Neil Dwane

CIO Europe

RCM

Setting up a so-called “bad bank” run by the government is the only way out of the current financial crisis, according to Neil Dwane, CIO Europe at RCM.

Without separation between troubled assets and clean assets, distressed banks will not be able to facilitate commerce, provide credit and hold deposits, Dwane says. And if banks are not functioning in that capacity, any shot of a recovery would be stymied.

Two years after the first signs of toxic assets there is still little lending activity at banks whose solvency has been compromised. Essentially, they are paralysed from lending because they have no capital to dole out. Driving this inertia has been widespread denial among bank executives, auditors and non executive directors about the valuation of many assets held on their balance sheets. The reality now is that these troubled banks don't have enough equity to absorb the losses on their balance sheet.

“If these assets are written off or written down to their appropriate real value (and the delicious irony here is that many are simply incapable of being valued, because the math supporting them does not work in these new world days) then the banks are bust, pure and simple,” Dwane says.

U.S. Treasury Secretary Timothy Geithner conceded that the valuation of toxic assets remains a significant hurdle to resolving the crisis. But what Dwane finds remarkable about his conclusion is that the external auditors and the non-executive directors are about to sign off their second “true and fair” balance sheets. “If the 2007 accounts were just about acceptable, then there can be no chance that these accounts are unqualified. Surely not? Mr. Geithner has just told all shareholders and stakeholders that the balance sheets are too tricky to value.”

Dwane suggests sticking with what has worked in the past. “History shows that almost every banking crisis has had a good bank/bad bank as part of the solution, such as Japan and Sweden in the 1990s, or the Savings & Loans crisis in the USA,” he says. “The solution works because the toxic assets are placed in a vehicle, underwritten by the State, which can cope with the toxicity over time and more importantly allows the clean bank to do what the body politic wants its banks to do; namely facilitate commerce, provide credit and hold deposits.”

Still, solving today's crisis is more complex because banks have expanded into huge financial conglomerates with different business lines sharing the same balance sheet, a structure made possible by the repeal of the Glass-Stiegel Act. Like a house of cards, if one card falls, the entire house will fall.

This puts Geithner and others in a tough spot because it is clear that politicians and the public at large will not tolerate further bail-outs within the financial services industry. And whilst nationalisation of the banks is political anathema and also a shocking increase in the liabilities of many countries' balance sheets, it is our belief that there is no alternative.”

Many U.S. policymakers and political leaders are ideologically opposed to nationalization because they view it as an admission of regulatory and policy failure, Dwane says. The sooner they realize that nationalization isn't necessarily a bad thing, the sooner the banking system can be rebuilt. Once stabilized, banks can actually drive the recovery instead of being a catalyst for a deep recession.

The Fix

Dwane's proposed steps toward solving the financial crisis:

1. Make clear what the minimum capital requirements are for all banks in the banking system (as global standards will be hard to obtain) and, for these purposes write-off all the 'hard-to-value' assets
2. Make a debt for equity swap with all banks to reach the minimum capital levels and ensure that there is no double counting of capital via insurance and other businesses
3. Produce full and clear accounts for all banks, highlighting the toxic assets
4. Put in place a new and fully independent board of directors for all banks post-refinancing who will oversee the correct balance of returns between depositors, shareholders and lastly employees
5. Promote a competitive return for depositors which rewards prudent savers for leaving their money with a bank, with a kind of lending success 'return' rather than just the national bank rate (i.e. depositors benefit from the successful lending of their banks, like the old building societies, rather than just the employees), so that depositors are no longer disadvantaged for being prudent
6. Ensure shareholder returns rank above employees, so there can be no longer a mismatch of risk and reward
7. Agree long-term employee remuneration to balance bonus versus malus and scale of returns earned
8. Separate the citizen-facing commercial banks activities from the highly speculative investment banking activities, and remove all guarantees from the latter
9. Initiate a long-term, tax advantaged scheme to induce greater saving into equities and bonds by the public using ISAs and similar instruments, as the costs of this bail-out will limit most economies ability to pay for healthcare and pensions in the years to come.