Readers Question: I was just wondering what recapitalisation of the banks actually involves?
Recapitalisation involves a major change in the way a bank is funded. This could come about through issuing new shares or loan from a government. Essentially recapitalisation involves providing the bank with new capital, e.g. the government agree to buy new shares. This improves the banks’ bank balance and prevents them from going bust.
(capital means liquid funds such as share capital or loans)
Why has Recapitalisation of the Banks Occurred?
Since the credit crunch, the banks have lost money. This means that their liabilities are greater than their assets. Therefore they technically owe more to other people than assets they own. Banks lost money because:
- People defaulted on loans and mortgages
- Banks lent money (bought CDOs) to sub-prime mortgage companies in America who lost money.
- Falling house prices mean that banks assets decline further and if they repossess homes it’s harder to get the value of the original loan back.
- The recession led to more defaults and losses.
Fall in Inter-Bank Lending
Before the credit crunch, many banks relied on interbank loans to improve their balance sheets. For example, a bank would lend a long-term 30-year mortgage and finance this loan by borrowing on short-term money markets.
However, the credit crunch meant that banks were no longer willing to lend to each other. This means that they had a shortfall in their balance sheets and were left with losses. If consumers asked to withdraw all their savings, then the bank would not be able to meet the demand to withdraw deposits. Therefore, this created the need for recapitalisation – so that banks had enough money to pay back depositors who have savings in their bank.
Recapitalisation and Confidence
One issue with recapitalisation is to restore confidence. If people have confidence deposits are secure, they won’t want to withdraw them. But, if they feel bank may go bankrupt then they will want to withdraw money. A recapitalisation can assure depositors their savings are safe – preventing a bank run.
How Does Recapitalisation Occur?
In the UK, the government agreed to buy preference shares with certain conditions. This meant the government gave banks money in return for preference shares. This means the bank has to pay dividends to the government (who have preference shares) before paying dividends to the rest of the shareholders.
The government also made banks agree to certain criteria
- Maintain reasonable levels of pre-2007 lending. (rather difficult since excess lending created problems in first place)
- Limits on bank bonuses (though again this has been controversial
Difference between Loans and recapitalisation
If you give a bank a loan, it can help improve liquidity, but it doesn’t improve their balance sheet because they still owe the extra money received. i.e. the money shows up as an asset, but also a liability because you have to pay it back.
Recapitalisation would inject money without creating a liability.
E.g. Germany is currently suggesting to use €100bn to give a loan to Spanish banks, but the IMF suggests it would be better to recapitalise directly.
UK Bank recapitalisation
In the UK bank recapitalisation involved capital injections of over £45bn in the Royal Bank of Scotland (RBS) and over £20bn in Lloyds Banking Group (LBG) – created following the merger of Lloyds TSB and HBOS – received £17bn of capital under this scheme. As a result, the Government also became a significant shareholder in RBS and LBG, currently 82% and 40% respectively. (HM Treasury)
In Ireland, the government provided recapitalisation for the major banks such as Allied Irish Bank (AIB), Bank of Ireland (BoI) and Anglo Irish Bank. Under the plan the Government would take €2 billion in preference shares in each of Bank of Ireland and Allied Irish Bank and €1.5 billion in preference shares in Anglo Irish Bank, giving it a 75% control of the latter.
How much do Banks need to Recapitalise losses from the Credit Crunch?
The IMF estimates banks need £400bn to recapitalise Spanish banks.