Drawing a line

A common view is emerging. The global recession was caused by a financial crisis triggered by a collapse in the US sub-prime mortgage market. Financial innovation was exploited to create obscure derivative products which were sold across the world, infecting financial institution balance sheets with toxic assets. When the collapse inevitably came, governments had to step in on an unprecedented scale with capital injections, asset protection schemes and guarantees to save the world from disaster. Now, as the recovery begins, government support can be progressively withdrawn. However, David Sayer argues that it is unlikely to be this simple, and there are wider lessons to learn about the impact of government intervention.

Very few would argue that urgent, decisive intervention by many governments and central banks in the wake of the Lehman Brothers' collapse, was not essential to avert financial disaster. And now, one year on, the price of that intervention is becoming apparent. This is not simply a matter of raw financial costs. It is a question of how the relationships between government, banks, industry and consumers have been dramatically altered.

Conflicting priorities
Governments face many conflicting priorities. Indeed, the art of good government is precisely to resolve apparently contradictory pressures and demands. But intervening so directly in the global financial system exposes the fact that when governments step in, even if initially they pledge to retain a 'hands-off' approach, the temptation of political manipulation is virtually irresistible. Over the last year, the level of public scrutiny and concern about banks' has made it effectively impossible for governments not to intervene directly in banking operations. Substantial or majority government shareholding gives some governments the de facto power to direct banking decisions for political rather than business reasons. Since government objectives may be contradictory or inconsistent, the pressure on banks to reconcile conflicting demands has become intense.

One of the most obvious impacts is on the balance sheet. The damage to public finances caused by massive bail-outs is such that governments need to withdraw financial support as soon as reasonably practicable, and return nationalized assets to the private sector. The priority is to rebuild capital reserves, strengthen the balance sheet and minimize lending. Regulatory proposals to increase capital adequacy requirements, and introduce counter-cyclical measures, magnify this need. At the same time, governments in the UK, US and elsewhere are exerting great pressure on banks to resume or increase lending to consumers and the corporate sector, and to underpin housing markets by recovery in mortgage lending.

As the recession has intensified, previously sound businesses have inevitably run into difficulties. Rational banks would naturally be more cautious about their lending in this environment. Similarly, house prices remain fragile, with the threat of further falls in future. Increasing unemployment threatens the credit-worthiness of borrowers. Banks are understandably cautious about new lending to less credit-worthy customers. Government pressure to see more liquidity injected into the market is potentially encouraging lending to the weak. This introduces unwelcome distortion into the market, and could delay the necessary process of cleaning out impaired assets. It also undermines the objective of unwinding government involvement as soon as practicable.

Political interference
Governments are driven by many other short-term priorities apart from ensuring that the banking sector returns to health. Favorable media headlines, and the avoidance of embarrassment, are highly sought-after. Responsibilities are distorted by the requirement to deflect blame. Officials focus on detailed risk management and controls, and insist on large volumes of information flows and paper trails to justify decision-making. The fundamental role of banks in providing the financial infrastructure to support business and consumers becomes compromised.

Some governments have also been increasingly tempted by the possibilities of more direct political intervention. Banks are being encouraged to extend finance to specific industrial sectors or individual companies which are under threat. Understandable public anger about the perceived excessive remuneration of senior executives, mainly in investment banking, has led to a raft of government proposals for direct statutory controls over the form of remuneration in all banking sectors. These are unforeseen developments in a free-market economy.

In the European Union, the Commission has to-date acquiesced in the bail-out of the financial sector, to avoid the greater disaster of complete collapse. However, it is now making clear what the price of state support will be. Under pressure from the Competition Commissioner, the UK banks in receipt of taxpayer support - Royal Bank of Scotland (RBS), Lloyds Banking Group, Northern Rock - have to sell off branches and businesses creating as many as three new retail banking institutions. Preventing owners of existing retail banks from bidding for these new institutions is likely to reduce their value, and could depress the returns to the taxpayer when they are eventually sold.

Government and markets
It is increasingly argued that the roots of the recent crisis lie not all in free-market banking excess. In 1977, the US Congress passed the Community Reinvestment Act (CRA). Extended and developed by subsequent administrations, the primary aim of the legislation was to encourage mortgage lending to low- and moderate-income households, previously excluded from housing finance by discriminatory credit and finance requirements, and by the practice of 'red-lining' high-risk areas. Under the CRA, banks and savings associations were effectively compelled to lend to people who would otherwise be rejected as bad credit risks: sub-prime borrowers. It is a salutary lesson that one episode of political interference in the financial system has contributed to the need for massively greater government intervention thirty years later.

It is inevitable and appropriate in highly-developed western economies, where the state is responsible for or controls up to half of total GDP, that the banking sector which underpins those economies should be the subject of close government concern. Moreover, it is a proper role of government to protect individuals and businesses from the fall-out from financial crashes as far as is necessary. Hitherto, this responsibility has been met through regulation and oversight. But a banking system which is nationalized in all but name, radically alters the relationships between governments, banks and citizens. Extricating government from these relationships may prove a lot harder than intervening in the first place. The long-term consequences are as yet unclear, but are likely to be with us for many years to come.

Author articles

David Sayer
Global Sector Leader, Retail Banking
KPMG in the UK Tel: +44 20 7311 5404 David Sayer View all articles by this author