The Credit Guarantee Scheme was devised to encourage institutions to lend to each other as it offers protection on interbank loans, while under the terms of the Special Liquidity Scheme, banks could revive their balance sheets by swapping mortgage-backed debts – which because of the credit crunch have become virtually impossible to trade – for Government bonds.
However, these measures have proved inadequate to support the banking system. Last Friday Barclays saw its share price plunge by 25% and today, Royal Bank of Scotland has admitted that its losses for 2007 will be more than £20billion – the biggest in UK corporate history. RBS has seen its shares lose more than 60% of their value today, raising the prospect that it may soon be fully nationalised – the Government currently owns 70% of its shares.
The knock-on effect of the ongoing problems within the banking industry is that individuals and businesses are still struggling to get loans, and this shortage of credit is one of the main factors crippling the economy.
With forecasters warning that the recession could be far deeper and more prolonged than expected, the Government has stepped in once again and announced it will pledge more taxpayers’ money to shore up the country’s financial system and get the banks lending to individuals and businesses once again.
What has been announced?
- A new insurance scheme has been set up which means the banks can effectively take out an insurance policy with the Government that will pay out if borrowers default on their loans.
- Falling house prices and rising unemployment mean that an increasing number of people are missing mortgage and loan repayments. Because of concern about rising levels of bad debts, institutions have been building up the amount of capital they hold to cover potential losses, rather than lending the money to individuals and businesses.
- The Government has said that it expects the banks to start lending again, now it is offering to insure these bad debts.
- In addition to the insurance scheme, the Bank of England is to be given a £50billion fund to buy assets from private sector companies. Many firms are struggling to raise credit at the moment because of the funding crisis so this measure is designed to ease the problem.
- The Credit Guarantee Scheme has been extended to include car loans as well as mortgage debts.
What does this mean for taxpayers?
The Government bail out is basically funded by the taxpayer. The total cost is unknown although some analysts believe it could equate to around £1trillion.
The taxpayer already owns Northern Rock following its nationalisation last year as well as stakes in Royal Bank of Scotland (RBS) and the newly formed Lloyds Group (the bank formed following today’s merger of Lloyds TSB and HBOS). The Government stake in RBS is now around 70% (up from 58%).
Our exposure to the troubled banking system will be heightened by the new insurance scheme as taxpayers will be taking on the risk of bad debts. The Government hopes that in the long run the value of the assets these debts are secured against, for example property, will recover so that taxpayers don’t lose anything but there is no guarantee of this.
Will the initiative help taxpayers in the short-term?
The main reason for the Government’s drastic action is to get banks lending again. If they don’t have to worry about covering the liabilities on loans that have turned back they should theoretically have more cash to lend to new borrowers. As a result, it should become easier for individuals to get mortgages and other types of loan such as car finance and personal loans. In turn the cost of mortgages should also come down.
And if loans are cheaper and more readily available, it should bring some much needed relief to the ailing housing and car markets which are currently being strangled by the fact many individuals are finding it so hard to borrow.
What’s happening at Northern Rock?
Following its nationalisation last year, Northern Rock has been actively trying to reduce the size of its mortgage book. It has not been marketing loans to new customers. Existing borrowers have also been affected as they have not been offered a new deal when the term on their current mortgage product is about to end.
However, the Government has announced that Northern Rock will review its business strategy and this is expected to result in it starting to offer mortgages to new borrowers again.
It is believed that one of the reasons behind this u-turn is that the Government hopes it can offset some of the extra risk it is taking on with the new insurance scheme by advancing new mortgages, through Northern Rock, to lower-risk borrowers. However, the exact details of who Northern Rock will offer loans to have yet to be disclosed and many of its existing customers are ‘higher-risk’ borrowers.
The lender has been badly hit by the downturn in the housing market as it was one of the biggest players in the 100%-plus mortgage market, lending to people who had no deposit. Many of these borrowers have found themselves unable to remortgage because falling house prices have meant that they still have no equity in their home. Northern Rock will therefore be under pressure to offer new deals to these customers.