Andreas Whittam Smith: At last, an escape route for the banks. But will they take it?

Both Darling's and Geithner's schemes are favourable to the private sector
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The Independent Online

I am not looking for green shoots. The image that the phrase conjures up isn't appropriate. This isn't springtime in an economy that has undergone a hard winter. My picture is rather that a hurricane has been passing overhead. Immense damage has been done to the economy by the seizing up of the banking system. I look anxiously to the sky to see whether the storm is moving away or not. And what I have seen this week is a new plan for repairing the American banking system.

Banking systems are working badly because everywhere they are weighed down with bad loans. Many of the lending arrangements that were made at the height of the boom now suffer from two grave problems. Borrowers can no longer afford to pay interest as it falls due. And the security that the banks took for protection against default has declined in value so sharply (see prices for commercial and residential property) that it is worth much less than the funds at risk.

This means in turn that great chunks of bank capital have been destroyed. In response, governments are struggling to find methods for removing the bad loans from the banks' balance sheets and for making good the missing capital. The storm will have passed when both these outcomes have been achieved.

The American plan, announced by Timothy Geithner, the US Secretary of the Treasury, comes a few weeks after Alistair Darling, the Chancellor of the Exchequer, announced the British solution to the same problem. Mr Darling's approach is that the Government insures the bad debts. Mr Geithner, on the other hand, has asked private investors to partner the US government in buying the bad debts from the banks, what is called a "public-private investment programme".

Both schemes are extremely favourable to the private sector but in different ways. In the British case the terms are very attractive for the banks. Take as an example a bad loan held by a British bank that has a face value of, say, £1,000. The British Government says the bank must take first £60 of any losses but need only pay £20 to insure 90 per cent of the rest. In other words, for a premium of £20, the bank with the insurance may dump up to £847 of potential looses into the Government's lap.

Under the American proposal, it is private investors who get attractive terms. Assume that a US bank has a bad loan with a face value of, say, $1,000. Say that the bank in question was willing to sell the dud asset for $840 to the private/public partnership. Each side puts up just $60 dollars in equity, making $120 in all. The rest ($720) is borrowed from Government institutions.

Thus American taxpayers carry all but $60 of the $840 at risk. However Mr Geithner's plan has one advantage that the British approach lacks. In effect private investors set the prices for bad loans that the banks can either accept or reject. This process is called "price discovery". In Mr Darling's insurance scheme, there is no price discovery and therefore greater scope for banks to take the taxpayer for a ride.

On neither side of the Atlantic are banks compelled to participate in these schemes, though all may do so. In fact in this country progress has been relatively slow. Only Royal Bank of Scotland and Lloyds have signed up so far. There are similar doubts as to how many American banks will avail themselves of Mr Geithner's facility.

The reason is that the banks are frightened of crystalising their losses. For then they may find that they are insolvent or approaching that dread state. In either case, they would have an urgent need to raise fresh capital with the risk that only the government would supply it with all the unpleasant consequences that such a course entails.

Left to their own devices, banks would far prefer to do without government help and nurse their losses in the hope that sooner or later conditions would improve so that they could recover their money. Meanwhile in order to preserve some capital, they would stop lending.

As this 19th-century attitude is fatal for modern economies, governments are driven to the elaborate schemes described above, enormously costly as they are to tax payers. Nonetheless, Mr Darling and Mr Geithner have, in their different ways, done the best that can be done. They have each provided an escape route for their banks. Some have taken it or will take it. Many will prefer not to do so.

So as I look up again I find that the clouds are still there, albeit a little less threatening.