In his quest for economic stimulus in the Autumn Statement, George Osborne failed to drive banks and borrowers to put the assets and resources of moribund businesses to good use.

For many months now observers have commented on the zombie companies that clog up our economy. Adam Posen of the Bank of England’s Monetary Policy Committee draws a parallel with Japan in the 1990s being stalled by unproductive borrowers on whose loans the banks could not afford to take losses. Although Posen’s observations were seeking to promote central bank monetary stimulus in continental Europe, the Bank of England has been expressing concerns about domestic bank forbearance since June 2011.

The many companies with low or no profitability or cash flow are adding nothing to the economy. Yet they tie up resources. Banks are increasingly concerned about zombie companies, but it is getting no easier for either the banks or their customers to generate positive growth. Without growth there will be no economic recovery.

The banks should stop holding on to this unproductive debt. The pretence that it is worthy of recognition in the banks’ capital ratios must be abandoned. The companies need freeing from the burdens of their creditors through an insolvency process, if they cannot be turned around

Although lending banks are feeling pretty bruised and the Bank of England is insisting they build up their financial buffers to withstand the current “extraordinarily serious and threatening situation”, tightening the definition of non performing loans so that loans to zombie companies are not counted towards the banks’ capital adequacy would have a number of benefits.

In the long term banks’ balance sheets would be strengthened. The business and resources that would be recycled through turnaround or insolvency would stimulate the economy, with entrepreneurs free from unpayable debt burdens once again being able to generate wealth.

Chris Laughton is a Restructuring & Insolvency partner at Mercer & Hole. The views given in this post  are personal to the author. If you would like to discuss the contents of this post with Chris you can call him on 020 7353 1597. 
 

 

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We reported just over a year ago (here) on Euler Hermes' 2006-2007 Insolvency Outlook, which suggested a 3% increase in business insolvencies in 2007.

Their latest report, issued in November 2007, forecasts under the headline

 "United Kingdom - A rise in insolvencies in sight"

an 8% increase in insolvencies in 2008. Interestingly, it relates that increase to GDP growth of 2%.

Three months on, forecasts are for rather lower GDP growth. The Bank of England Inflation Report published on 13 February suggests (here) a decline to well below 2% GDP growth during 2008, particularly when the Governor's introductory remark is taken into account:

"the potential for further falls in asset prices and tightening of credit conditions means that the balance of risks around the central projection is on the downside, particularly over the next eighteen months."

Euler Hermes' previous report (linked here) noted the strong negative correlation between insolvency and GDP growth, and the elasticity - a 1% fall in GDP growth gives a 10% rise in insolvencies.

With the lower GDP growth now forecast by the Bank of England, the prospects are for a somewhat larger increase in insolvencies than Euler Hermes' November forecast of 8%.

PS Does anyone know why there was an anomaly in the q4 2006 administration statistic? From the Insolvency Service figures there appear to be perhaps 700 extra appointments that quarter, mainly in London.

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The Treasury's proposals to provide funding for private sector bids for Northern Rock (announced here) look something like this:

• billions of £s of the Rock's assets (mortgage loans etc) would be sold to a special purpose vehicle;
• the SPV would issue bonds, secured on the assets and guaranteed by the Treasury (ie the taxpayer), raising say, £30bn;
• the money raised from the bonds would be paid to Northern Rock (to buy the assets moved into the SPV);
• Northern Rock would repay the loans it has had from the Bank of England.

Staightforward so far - the assets and liabilities are taken off Northern Rock's books and the Bank of England loans are turned into government guarantees. The securitisation does look suspiciously like the CDOs we have seen suffering in the capital markets in recent months, but at least the bonds will be gilt-edged.

There is more:

• to ensure the bonds are fully secured and to reduce the risk to the taxpayer if asset values fall (eg if residential property values fall or loan arrears rise) - in other words, to keep the SPV solvent - the value of assets transferred from the Rock will be more than the amount raised from the bonds and the difference will be a loan to the SPV from Northern Rock;
• Northern Rock will also provide the Treasury with a guarantee, secured on its remaining assets;
• Northern Rock has to raise additional equity capital and the Treasury will have an equity stake.

