Hamish McRae: It will be no comfort for investors, but this bailout will succeed

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The Independent Online

The government throws tens of billions, maybe hundreds of billions, at the banking system – and bank shares promptly plunge. You might imagine that shareholders would be grateful for this support but instead they seem to be in despair. What's up?

The first thing to be said is that this bank support package is a huge and pretty much unprecedented deal and all our experience of intervention on this scale is that first reactions are often wrong. The markets have to come to an instant view because that is what share prices (or indeed the price of government securities) signify. But as we know all too painfully, markets get things wrong. There are rational reasons for bank share prices to fall but the reaction should not be seen as a thumbs down for the initiative as a whole.

What is becoming clear is that the damage to the world banking system of the failure of Lehman Brothers is worse than the world's monetary authorities had thought possible. The banking system had been gradually recovering through last summer and might have continued to do so. But when Lehman was allowed to fail, trust in the banks worldwide was destroyed. That led, within a week or so, to a freeze on trade both within countries and between them.

So what the UK Government is doing now is a pretty big step along a path that all monetary authorities are having in some measure to tread. Because the UK has a relatively large financial sector, the numbers are correspondingly big. But there is no option but to pile in resources by whatever means possible to restore the banking system to reasonable health. Most countries have similar problems in some degree, though the scale does differ. Just about every country, however, is being hit by the consequent impact on the real economy. Even countries with relatively solid banks are being savaged by that.

Bank rescues are always messy for the scale of the bad debts is inevitably unclear. In the past the tendency has been to assume that the indebtedness is worse than it ultimately turns out to be, though this time maybe the reverse is happening. But what makes the present situation particularly messy is its international nature. As Gordon Brown pointed out, part of our problem is that much of the lending in the UK came from foreign banks. The Government has some lever over UK institutions but very little over foreign ones. And we don't have enough savings in the country to fund lending at the level it was running at 18 months ago.

Now the Government has brought in a string of measures that should enable the UK banking system not only to resume lending at a reasonable pitch but maybe take up a bit of the slack left by the departure of foreign lenders. No one, however, can be confident that it will be enough. So we know – and this goes for all developed economies – that the authorities have no alternative to go on and on until banks are functioning properly again.

That leads to two final questions. Will it work? And why are the banks, or at least their shareholders, in such a funk?

On the first, the detail of the package looks promising. You have to remember that the state can take risks on a scale that commercial enterprises, however large, cannot do. It is much better to deploy that power in giving loan guarantees than trying to puff up the economy by for example a temporary cut in VAT. It makes sense too to further recapitalise the UK banks in which the state already has a stake. The Bank of England asset purchase facility pushes money immediately into the banking system, and the commitment by Northern Rock and Royal Bank of Scotland to increase lending will also have a swift impact.

So it is a well-structured package. The authorities may have to do more and there will be a big burden on taxpayers for a decade, maybe more. It is tragic that we have gone into this situation with very weak finances but that is done. But they will ultimately succeed.

And bank shareholders? For some, there is a danger they will be left with very little value, maybe none. That is harsh. But it is not the fault of the Government, except insofar as it was an inadequate regulator. Market capitalism dishes out its rewards and its punishments and this is the time for the cane.

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