£37bn Bank Bailout

14 10 2008

The UK Government announced on Monday (13 Oct) that it was going to lend £37bn to three of UK’s biggest banks with the aim of “unfreezing” the frozen credit market. The Royal Bank of Scotland (RBS) will receive the biggest cash injection worth £20bn. The Government will buy £5bn worth of preference shares and another £15bn worth of ordinary shares in RBS if they are not bought by ordinary investors, which will give it a healthy 60% share of the business. HBOS and Lloyds TSB will jointly receive £17bn in return for which the Government will receive approximately 43.5% of the merged business. Preference shares, as the name suggests, are given preference when it comes to paying dividends. This means that the Government will be paid the dividends, if there are any, before they are paid to the ordinary shareholders. It also means that the Government will have a say in the operations of the banks.

Although this announcement would have lead to a sigh of relief for some since the banks will get the cash injection they desperately need and give them stability, many investors are worried that the purchase of a huge number of shares by the Government will lead to a dilution of shares of the existing shareholders. Dilution basically means that since the total amount of shares of the banks will increase, this will mean that the existing shareholder’s ownership of the company in terms of percentage will decrease.

There has been support and opposition to the bailout plan proposed by the UK and American Governments. Many people are angry that taxpayers’ money is being used to pay for the mistakes of a few irresponsible bankers especially since most of the bankers got bonuses and left the general public to clear up the mess. However, the bailout is a necessary evil. This is because the credit crunch ultimately affects all of us. If banks are reluctant to lend to each other, it means that banks cannot lend to the general public, which means that the general public cannot spend this money which affects local businesses, this leads to a loss of jobs and goes on and on like a downward spiral. There have been reports recently that many small businesses have seen their overdraft facility severely reduced of even cancelled in certain cases. This has affected their cash flow. Businesses that were sound a month ago are finding it hard even to pay their staff.

The Economist (http://economist.co.uk/) described the lack of credit in an interesting manner by comparing it to air. We always take the air we breathe for granted because it is readily available. When we start drowning, we suddenly realise the true value of air because the lack of air hurts. Similarly, when credit is flowing, everything runs smoothly. However, the lack of credit leads to a lot of problems. The bailout plan is not a silver bullet that will solve all the current problems, but it remains to be seen what effects, if any, it will have in the near future.

The BBC website has an interesting article about past bailout plans and whether they worked. Have bailouts worked? http://news.bbc.co.uk/1/hi/business/7648330.stm

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