John Hemming: The curse of living in interesting times

Oct 14 2008 By John Hemming

I think people now know why “may you live in interesting times” is a Chinese curse.

This week was particularly interesting in terms of the financial system. In the US a “rescue package” has been developed for the banking system which basically has the tax payer buying dubious assets off the banks. In the UK we have gone for an alternative.

The issue of liquidity (ensuring that banks can pay for things today) is not as important in the long term as solvency (making sure that over time everything can be paid for) although it is far more urgent.

The government had until now steered clear of trying to solve the general solvency issue, instead acting in a rather unpredictable manner solving immediate problems rather than looking strategically.

The measure of solvency for a bank is done by the ratio of tier one and tier two capital.

This is a mechanism for identifying what reserves a bank has if “the music stops”. The question is whether or not there are enough chairs upon which all the creditors (mainly depositors) can sit.

The tier one ratio is the percentage of revalued assets that is spare to ensure that creditors get paid. Most of the big banks have a reserve of between eight and nine per cent.

One of the best aspects of the proposal to offer preference shares for the banks is that this may give sufficient confidence in the banks as to make using the funds unnecessary.

HSBC has already said that it does not intend calling on this facility. It is bit like knowing that there is a safety net in place that makes people willing to walk on a tight rope.

They are not likely to need it, but its existance gives the confidence to walk on the high wire.

A modern version of the Cod Wars (during which Icelandic vessels were rammed by UKvessels because the Icelanders were cutting UK nets) seems to be kicking off as well. There was a good reason that Icelandic banks paid seven per cent interest and everyone else paid five per cent.

It is now obvious what that reason was. This particular aspect of the financial pressures is the one which will be more complex in the long term.

Most of the difficulties in the market have arisen from the overvaluation of property.

On that basis it is not surprising that the market leader in mortgages (HBOS) is the leader in terms of having capital ratio problems. As the value of the security against loans goes down, then so does the tier one capital ratio.

The second big problem we face remains energy supplies.

Oil prices have continued dropping because of reductions in demand as a result of increased prices. This oscillation in price is likely to happen a number of times as the global economy lurches through the period of peak oil and gas production. This may give false summits, but it will will cause considerable disruption.

In both of these areas the UK is suffering in part from a global problem. It is not, however, as if the Government was not warned about the difficulties.

We have a very long way to go before we can cope in the UK without substantial pain and we have not even really started to put things right.