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A comparative study on UK, US bailout schemes

By Xin Lian (chinadaily.com.cn)
Updated: 2008-10-30 11:40

Facing the escalating financial crisis, the British government announced a plan on Oct. 8th to recapitalize its financial institutions. America followed suit by reengineering EESA, shifting priority from acquiring assets to replenishing capital. Building on the merits of the British prototype, the American version expects to be more effective. Below is a comparative analysis of the two.

1. Highlights of the British initiative

a. A 50-billion-pound lifeline for the financial institutions in exchange for their preference and common shares. The 7 largest British banks and Nationwide Building Society received 25 billion pounds. And the rest was distributed among other eligible banks.

b. Phased implementation. In the first phase, 37 billion pounds was injected into struggling RBS, Lloyds TSB Group Plc, and HBOS. In return, the government received 28-billion-pounds-worth of their newly issued common stocks (priced at 91.5 percent of what they closed at the day prior to recapitalization) and 9-billion-pounds-worth of preference stocks (redeemable in 5 years and with a coupon of 12 percent).

c. Conditioned bailout. The government will nominate non-executive directors for the beneficiaries. No dividends shall be distributed until all the preference stocks issued to the Treasury are paid back. Compensation programs must be overhauled to discourage speculation. The 3 banks shall continue to provide credit for SMEs and homeowners.

2. Highlights of America’s TARP

a. A 250-billion-dollar injection for senior preference stocks and warrants. Funding for each institution ranged between 1 percent of risk-weighted assets and the lesser of 25 billion dollars and 3 percent of risk-weighted assets. Half of the amount was channeled to the 9 biggest banks.

b. Nondiscriminatory terms. (i) Preference stocks are acquired at the market price. (ii) The coupon is 5 percent for the first 5 years, and 9 percent thereafter. The government holdings enjoy preference over common stocks and other preference stocks in dividend payment. (iii) Beneficiaries may redeem these shares in 3 years at par or buy them back by issuing extra preference or common stocks.

c. Attached warrants. These 10-year warrants allow the government to buy, at its discretion, common stocks of these banks equivalent to 15 percent of the senior preference stocks, at the 20-trading day trailing average prior to recapitalization. If the banks buy back the stocks by issuing extra common and preference shares, the number of shares underlying the warrants will be halved.

d. Requirement for rigor compensation regime and corporate governance. Deferred bonus schemes, a ban on golden parachutes, and other remuneration reforms will slash the executives’ appetite for exposure.

3. Comparison between the 2 bailout schemes

To make the bailout simpler and more effective, both governments reoriented their schemes from acquiring distressed assets to recapitalizing banks. Despite the same concept, their details are different.

Similarities

a. Policy goals. Both schemes aim to improve the capital adequacy ratio of the banking sector, in particular the heavyweights that are fragile to external volatility. They also expect to restore the confidence of borrowers, lenders and investors, reactivate credit flow, and alleviate the shock to the real economy. Capital replenishment is believed to be a better choice as it may unleash more liquidity via multiple effect.

b. Protection for creditor. In case of liquidation, creditors enjoy preference over owners. Therefore, government bailout offers a stronger capital buffer, relieves concerns over counterpart risks, and brings down the pressure and cost of borrowing.

c. Protection for taxpayers and prevention of moral hazard. In both countries, a coupon of preference stocks is higher than a 5-year treasury bill. Assuming the worst is over, the government will make a net profit at maturity. With nondiscriminatory trading terms and restrictions on executive benefits, both plans reduce moral risk and gain political high ground.

d. Exit mechanism. The 12 percent coupon in UK and the 5 percent-to-9 percent notch-up in the US give banks incentives to replace government capital with market funding when conditions are favorable.

Differences

a. The American version offers greater protection for existing shareholders, appealing to potential investors and promising to be more effective. The 5 percent coupon (below the prevailing funding cost), limited amount of warranties, and the provision for reducing them by half help to protect owner’s equity from excessive dilution and offer incentives to new investors. In contrast, the UK charges 12 percent annual interest and forbids banks to redeem preference stocks or pay dividends of common shares in 5 years. These are disincentives for investors as they will encroach upon banks’ bottomline and shareholders’ interest. As a result, stocks of the American beneficiaries rallied while those in the UK kept weakening.

b. The American scheme cautiously keeps “an arm’s length” from the banks, hence distinguishing its relief from nationalization or socialism. Different from the British plan, the American government will only hold non-voting stocks. Moreover, it won’t nominate directors or participate in day-to-day management, so as to underpin the free market principle.

4. Market response

The bailout packages were well received. Economists and institutional investors, with Paul Krugman and George Soros as the representative of each community, were the most vocal proponents. The financial sector led a major worldwide rebound. CDS spread of leading banks narrowed down. All of it testified to the viability of government bailout. However, the momentum was temporary as people generally believed that a global slowdown was looming in spite of government bailout. The pessimism has triggered a new downward spiral. Germany, France, Switzerland, and Austria have since announced similar plans to recapitalize their domestic banks.