Monday, October 6, 2008

Worst-case scenario is approaching rapidly

The credit crisis, which has been building slowly for the past year, is now moving so fast that governments around the world are finding it impossible to keep pace.

On Saturday Angela Merkel, the German leader, criticised last week’s decision by the Irish to guarantee all deposits in their leading banks without consulting other European countries. The Irish Government said that the move was forced on it by the threat of a run on one of its banks. Only a day later Ms Merkel was forced to take almost the same action in almost the same circumstances.

In the longer term, this clearly raises questions about the hopes for (or fears of) European financial integration. In the short term, it presents serious challenges for other European governments.

A week ago the British Government was hoping that it had coped with its immediate banking headache after the bailout of Bradford & Bingley. With the proposed rescue takeover of HBOS by Lloyds TSB, this stabilised the two big British banks that looked most vulnerable.

Then came the shock move by the Irish Government to guarantee not only individual savings but also the large deposits held by companies. Downing Street was furious because British banks feared they would see a flight of money towards Irish banks.

Downing Street decided merely to accelerate the planned increase in the ceiling on guaranteed deposits from £35,000 to £50,000, although the decision remains under review.

The Irish move was triggered partly by the failure of Congress to vote through the proposed $700 billion bailout package for the troubled US banking system. The uncertainty about the package caused another blow to confidence in banks around the world, making it even more difficult for them to get long-term funding.

On Friday the Bank of England responded by saying that it would inject another £40 billion into the system to ease the pressure on British banks. Combined with the passing of the US bailout Bill at the second attempt, this appeared to buy the authorities a bit of time.

But yesterday’s decision by the German Government plunged Europe back into turmoil. It is less of a threat to British banks than the Irish move as it applies only to retail deposits.

Although the Government has made clear there is an implicit guarantee on all personal savings, it is very reluctant to make that explicit because of the potential exposure of the taxpayer and the concern that it would be difficult to remove once the crisis is over.

But it seems likely that other European countries will be forced to follow Germany, increasing pressure on Britain to fall in line.

The Bank of England and the Treasury are also considering a range of other measures to shore up the banking system, including the injection of taxpayers’ money into leading banks and a US-style purchase of banks’ “toxic” mortgage-related investments.

These were viewed as worst-case contingency plans. After this weekend, the worst case appears to be approaching rapidly.

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