Government stakes in banks raise counterparty conundrum

Governments in the UK, Europe and the US have announced a series of measures over the past month to shore up troubled banks and restore confidence in the financial system. In many cases, this has involved governments injecting capital into banks in return for preferred or ordinary shares. As part of the rescue package, various governments have also offered guarantees on short- and medium-term bank debt to kick-start the wholesale lending market.

“We do not know yet how the government guarantees will work. We don’t know what it means to deal with one of these banks. Will the fact the government has taken an equity stake in a financial institution be a competitive advantage or disadvantage for us?” asks one head of structuring at a European bank, which was not part of any government rescue scheme.

On October 8, the UK government declared it would recapitalise the ailing banking sector by injecting up to $50 billion into eligible institutions. A week later, on October 13, it revealed it would pour a total of up to £37 billion into Royal Bank of Scotland, HBOS and Lloyds TSB in return for equity stakes in those firms. Once the capital injections have been made, the tier-one ratio of the banks should rise above 9%, the government said.

It also stated it would offer around £250 billion in government guarantees on short- and medium-term debt issued by those institutions that have raised tier-one capital to “appropriate” levels.

Other countries quickly followed suit. On the same day, a number of European governments, including Germany, France and Spain, announced similar measures to guarantee medium-term bank senior debt and invest in financial institutions, either through the purchase of preferred or ordinary shares, in order to boost tier-one capital levels.

And on October 14, US Treasury secretary Henry Paulson unveiled a plan to invest up to $250 billion in banks and thrifts, as part of the $700 billion rescue package approved by the US Congress earlier that month. Banks will receive capital in return for preferred shares, as well as warrants for common shares.

The capital injections also came with other conditions. In most cases, this included curbs on executive pay and bonuses, and commitments to help struggling borrowers stay in their homes. In the UK, for instance, the three banks had to commit to continue lending to homeowners and small businesses and support schemes to help people struggling with mortgage repayments to stay in their homes.

The three UK institutions also made commitments on the remuneration of senior executives. As part of this, the government said it expects no cash bonuses to be paid to board members this year. In the future, bonuses will be linked to “long-term value creation, taking account of risk”.

In addition, the government will have the right to agree with boards the appointment of new independent non-executive directors, and will have a say in dividend policy. Other countries’ rescue packages went further, insisting on government representatives on the board of directors.

Some dealers suggest these conditions could mean recapitalised banks are restricted in the derivatives business they can do in future. Caps on remuneration may also drive derivatives traders at those institutions to other banks.

“The recapitalised banks may well be seen as rock solid derivatives counterparties in future due to the government guarantees,” says one head of trading at a European firm, also untouched by government intervention. “But these firms aren’t likely to have the same appetite to structure derivatives. Can you imagine the headlines that would appear if a bank in which the government had a partial stake were to sell a derivative, and the client that bought it subsequently blew up? I just can’t see them letting that happen.”