Jeremy Warner's Outlook: A comprehensive bailout for banks, but will it work?

Sir Fred Goodwin's top bullet point in his slide presentation to the Merrill Lynch banking conference in London yesterday morn-ing was: "The outlook is subdued". Even by the notoriously phlegmatic standards of the Royal Bank of Scot-land chief executive, this was something of an understatement. In fact, the outlook was truly dire at the time he made his remarks, as one glance at Sir Fred's plummeting share price graphically illustrated – at the close, it was down by nearly 40 per cent to a 15-year low of less than a pound.

The big question: is it going to be much improved by the comprehensive bailout package expected to be unveiled by the Government this morning?

If there wasn't a fully blown retail and wholesale run on RBS going on already, there certainly would have been by the time everyone clocked the meltdown in the RBS share price. Quite who was responsible for this latest, calamitous collapse in confidence scarcely seems to matter any more. Was it cack-handed briefing by the Treasury or merely confidence-sapping guesswork and speculation? Certainly, it conforms to the Treasury's inept handling of this crisis from the start, where kite flying and leaks over what course of action the Government might or might not adopt have only succeeded in making a bad situation infinitely worse.

Who knows? What's important is that the Government is now seen to act, and despite the denials and hand-wringing by all the major banks yesterday a substantial injection of taxpayers' money into the banking system has become a major part of the policy response to be announced this morning.

At the time of writing, bankers had been summoned to Downing Street to be pre-briefed on this truly momentous decision, which amounts to part-nationalisation of the UK banking system. The details last night remained unclear, but I think we can be reasonably clear about how it's all going to work. One way or another, the weaker banks are going to be forced to sign up to recapital-isation whether they like it or not. Policymakers have taken the view that it has to be all for one and one for all. There's no point in a piecemeal approach as this will only switch the confidence issue from one bank to another.

Even Barclays, hitherto fiercely resistant to the idea that it needs more capital having only recently committed itself to a dividend increase, seems to have dropped its objections and is prepared to be supportive. A one-size-fits-all approach would be acceptable to Barclays if it helps restore confidence in the banking system. As things stand, there is a high chance of a domino effect of failing banks. Once the markets have finished with one bank, they merely move on to another. If a bank as big as Royal Bank of Scotland is thought to be in danger, then all banks will eventually get sucked into the hole. An industry-wide solution is therefore essential.

One reasonably eloquent way in which this might be achieved, which would address the apparent belief at Barclays in particular that it remains adequately capitalised, would be to make it mandatory on UK banks to raise their so-called tier one equity capital ratios to 7 per cent or more. The Treasury would stand ready to provide the money that would enable this to happen. In return, the taxpayer would get convertible preference shares on favourable terms, together with boardroom representation. There may also be strict limits on executive pay. It's a whole new world we seem to be moving into.

The approach just described would leave the better capitalised banks – HSBC and Santander, where there is no perceived problem – free of interference. Only RBS, Barclays, HBOS and Lloyds would be caught by the edict. Can the UK Government do this unilaterally? The time for international convention on these matters seems to have passed. Each country must do what it can to bolster confidence in its banking system.

All the same, the dilution of existing equity involved will be tough for banks to sell to investors. According to a note produced by Cazenove yesterday, the capital required to raise Royal Bank of Scotland's tier one equity capital ratio to 7 per cent would involve a27 per cent dilution, or possibly more after yesterday's share price plunge.

Exaggerated media reports that Sir Fred had begged the Government on bended knee for a massive capital injection certainly played their part in yesterday's further, catastrophic collapse in bank share prices.

By the way, as an aside I am told that absent of a sharp recovery in the HBOS share price, Lloyds TSB will now definitely move ahead and renegotiate the terms of its all-shares merger. The recapitalisation plan is regarded as sufficient cause to lower the terms.

Since the damage is now done, here's my penny's worth to add to the growing weight of negative speculation. According to one of the stories circulating in the market yesterday, so challenging did RBS's funding difficulties in its US retail banking division become late last week that it was forced to seek emergency assistance from the Bank of England on top of the liquidity available through more general channels. Believe it if you will.

Whatever its validity, stories such as these have been piling the pressure on the Government to come up with an urgent, bold and immediate response. Will this morning's package work? Recapitalisation on its own is unlikely to do the trick. Indeed, there is some danger that taxpayers will only be throwing good money down the drain by bolstering capital in this way. RBS, HBOS, Barclays and Lloyds TSB have already raised massive amounts of new capital from investors. It hasn't done any good in underpinning confidence.

Yet in conjunction with a state guarantee of deposits, as announced by Ireland and others, deep cuts in interest rates and further injections of liquidity, it might just succeed in putting a floor under the British banking system, and thereby halt the process of "deleveraging" which is threatening to collapse economic activity. Mind you, official interest rate cuts are not going to have much effect when it is now the markets that determine the cost of money, and right now they are charging an arm and a leg for it.

The present banking crisis is primarily one of funding. As markets and depositors became progressively more mistrustful of the state of each others' balance sheets, they started withdrawing their money and stopped lending to one another. Money markets became frozen, despite the addition of massive amounts of central bank liquidity. Yet as explained in this column yesterday, issues of funding and capital are for banks binary. They are intimat-ely linked. If there is no liquidity, then it requires more capital to fund committed lending. Without that capital, the lending must shrink, as is already apparent in the mortgage market and increasingly evident in other parts of the economy. Banks that can-not get adequate funding must shrink their balance sheets to match, or, to use the jargon of markets, "deleverage". Yet if they have more capital, they don't have to deleverage to the same degree, and furthermore, may begin to attract the funding they need.

What's made the situation much worse is the fear that in a prolonged recession banks will find their profits wiped out by bad debts. This has further undermined confidence and added to the funding difficulties. Banks may need a lot more capital to see them through a prolonged downturn.

As I say, recapitalisation cannot work on its own. At the time of writing, it looked as if the Government would also guarantee deposits in the manner of Ireland and others. The consequences for the public finances of such actions long ceased to be a consideration for ministers.

In the context of the rescue package being concocted in the Treasury, yesterday's debate in the House of Commons over the Government's "fiscal rules" took on an almost surreal quality. In apparent recognition of the way the crisis is busting all conventions, European finance ministers yesterday as good as agreed to suspend the limits the Stability and Growth Pact places on budget deficits for members of the euro, and sanction national governments to pursue whatever policies they think necessary to support the banking system.

The rush to guarantee banking deposits amounts to a form of econ-omic nationalism worryingly reminiscent of the tit-for-tat protectionism that broke out in the 1930s. In a serious downturn, it is every nation for itself. The danger is that once markets have finished trouncing the banks, they will move on to countries and currencies. Smaller countries with overly large banking sectors cannot in truth afford to back their deposits with a taxpayer guarantee. Those outside the umbrella of the euro or the dollar might find themselves particularly exposed.

On the other hand, the argument can be made both ways. It's not imm-ediately apparent that the euro will be able to withstand the pressures of the economic nationalism now being so unashamedly pursued throughout Europe. On all fronts, the potential for this crisis to spiral out of control, plunging the world into a severe and prolonged downturn, remains high. Having acted individually to save its banking system, Britain must now bend behind the effort at international co-operation with all its might.