Piece by piece is best for now

Anthony Hilton
2 Oct 2008

One of the more bizarre suggestions I have heard this week was that we are not in a systemic crisis. It used to be only at weekends that banks collapsed, were nationalised or forced into mergers but now it is almost a daily occurrence.

This week, which started with Fortis and Bradford & Bingley, has expanded to include the cross-border rescue of Dexia, the bailing out of the third largest bank in Iceland and the Irish government giving a blanket guarantee as to the health of all its major banks.

Meanwhile the market is vigorously questioning the Lloyds TSB rescue of HBOS and it is still only Thursday. If this is not systemic, what is?
Yet this is a very important point, because arguably in Europe this crisis is not yet systemic.

And this matters a lot, because it determines fundamentally the way the crisis should be handled, and as importantly the kind of financial system we will be left with at the end of it.
In America it probably is systemic and that explains why the Paulson plan is necessary. What is less appreciated is how what happens in the US has a direct impact over here.

Most comment thus far has been on the lines that if the Americans have a blanket bailout of the system then we must have one here, too. But perhaps the opposite is the case.

If the Americans do fail to get their act together, and that is seen by markets to be the final decision, then we really do move into uncharted territory.

The dislocation in the markets could conceivably become far worse than anything we have seen to date, which is indeed saying something given that the pyrotechnics have already been spectacular enough for most tastes.

In that ensuing turmoil it may well be that our problems here also become systemic, and may need some co-ordinated, orchestrated response from all Europe — the Bank of England, the ECB, the Swiss authorities and the governments all acting in concert.

But if, as is the more likely bet, the Americans decide that having raised hopes of a systemic rescue they are now obliged to deliver, then the mood in the markets and in Europe ought to be calmer.

It does not mean that the crisis will end or that the clouds will miraculously clear, but it does mean that the problem of falling-over banks can continue to be dealt with as they occur.

Bradford & Bingley's nationalisation and sale last weekend was in fact a well-executed operation, which showed the authorities had got their contingency plans in place.

Presumably there is something similar there for HBOS should it become impossible for Lloyds TSB to proceed with its rescue. And equally they must be alert to some of the difficulties faced in other parts of the financial system which it would be unhelpful to name publicly.

Why the piece-by-piece approach matters is that you can't wait for the end of the war before you begin to plan for the peace.

The authorities must have a view of the banking system they want when this crisis is over and they believe that the less intervention in free markets and the more of the system they can preserve intact the better.

They are very conscious of the fact that in the 1980s Tokyo was widely expected to become a global financial centre. But when its banking crisis broke the authorities' actions in propping up the system had the effect of suffocating it.

The system survived, more or less, but Tokyo's international ambitions were destroyed.

Given how important financial services are to the UK economy, it is vitally important that the architecture is not changed so much that it does not function effectively any more.

The authorities in London want to avoid if at all possible the kind of heavy-handed intervention which, while it may calm the markets, would cripple London's effectiveness internationally. They are determined if at all possible not to throw the baby out with the bathwater.

This inevitably causes frustration among some of the City's financial houses, who look at solutions adopted in previous crises in Sweden, in the 1990s in Japan as mentioned and even before that in Hong Kong. They think it high time we saw the same decisive action here. The attitude is understandable but it is also self-serving.

A systemic rescue would save their institution and allow them to begin to rebuild having passed their problems on to the taxpayer.

A bank-by-bank solution leaves in place the possibility their bank — and their job — might be one of those which does not make it through to the other side.

So on balance the authorities should be given the opportunity to play it their way — for the moment.