After earlier unconvincing efforts, the governments in developed countries have now come up with financial rescue plans that focus on directly recapitalising the banks. This may be the best option now... and may actually work. By Shivshanker Verma

It is over a century now since the financial crisis of 1907, very similar to the current one, hit the US banking system. Back then, many financial firms that were considered safe, placed huge bets in the stock market and nearly went belly-up when those investments soured. Fear gripped the system, no bank was ready to trust its peers, and the credit market was frozen.

J P Morgan, then the godfather of Wall Street, stepped in to resolve the crisis. He convened a meeting of the nation's bankers at his home, asked them to come clean about their financial positions and offered them fresh capital. The meeting produced instant results, as the recapitalised banks started lending again and a recovery was soon on its way.

Yesterday, US treasury secretary Henry Paulson did a J P Morgan and convened a meeting of nine of the country's top bankers. At the meeting, the bankers were reminded about the grave crisis they were in and the dangers of a long drawn-out recession.

They were then told to issue preferred shares to the US government and agree to some controls on executive compensation. The nine banks called to the meeting were given no choice; they had to participate in the programme. Smaller banks have a choice and have been given a month's time to decide whether to accept fresh capital from the government.

The Capital Purchase Programme, or CPP, is not a completely new plan. It will be part of the $700-billion TARP, Paulson's earlier plan to buy up failed assets from the banks and unfreeze the credit markets. Given the sceptical market response to TARP, Paulson just decided to use $125 billion from the $700 billion to directly recapitalise the banks.

Nor is the CPP original either. The US is merely following the lead taken by the UK (See: Britain unveils $906-billion bailout plan for banks),   which was then accepted by some other European governments (See: Europe unveils bailout plan) 

It was British prime minister Gordon Brown's idea to directly take equity stakes in banks. His plan worked wonders in rebuilding confidence, at least in the stock market as the major global equity indices recorded their biggest ever one day gains. The prime minister was hailed as 'Gordon the Saviour' and many influential economists, led by this year's Nobel laureate Paul Krugman, urged the US government to copy the British example.

How this is a superior rescue plan
As we all know now, at the root of this crisis is the huge investments made by banks in mortgage-backed securities. When housing prices started declining and borrowers started to default, the value of these investments fell sharply. To make it worse, the market for these assets are highly illiquid which accentuated the price drop. Because the fair value accounting rule requires them to do so, even banks which were not planning to sell these investments soon were forced to write down the value of their holdings as their market prices had dropped. Banks reported huge losses and their capital bases were severely eroded. Nobody trusts a weak bank, not even another bank. So, lending came to a standstill and we had a severe global financial crisis.

Paulson's first plan, the TARP, which he says will still be implemented, seeks to solve the problem by buying up all the toxic investments from banks. If implemented successfully, the plan will create a market for such assets and prevent their prices from falling further. That means banks need not worry about asset write-downs anymore. Banks will get some money in return for the assets they desperately want to get rid of and they can start lending again.

But, the TARP is a plan which was hurriedly put together without detailing the specifics. Paulson's team is still not sure how to price the toxic securities and are working on a system to buy them. The plan is unfair in the sense it will bail out equity shareholders and bondholders and does not require top managers of participating firms to be changed.

The TARP did not lift market sentiment because it does not address the immediate problem which is the weakened capital base of banks. Buying up bad assets will only prevent further capital erosion and the money received from the government will not improve banks' capital ratios. Until recently, Paulson did not like the idea of the government directly providing capital as it might indicate that the receiving firms have failed. Instead, he hoped that private investors would step in and provide fresh capital once the banks' books are cleared of the bad assets.

But, private investors will remain cautious when the risk of a complete wipe out of their investments remains high. As the shareholders of AIG and Lehman Brothers realised recently, in a highly stressed environment most firms are vulnerable. Even Warren Buffet, the only private investor who actually provided some fresh capital, was willing to consider only the strongest of the banks, Goldman Sachs. In such an environment, it will be impossible for weaker banks to attract fresh capital and the crisis will not subside.

Additional capital is critical to improve market confidence as it will increase the banks' ability to absorb future losses. As the system has become highly complex, nobody is sure if the value of other asset classes can drop in value and cause more losses for banks. Without additional capital, the already weakened banks will surely fail if that happens. Additional capital will give them the cushion to take one more hit and survive, at least for some more time.

Potential downsides
In the short term, this is probably the best plan to ease the crisis and save the world from a deep and painful recession. At the same time, this rescue plan is not without potential long-term risks either.

The most obvious risk is that the rescue plans are of unprecedented scale and will strain government finances in most developed countries for many years. The cost of the US rescue plan is close to $1 trillion, if we add the tax cuts and other incentives added to TARP to win the approval of the US Congress. The plans announced by European governments over the last week exceed $1 trillion.

Then there are efforts by other countries like Australia, Russia and Brazil to protect their banks and stimulate their economies.

Most of these governments will be forced to borrow more from the market to finance their rescue efforts. This will lead to a rise in bond yields, make credit costlier and crowd-out private borrowers to some extent. After the sharp fall in commodity prices, investment flows into the developed economies from commodity exporting countries will slow down. So, the overall availability of capital will be lower and will push up rates further. Countries like the US, where the fiscal deficit is already very high, will find it extremely difficult to finance other vital programmes. This will weaken overall competitiveness of the economy and drag down growth in the long term.

Though opponents of government interventions in the market are harping about the return of socialism, none of the governments seem intent to stay invested in banks in the long term.

But, the governments, which have announced the rescue plans do not seem to have a clear exit strategy. They are all betting that, sooner than later, banks will start functioning normally, they will find private investors and return all the public money. Nobody has any idea what the governments should do if things don't go according to this plan. Will the governments provide more capital? Or nationalise the entire banking industry and de-list the firms from the stock markets?

These rescue plans primarily aim to build confidence, not to bring down cost of credit. To prevent recessions, central banks may have to cut interest rates again. The target Fed rate in the US is now 1.5 per cent and the real rate, after adjusting for inflation, is negative. The US Fed may be forced to bring the Fed rate down to 1 per cent or even lower.

There are not many who disagree that the Fed's decision, in the aftermath of 9/11, to keep interest rates low for a long period was one of the main factors that inflated the global credit bubble well beyond the danger mark and led to the current financial crisis. If the Fed and other central banks repeat that mistake again, we will have yet another crisis some years from now. That crisis will be even bigger and more painful.