Not terribly appealing requirements for Virgin, Olivant et al.

If the SPV were to go bust, the Treasury would have recourse to the net assets of Northern Rock. How much would they be worth? It's difficult to say, but it's not hard to imagine them being exhausted if market conditions are such that the SPV has failed. But remember the shareholders' capital will be very much less than the value of the government guarantee.

It's the taxpayer who pays the bondholders if everything goes wrong.

If everything goes right, what happens?

• The Treasury is paid fees for its guarantees, which are released over a period of, say, 5 years; and
  
• Northern Rock's shareholders take the profits.

The negotiations will be fascinating. Despite the government's reminders that nationalisation remains an option, it is clearly politically unattractive. How much of an equity stake will the Treasury be able to persuade the private sector bidders it should have? Will the Treasury's upside return properly reward its downside risk?

Robert Peston implies here that a successful private sector bid is not a foregone conclusion.

Would the Lloyds TSB deal on offer in early September have meant less cost and risk for taxpayers? Even the Treasury Select Committee isn't sure (see our post on their conclusions here), but they did suggest that this restructuring lacked a key ingredient - early decisive action.

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Headlines and commentary abound, but the real thing (181 pages) is here (pdf) or  here (html).

It stretches from mention of previous bank runs (Overend, Gurney & Co., 1866;  City of Glasgow Bank, 1878), Barings' liquidity crisis and the liquidation of BCCI to a detailed analysis of the development of the Northern Rock crisis in August and September 2007.

The conclusions (quick link here) highlight firmly the responsibility of Northern Rock's directors for the reckless business model - borrowing short and lending long - which collapsed with the credit crunch, for failing to ensure that the bank remained liquid as well as solvent, and for failing to provide against the risks they were taking.

But they are also highly critical of the FSA:

• "substantial failure of regulation."
• "it was wrong of the FSA to allow Northern Rock to weaken its balance sheet at a time when the FSA was itself concerned about problems of liquidity that could affect the financial sector."
• "The current regulatory regime for the liquidity of United Kingdom banks is flawed."
• "It was the responsibility of the Financial Services Authority to ensure that the work of the Board of Northern Rock was sufficient to the task. The Financial Services Authority failed in its duty to do this."
• "The Financial Services Authority should not have allowed nor ever again allow the two appointments of a Chairman and a Chief Executive to a "high-impact" financial institution where both candidates lack relevant financial qualifications"
• "The FSA did not supervise Northern Rock properly. It did not allocate sufficient resources or time to monitoring a bank whose business model was so clearly an outlier; its procedures were inadequate to supervise a bank whose business grew so rapidly. We are concerned about the lack of resources within the Financial Services Authority solely charged to the direct supervision of Northern Rock. The failure of Northern Rock, while a failure of its own Board, was also a failure of its regulator."
• "In the case of Northern Rock, the FSA appears to have systematically failed in its duty as a regulator to ensure Northern Rock would not pose such a systemic risk, and this failure contributed significantly to the difficulties, and risks to the public purse, that have followed."

The Bank of England gets off relatively lightly with recommendations as to its response but few direct criticisms:

• "We are unconvinced that the Bank of England's focus on moral hazard was appropriate for the circumstances in August. In our view, the lack of confidence in the money markets was a practical problem and the Bank of England should have adopted a more proactive response."
• "we have concluded that the Bank of England should have broadened the range of acceptable collateral at an earlier stage in the turmoil."

The report's conclusions about the Chancellor's role are somewhat more opaque:

