Government Reactions to Stem the 2008 Financial Crisis

On 28 September 2008, the US Congress finally agreed a US$700bn banking rescue package to address the then deepening financial crisis. Just over a week later, with considerably less political disagreement, Gordon Brown announced a different package of measures to address the crisis. This package has been used as the template around the world for generally addressing the credit crunch.

The US Rescue Plan Had History

The US has faced similar crises before, albeit not on this scale, and the US$700bn should be seen in this light. In the 1980s, it suffered from the savings and loans crisis and launched a bailout by creating the Resolution Trust Corporation, which purchased and then sold hundreds of billions of property from failed savings companies. Then in 1982 the US government invented Brady Bonds, which attached a US government guarantee to Latin American debt. The original holders made losses, but liquidity in the bond market was restored.

The US$700bn rescue package announced in September was not clear but had elements of both these ideas as ways of unblocking the financial system. It contained ideas of purchasing the loss-making assets, elements of recapitalising the banks, and insurance for investors in money market funds. Initially, the markets reacted positively to the package but after a few days it was clear that it was not enough.

In addition, even before the rescue plan was announced, both the UK and the US had announced a prohibition on short selling to protect financial institutions. This action was followed by other governments around the globe.

The UK Rescue Programme

On 8 October, the UK’s prime minister, Gordon Brown, announced a rescue plan for the UK banks. The plan consists of five key points:

1. Banks will have to increase their capital by at least £25bn.
2. An additional £25bn in extra capital will be available from the UK government in exchange for preference shares.
3. £100bn will be available in short-term loans from the Bank of England (BoE), on top of the existing £100bn loan facility.
4. Up to £250bn in loan guarantees will be available at commercial rates to encourage banks to lend to each other.
5. To participate in the scheme banks will have to sign a Financial Services Authority (FSA) agreement on executive pay and dividends.

The beauty of this plan is that each point addresses a specific issue. The losses caused by the crisis, and the inability of institutions to sustain them, indicates that the system did not have enough capital. The government is therefore addressing this shortfall by insisting on a £25bn capital increase.

Point 2 addresses the fact that at present investors are not keen to recapitalise loss-making banks, so the government itself will invest the funds. Having government owning parts of the institutions gives an implicit guarantee against future defaults. Liquidity in the system is a key concern with banks not lending to each other.

Point 3 increases the amount of funds available to the banks to finance lending. This addresses another key concern as the lower amount of lending by the banks has in effect destroyed money.

Point 4 attempts to remove the last obstacles from banks lending to each other by having the UK government guarantee the lending between banks. In theory, banks should no longer be concerned if their counterpart has hidden losses, as the lending will be guaranteed.

The last point addresses the feeling by the taxpayer that those working and investing in the banking industry have made huge profits by acting irresponsibly. Financial institutions will find they have much tighter oversight of these matters in the future.

In addition, the UK had already slapped a ban on the short selling of 34 financial stocks until January 2009. By 8 October interest rates were down to 4.5%, a fall of 50 basis points in a month, and last week the BoE made a 1.5 percentage point cut in UK interest rates to 3%, the lowest level since 1955.

This was a comprehensive plan that addresses the immediate issues. It does not buy the toxic assets, but strengthens the strong banks against liquidity and capital concerns. This formula for dealing with the crises was copied widely by the other major regulators. The early signs look very hopeful for averting the crisis. Now the world has to deal with the effect of a global recession.

Government Intervention Strategies

The actions taken by governments in this crisis can be categorised under six headings:

1. Liquidity lending guarantees – government guarantees related to bank lending.
2. Interest rate cuts – to encourage borrowing.
3. Bank deposit guarantees – to instil depositor confidence.
4. Recapitalisation – to replenish banking capital and compensate for losses.
5. Asset purchase – to remove ‘toxic assets’ from the system.
6. Short selling crackdown – to discourage share price collapse of institutions.

After the announcement of the UK plan, a number of countries implemented plans based on the UK solution (see below for a summary of the actions taken by a selection of governments). One can see the similarities with the UK plan. Only the US has elected to have a significant asset purchase programme. All jurisdictions have a liquidity support programme, interest rate cuts, deposit guarantee increases for retail depositors, and a strong element of government capital support.

One of the difficulties in purchasing the defaulted assets is determining what price the assets should be bought at. If the purchase price is too high, then governments will be injecting capital into banks, perhaps rewarding bad behaviour. If the price is too low, then it will make the capital depletion even clearer and institutions will need to raise yet more capital. The advantage of removing the assets is clearly the increased confidence institutions will have if the threat of these assets were no longer on their balance sheets.

It should also be noted that all jurisdictions have pushed for a cap on executive rewards schemes as a result of the crisis. This is the very least the public can expect when one considers the size and impact that this turmoil will reek.