Jeremy Warner's Outlook: Lloyds-Halifax shows policymakers are starting to get it right over crisis

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The Independent Online

There were two distinct views in the City yesterday on Lloyds TSB's £12.2bn bid for HBOS. Some think Lloyds is paying far too much, as in the absence of the bank's rescue takeover bid HBOS would have been facing the possibility of Northern Rock-style nationalisation, leaving shareholders with nothing.

The other was that HBOS had in the panic of the moment sold a still hugely valuable consumer franchise spectacularly short. Eighteen months ago it was worth nearly five times as much. Only a few months back, the bank raised £4bn in a rights issue at 275p a share, and less than a year ago it was still buying back its own shares at more than £8 a pop. At less than half book value, Sir Victor Blank, chairman of Lloyds TSB, seems to have got the steal of the century.

Yet the truth is that in the circumstances both sets of shareholders have plenty to celebrate. The same cannot be said of consumers. The insistence by Sir Victor Blank, chairman of Lloyds TSB, delivered poker-faced without any apparent irony that the deal would also be good for customers, is frankly laughable. It's only good for consumers in the sense that HBOS depositors might now feel a bit safer about their money. In terms of charges, deposit and borrowing rates, it must by definition be bad to allow such a massive reduction in competition.

But before moving on to the coach and horses this deal has driven through the Government's anti-trust policies, let me explain why I think it's good for both sets of shareholders, and may even mark a turning point in a banking crisis which was showing every sign of turning into financial Armageddon. For Halifax Bank of Scotland, the deal is a no-brainer. Sir Dennis Stevenson, the chairman of HBOS, says he still believes the bank might have been able to muddle through the crisis in funding, but after the events of the last week, when Lehman Brothers and AIG collapsed and the money markets imploded, it wasn't worth taking the risk. The only safe option was to hurl himself into the arms of Sir Victor Blank.

Lord Stevenson and his chief executive, Andy Hornby, both non-bankers by background, admit to mistakes, and in particular making Britain's largest mortgage bank dependent on wholesale and securitised funding. Yet it's too late to be crying over spilt milk now. The issue for today is whether they have solved the problem at a reasonable price. By negotiating an ongoing interest of 44 per cent in the combined bank, they seem to have secured a better deal for shareholders than anyone could have dared hope for, given the dire position they were in. It would have been easy for Lloyds TSB to hang HBOS out to dry, leaving investors with little or nothing at all.

By luck as much as design, Lloyds TSB is one of the few British banks not to have made any obvious mistakes in recent years. Its funding is largely provided by its current account float, giving the bank a loan to deposit ratio of just 140 per cent, against 180 for HBOS.

Ever since the days of Sir Brian Pitman, Lloyds TSB has eschewed the racy attractions of investment banking and credit securities and instead stuck to a more traditional banking model. Eric Daniels, the current chief executive, continued in that mould, in part because he didn't really have any option. The overpriced acquisition by his predecessor eight years ago of Scottish Widows severely restricted his freedom of action. So dull, boring and predictable did Lloyds TSB become, that the financial pages gave up covering its results. Now the tables are reversed, and all of a sudden Sir Victor finds himself head of one of the best-placed banks in Britain. Together with Mr Daniels, he's now seizing the moment to pull off a deal he says they've wanted to do for years, but been kept from by competition concerns and relative valuations. It's one of the most remarkable reversals in banking history.

But will it work? There was disappointment in the City yesterday both at the generosity of the terms and the fact that Lloyds TSB has used the deal as an excuse to axe the dividend so as to rebuild capital. Lloyds TSB may not have a funding problem, but it is actually more poorly capitalised than HBOS, and there is obvious concern that now it has taken on somebody else's problems, it will lose its triple-A credit rating, perhaps creating the very funding problem it has so far managed to avoid.

