About-face

"Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning." The famous wartime refrain of Winston Churchill, whom U.K. Prime Minister Gordon Brown recently invoked in an expansive moment, comes to mind as the British banking sector steps back from the abyss. Though a complete collapse has been averted, neither the embattled Brown nor the fragile banking industry can prevent a painful period of deleveraging. Bank lending could take years to recover as institutions shy (or run) away from risk.

The Treasury and the banks are putting on a brave face. When the government on Oct. 13 plan to inject up to £37 billion ($63.1 billion) into three major U.K. banks -- Royal Bank of Scotland Group plc, HBOS plc and Lloyds TSB Group plc -- the Treasury said the lenders had made a "commitment" to maintaining, over the next three years, mortgage and small business lending at 2007 levels.

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The banks will be supported by the government's overall rescue plan, which includes new liquidity and £250 billion in bank debt guarantees.

But is the lending commitment sustainable in such a ravaged global financial system? Analysts are doubtful. Says Derek Chambers, U.K. banks analyst at Standard & Poor's Equity Research, "It is hard to see how you can operationalize this. It's aspirational."

Wrote Jonathan Pierce, U.K. banks analyst at Credit Suisse Group, in a note, "It is still not quite clear what this [2007 levels] means."

The British Bankers Association also looks for more clarity. "One of the government's stated aims with this package is to free up lending to individuals and small businesses. How that is measured is still to be explained. But, obviously, the intention is to continue to uphold the industry's commitment to lending responsibly," says chief executive Angela Knight.

John Muellbauer, professor of economics at Oxford University and a housing expert, was quoted by the Financial Times as saying of the 2007 target: "It's like asking a victim to dance in his grave, or setting a target for water to run uphill. It seems to suggest a misunderstanding of market forces. ... This target doesn't make sense."

There are signs that the Treasury is backing down. One source close to the department, who does not wish to be named, says that "all we want to ensure is that the mortgage market is provided with a wide range of products for creditworthy borrowers and similarly that there are affordable products for small businesses."

Bank executives and Treasury officials have also battled over the government's initial insistence that banks tapping the £37 billion bailout program won't be allowed to pay dividends until the government redeems its investment. Brown last week said the government was talking to banks about the dividend, signaling that ministers may soften
their stance.

Whether bank dividends are paid or not, many businesses and consumers will struggle to get credit.

"Over the last 10 years, there has been an extension of leverage beyond what the economy could sustain. The antidote will be a period of deleveraging,"
Chambers says.

This grim reality was implicitly acknowledged by senior Royal Bank executives during a remarkably self-assured performance on a conference call with journalists on Oct. 13.

Scant mention was made of the most humbling fact: It is entirely possible that the government may take a 60% stake in Royal Bank if the lender's £20 billion fundraising does not attract enough private investment.

Leading the brigade for Royal Bank is Stephen Hester, who will soon take over from Fred Goodwin as CEO. A veteran banker at Credit Suisse First Boston and Abbey National plc and the former head of British Land Co. plc, Hester is a familiar face in U.K. finance. On the conference call he noted there would have to be "lower risk" and "lower leverage," as well as an emphasis on "efficiency" in the business.

Outgoing Royal Bank chairman Sir Tom McKillop spoke of the need to "derisk the business." These are telling comments from a bank that led last year's €72 billion ($98 billion) acquisition of ABN Amro Holding NV, the biggest financial services takeover in history.

Royal Bank also faces significant costs as it refinances some of its short-term debt. Although the government will guarantee these loans, analysts predict the expenses will be high as the bank funds 54% (£25 billion) of its total borrowings in the wholesale markets as of the end of June, according to Pierce at Credit Suisse. Royal Bank, however, said only a small amount had to be refinanced this year.

In addition, the bank will want to buy back the government's £5 billion worth of preference shares, and that will take about two years, according to Credit Suisse analysts.

Royal Bank is one of the most important corporate lenders and providers of acquisition finance in the U.K., so its newfound caution will have serious consequences for the capital markets and M&A, as well as for a wide range of
U.K. businesses.

According to data provider Dealogic, as of the third quarter of 2008, Royal Bank was the world's second-biggest lender to private equity firms, extending some $7.8 billion in loans. The quarter saw an 87% fall in such loans compared with the same quarter in 2007.

Of course, the vast majority of leveraged buyouts have been put on hold since the mid-September bankruptcy filing of Lehman Brothers Holdings Inc. Private equity firms expect only limited dealmaking for the foreseeable future.

"We've seen a number of deals pulled because of the financial crisis in recent weeks," says Julian Hirst, joint managing partner of Tri-Artisan Partners Europe LLP in London. "The government's move will at least stabilize things, but new deals, especially those involving leveraged finance, will be very difficult. Banks won't want to hold more than £25 million each, and debt-to-Ebitda ratios will be at no more than 2 to 2.5 times."

Still, the Brown government seems to have stabilized the financial system, a critical first step toward any meaningful progress.

At press time, LIBOR -- the London interbank offered rate that banks charge each other for three-month dollar loans -- had fallen for four straight days, signaling that frozen credit markets were beginning to thaw.

According to data provider Markit Group Ltd., credit default spreads for U.K. banks have tightened since the announcement of the government's rescue plans. They have fallen below 100 basis points even for HBOS, which, as the U.K.'s biggest mortgage lender, is the bank most exposed to the housing market. Confidence is returning, slowly. As recently as Oct. 6, HBOS' spread stood at 300 basis points.

It is also possible that banks less affected by the crisis -- including Barclays plc, which is seeking to raise funds without government help, and HSBC Holdings plc, which is raising funds only for its U.K. business and also without state help -- will be able to lend at pre-crisis levels.

Financial stability is real, but precarious. "The steps taken by the U.K. government to assist the U.K. banking system are dramatic and far-reaching," says James Bateson, head of financial institutions at Norton Rose LLP. "But it remains to be seen whether they will achieve their objective of stabilizing the situation, restoring liquidity and building confidence in the banking system for the longer term."

This is, surely, a long-term battle. It's not -- back to Churchill -- the beginning of the end, but it might be the end of the beginning.

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