rate it is borrowing from the Fed at.

Because on the analysis of eg NG’s latest favourite pundit, LIBOR is high really only because banks aren’t using it anymore and because this is a de facto subsidy for banks. Which sounds a bit like cheating to me.

rog
rog
13 years ago

My death notice of the bull market was premature, a pulse has been detetcted

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