As one City analyst has observed, yesterday's press release seemed to have been written more by Downing Street than commercially minded bankers. The £1bn of annual cost savings envisaged is about half what the City thinks possible, while the commitment to preserve Scottish jobs as well as The Mound in Edinburgh as HBOS's Scottish headquarters looks like part of the price that had to be paid for dispensation from normal competition laws. The Chancellor's constituency is in Edinburgh and the Government is struggling to hold Labour seats. In any case, the transactional risk is considerable. Mergers of this size are notoriously difficult to make work, and there is a real possibility that one and one, far from equalling three, could add up to rather less than two.

Yet leaving aside these concerns, this is on the face of it a corker of a transaction, leaving Lloyds Halifax, or whatever the new combine chooses to call itself, far and away the dominant British banking brand, with some kind of a relationship with more than 40 per cent of the population. Small wonder that rivals are spitting tacks.

Round at Gogarburn, Royal Bank of Scotland's Edinburgh headquarters, Sir Fred Goodwin can hardly contain his anger, which will be directed in part at himself. Lloyds is buying itself market dominance in the UK for little more than Sir Fred paid a year ago for the crud which was his share of ABN Amro.

Santander likewise is kicking itself for having forked out for Alliance & Leicester, the biggest British banking consolidation it thought the authorities would allow, when the Government was about to waive all its competition laws to make the much larger prize of HBOS available. The A&L deal has already progressed too far to make it possible to switch horses now.

As for the price Lloyds TSB is paying, Sir Victor is right to attribute a reasonable value to HBOS, if only for the reason that if he had attempted to buy it for nothing, it would have accentuated the sense of crisis around HBOS's affairs and further undermined confidence in the British banking system. Charles Goodhart, a former member of the Bank of England's Monetary Policy Committee, hit the nail on the head yesterday when he said policymakers had spent too much time worrying about moral hazard and not enough about economic hazard.

The idea, much touted by Mervyn King, Governor of the Bank of England, and underscored through their actions by policymakers in the US, that it is somehow a good thing that equity holders in financial institutions with funding difficulties be wiped out so as to prevent the creation of moral hazard is completely flawed. The prevailing wisdom is that depositors be protected but equityholders not.

Policymakers from the distant past understood this better than the "sophisticates" of today. For instance, way back when, it used to be illegal to short bank shares. Belatedly, regulators on both sides of the Atlantic are again moving to outlaw the practice, having observed how a run on a share price can cause a collapse in confidence all round, thereby finishing off what was previously thought a perfectly viable bank.

With banks, the distinction made between equity and other creditors is a wholly meaningless one. To the contrary, since equity-holders provide the capital on which confidence in the bank is based, they are crucial to the viability of the entire banking system.

In attributing some kind of a value to HBOS's equity, Sir Victor has recognised this point. So, too, has the Government in agreeing to lift competition constraints so as to allow the deal to proceed. Sir Victor had the Government over a barrel. Without his equity, the Government was facing the possibility of having to take HBOS into national ownership alongside Northern Rock.

One of the ironies of this banking crisis is that the instant communications of today and transparency of modern accounting rules was meant to make the system safer; in fact they have acted like a lightning conductor in making the situation infinitely worse.

The internet has compounded the sense of panic by giving voice to a bewildering array of negative news and doomsday commentary. Whereas in the past loans would be held to maturity, allowing banks more easily to weather the ups and downs of the cycle, today they have to be "marked to market", prompting a vicious downward spiral in bad debt provisioning, asset sales and capital raising. These are only some of the issues that will need to be addressed when regulators come to survey the wreckage of the financial hurricane.

Despite the humbling of competition policy involved, yesterday's deal, in combination with co-ordinated action from central bankers and news that the US Treasury is about to create a Resolution Trust similar to that set up in the wake of the savings and loan crisis to take over the bad assets, offers a glimmer of hope.Infuriating though it may be, when the banking system gets sick, policymakers have no option but to treat the patient until the fever goes away.