Page last updated at 12:22 GMT, Monday, 13 October 2008 13:22 UK
Bank shares fall despite bail-out

By Jorn Madslien
Business reporter, BBC News

After weeks of turmoil in the financial markets, the UK and European governments have committed billions of pounds and euros to end a credit crunch that is threatening to send the world into a global recession.

Trader in London, 13 October 2008
Investors are cautiously optimistic

The UK and other governments are taking large, at times controlling, stakes in troubled banks, and they are to guarantee loans between banks to revive confidence in the banking sector and kick-start the stalled mortgage and corporate lending markets.

So have the concerted action by the UK and European governments delivered the silver bullet?

The initial market reaction - UK and European stock markets rose during early trading on Monday and oil prices gained on hopes of an economic revival - suggests investors are cautiously optimistic.

"After a haphazard start, Europe is finally getting its act together," a Bank of America research note says.

"The size and nature of the national plans suggest that they could finally make a difference."

Peter Dixon of Commerzbank agrees: "Based on the markets' response this morning, they certainly appear to believe that last week's sell-off was massively overdone."

Uncertain future

Yet there are also those who warn that the future remains distinctly cloudy.

"For now, the hope is that today will mark a watershed," says Keith Bowman, equity analyst with Hargreaves Lansdown. However, he adds, "it is still too early to appreciate the ramifications of these moves".

Victor Shum, energy analyst at Purvin & Gertz, also remains cautious: "It's a shot in the arm, though it's too early to know if this will restore confidence to the credit markets."

Cautious banks

Nevertheless, some conclusions can already be drawn.

For starters, observes Mr Dixon, it is clear that "we will see a very different banking sector emerge", in which "the state will have a much bigger say in [the banks'] business practices".

This is crucial since it will take us into a future where "banks will not be in a position to take many of the risks with their capital which they have done in the past".

So for instance, although interbank lending should pick up, it seems unlikely that financial institutions will return to recent heady loan-pushing practices, whether credit cards or mortgages.

And with this new cautious attitude in place, do not expect a return to excessive consumer spending, nor a return to runaway house prices boosted by easy-access mortgages.

Targeted lending

Instead, we can expect bank lending to be targeted, and perhaps even partially aligned with government objectives, according to Mr Dixon.

European Commission president Jose-Manuel Barroso and French President Nicolas Sarkozy
We are reaching a point where policy could soon start to have an impact on the credit markets and once it does that will help the equity markets
Daniel McCormack, strategist, Macquarie Securities

"We may see a move towards 'socially responsible' lending in areas such as small business or public/private partnership schemes", he predicts.

For example. one of the conditions the UK government has attached to injecting money into Royal Bank of Scotland, Lloyds TSB and HBOS is that they maintain lending to homeowners and small businesses at 2007 levels over the next three years.

This could be taken as an example of a lending policy that sets out to achieve a politically-motivated objective rather than merely make a profit for the bank - although, obviously, it might well deliver both.

Recession looming

Another reasonable prediction is that the rescue plan should "eventually get the money markets up and running again", with the banks lending money to each other again.

However, David Keeble, head of rates strategy at Calyon in London, says it "might take a few weeks to get it filtering through to the coal face, as it were".

Kenneth Broux, financial markets economist at Lloyds TSB, agrees."It is probably a story for 2009," he says.

"I still think we'll see a major scramble for funds up until 31 December, then improvement in 2009."

Nevertheless, observes James Hamilton, banks analyst at Numis Securities, "this is the end of chapter two of the horror story, but unfortunately chapter three - the recession - is on the way".

Rising or falling?

With a recession looming, and with the banks being more cautious, it is unlikely that we will see a lot of leveraged debt-financed investment in the near future.

Moreover, it seems foolhardy to expect the stock markets to bounce back on the basis of any fundamental belief in soaring earnings for companies.

"A weakening in demand is forcing firms to cut their prices", Paul Dales of Capital Economics points out.

But this also means "inflation is not a great problem anymore", observes Philip Shaw of Investec.

Consequently, the Bank of England, the European Central Bank and others are expected to cut interest rates again in the months ahead.

Lower interest rates make it unattractive to hold cash, hence shares look tempting in comparison.

This, combined with efficient interbank lending, means companies should find it easier to attract investment, which in turn should boost both the so-called "real economy" and stock markets.

"We are reaching a point where policy could soon start to have an impact on the credit markets and once it does that will help the equity markets," says Daniel McCormack, strategist for Macquarie Securities.

Moreover, current stock market valuations seem to factor in a deep and prolonged recession that might now be avoided.

According to the Bank of America report, the rescue plans not only "ease the plight of the financial sector", they also "mitigate the risk that the current recession could become even deeper and more protracted".

But the biggest thing for stock markets is confidence, a most fragile commodity during a recession that most observers still see as inevitable.

It seems the stock markets will remain arenas for the brave, or the foolhardy, for some time yet.

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