Reconsidering Bailout Strategies

Editor's Note: MarketMinder does not recommend individual securities; the below simply illustrates a broader theme we wish to highlight.

Good news, folks! Bank of England Governor Sir Mervyn King has figured out how to turn around RBS, the beleaguered UK bank still trying to recover from 2008. The novel solution, as presented to Parliament’s Banking Standards Commission: Split RBS into a “good bank,” which can lend freely to the broader economy, and a “bad bank,” which can unwind its distressed assets.

It’s a perfectly sensible solution, and one that would have worked well ... four and a half years ago.

Now, however, I believe it shouldn’t even enter public debate.

The good/bad bank solution is fairly simple: Nationalize the bank, silo the distressed assets, spin off and privatize the profitable operations, and sell off the so-called “toxic waste.” The US did this with AIG, siphoning its distressed assets into the Maiden Lane II and Maiden Lane III holding companies (Maiden Lane I held Bear Stearns’ filth) and selling them off over time. The Fed sold the last of its Maiden Lane II and III stakes in January, reaping a $9.4 billion profit.

When rescuing RBS, however, the UK took a different tack. Then-Prime Minister Gordon Brown and Chancellor Alistair Darling reportedly considered the good/bad bank approach (suggested at the time by Sir Mervyn). But since RBS’s troubles stemmed largely from overpaying for Dutch bank ABN AMRO (RBS took credit-market related writedowns, but the acquisition was the tipping point), they figured a less drastic solution would suffice. So they injected £37 billion in fresh capital and underwrote a £15 billion rights offering (and purchased all the shares), eventually walking away with an 82% stake in the bank and running it at arms’ length through UK Financial Investments, a Treasury subsidiary.

The original plan gave RBS about five years to rebuild its balance sheet while focusing on lending to UK households and small businesses, after which the government would sell its stake—ideally at a profit. And it was well on its way. Shares crashed in January 2009 after the bank announced a £28 billion loss, but the company began turning itself around, and by May 2010, the government’s holdings had a small unrealized gain.

Since then, however, RBS has struggled, and the Treasury now has a £15 billion unrealized loss. Sir Mervyn claims that’s because the bank’s still too distressed to function properly, hence the good/bad bank suggestion—force it to take all necessary losses once and for all, make the taxpayer take the hit, and hope the good bank fetches a profit when privatized.

Here’s the problem with that logic: RBS isn’t having trouble functioning because its balance sheet is still in tatters. It’s not lovely, but it’s in much better shape than four years ago. However, regulators have whacked the heck out of it and the rest of the UK’s banking industry. In June 2010—one month after the public stake in RBS was in the black—the government established the Independent Commission on Banking (ICB) to recommend policy changes to “promote financial stability.” Nine months later came the ICB’s recommendation to ring-fence retail and investment banking—the so-called Vickers Rule. Debate and uncertainty over implementation continues today, even after Chancellor George Osborne announced plans to implement the full ring-fence and break up banks that don’t comply.

The Vickers Rule, the threat of higher capital requirements and the prospect of tougher regulations post-LIBOR scandal are a three-headed monster of regulatory uncertainty—something banks hate. This has hurt investor confidence, weighing on shares. It’s also hindered banks’ operations: Faced with the threat of forced restructuring, more limited trading operations and higher capital requirements, many banks—RBS included—have played it safe, keeping credit tight. Those loans they have made aren’t terribly profitable thanks to quantitative easing’s impact on the yield curve. RBS, at the government’s behest, has actually lent a bit more than the average bank, but it’s still not a fount of credit—and as long as regulatory requirements remain murky, it likely won’t be. That’s true whether or not its balance sheet’s in perfect order right now.

Call me crazy, but UK taxpayers shouldn’t have to take another hit because of regulators’ blunders. RBS’s predicament isn’t ideal, but eventually, it should return to private hands without another taxpayer pound spent. Maybe the government takes a loss, maybe it doesn’t—but at least seeing the process through adds a layer of certainty. Remember, one reason 2008 was so painful was the US government’s erratic bailout approach—bailing out Fannie and Freddie, nationalizing AIG, letting Lehman fail, leaving investors guessing and panicked all the while. The UK’s approach, at least, was consistent: Lloyds, RBS and Northern Rock received similar treatment. Changing the rules now could cause investors to worry about mismanagement of future bank failures (because, face it, the ring-fence won’t prevent them). That’s a negative. A negative on top of a negative, when you consider the impact of nationalization on existing shareholders. Many shareholders have hung on tight since 2009 and 2010, waiting for a turnaround. Why punish them and force them to throw in the towel now?

I realize it’s weird to argue a bank should remain in mostly public ownership, but in this case, I believe it’s the right choice for now. Yes, that means the Treasury will have an albatross on its balance sheet for a while longer, but that’s temporary and already accounted for in public finances. Thankfully, Osborne seems to agree—he’s already rejected the good/bad bank proposal and seems determined to return the institution to private hands when the time’s right. Hopefully Sir Mervyn won’t press the issue, allowing the chatter to die down and giving the banking sector some relief.