•  "State support for Northern Rock has involved the Government entering into contingent liabilities on a very large scale. It is important that the Treasury discharges its obligations to the House of Commons—and through the House of Commons to the taxpayer—promptly and fully to report on the extent of such liabilities."
• "We cannot accept, as some witnesses have suggested, that the Tripartite system operated "well" in this crisis. In terms of information exchange between the Tripartite authorities, the system might have ensured that all the Tripartite authorities were fully informed. However, for a run on a bank to have occurred in the United Kingdom is unacceptable, and represents a significant failure of the Tripartite system. If the system worked so "well", the Tripartite authorities should take a closer look at the people side of the operation."
• "While we welcome the Chancellor's admission that he was ultimately in charge of the decision making process relating to Northern Rock, we are concerned that, to outside observers, the Tripartite authorities did not seem to have a clear leadership structure."
• It is unacceptable, that the terms of the guarantee to depositors had not been agreed in advance in order to allow a timely announcement in the event of an adverse reaction to the Bank of England support facility."
• "We are also concerned that it did not prove possible to announce the guarantee that was decided upon that day before the markets opened the following day. The cumulative effect of these failures was to delay the guarantee until the evening of the fourth day after the run started and thus to make the run on the deposits of Northern Rock more prolonged, and more damaging to the health of the company, than might otherwise have been the case."
• "In view of the role that fears of a leak of a support operation had played in the decision on Tuesday 11 September that a covert operation was not possible, the Tripartite authorities were unwise initially to accede to Northern Rock's request for the announcement of the support operation to be delayed until Monday 17 September. In the light of subsequent events, it seems evident that the Tripartite authorities and Northern Rock ought to have strained every sinew to finalise the support operation and announce it within hours rather than days of the decision to proceed with the operation."
• "In failing either to make an announcement earlier in the week or to put in place adequate plans for handling press and public interest in the support operation, the Tripartite authorities and the Board of Northern Rock ended up with the worst of both worlds."

It will be interesting to see whether the Committee's recommendations for regulatory reform are followed, given the Chancellor's slightly different proposals aired last week.

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The Northern Rock crisis has prompted Alistair Darling, Chancellor of the Exchequer, to announce proposals for a special insolvency regime for banks in the UK. Following the publication of a consultation paper in October 2007, “Banking reform – protecting depositors”, and consideration of its results, the Chancellor revealed in an interview with the Financial Times, reported here on 3 January, some hints about his intentions.

Details are patchy – perhaps deliberately – with the Chancellor planning to release more information to the Treasury Select Committee on Thursday 10 January.

It seems that the FSA (Financial Services Authority) would have a role to step in at the beginning of one or more “trigger events” such as the provision of emergency funding by the Bank of England.

A debatable observation from the Chancellor was that “Insolvency laws make it actually quite difficult to move quickly if you need to take action”. He also appeared to criticise the US system, where he said a healthy bank could find itself being restructured, while he suggested that there may be ideas worth following in the Canadian and Belgian systems.

What special insolvency regime does your experience suggest will work for banks?

 

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Was the Bank of England's bail-out of Nothern Rock, Britain's 5th largest mortgage lender justified on the grounds that it met Mervyn King's parameters explained recently in a letter to the Treasury Select Committee?

". . .central banks, in their traditional lender of last resort (LOLR) role, can lend
“against good collateral at a penalty rate” to an individual bank facing temporary
liquidity problems, but that is otherwise regarded as solvent."

Professor Willem Buiter of the LSE, formerly a member of the MPC, believes the Bank is proven to be a paper tiger. Firstly his blog notes (here) Northern Rock's "extremely agressive and high risk" business strategy and that its share price was declining steeply well before the credit crunch in recognition of an absence of long term viability.

Adam Applegarth, Northern Rock's chief executive is quoted by the Times on 15 September 2007acknowledging a flawed model (here): “Is the model flawed looking foward? Of course it is. Is it flawed looking back? I think the answer is no because of the markets that we were operating in prior to August 9".

Mervyn King's letter also stated:

"The moral hazard of an increase in risk-taking resulting from the provision of LOLR lending is reduced by making liquidity available only at a penalty rate. Such operations in this country are covered by the tripartite arrangements set out in the MOU between the Treasury, Financial Services Authority and the Bank of England."

Professor Buiter quotes the Memorandum of Understanding:

"Such a support operation is expected to happen very rarely and would normally only be undertaken in the case of a genuine threat to the stability of the financial system to avoid a serious disturbance to the UK economy.”

and argues that if Northern Rock were to fail it would neither threaten the stability of the UK financial system nor seriously disturb the economy.

According to the Times article, two white knights have walked away from rescuing Northern Rock.

But despite reports of savers queing to withdraw £1bn today, the BBC's story "What if Northern Rock goes bust?" shouldn't become reality. The Old Lady of Threadneedle Street has stepped in as Lender of Last Resort.

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