Business

Staving off serious loss of confidence among investors

— FILE PHOTO

Citibank headquarters in Mumbai.

Given the serious systemic implications that another large bank failure would have had, it was perhaps inevitable that the U.S government would mount a rescue. Especially because the bank in question is the Citigroup, one of the world’s largest banks and until the start of the financial crisis America’s most valued financial institution.

Citigroup operates in more than 100 countries including in India where it is a very significant player in the non-banking financial sector too. So, obviously its travails are a matter of concern for the global financial system as well. It has more than $2,000 billion of assets.

Its business encompassing traditional commercial banking with investment banking, the so-called universal banking model, had also become complex and posed daunting challenges to the financial sector regulators. After the rescue, financial regulators in every country have reasons to feel relieved.

An official bailout became inevitable because Citi was too big to be allowed to fail.

Because of the interconnected nature of modern banking, a default by any one bank will have catastrophic consequences for the entire financial sector.

There was another reason why the Citigroup had to be rescued fast. Its share value plummeted leading to the rescue engulfing other banks. That capped a year-long free fall. A year ago its shares were trading at about $30 and a few days before the rescue the scrip closed at $3.77.

Signals from the stock markets are watched very closely along with other periodic data such as the quarterly results, which, in the Citigroup’s case, were not flattering either. It was a question of staving off a serious loss of confidence, not only in America’s biggest bank but also in the global financial system. The bailout package of over $300 billion differs fundamentally from previous rescue attempts.

The U.S. government will provide additional capital of around $20 billion, a relatively small amount. But it will provide guarantees to the bank against losses arising out of a portfolio of “most distressed assets” for a much larger amount. Basically, the government is providing a kind of insurance: one of the main advantages is that it will help in setting a floor price for these securities.

The government’s contingent liability therefore goes up while its capital infusion will be relatively small.

Initially, the government announced a plan to buy out the distressed assets at a price higher than their worth. That, it was hoped, would facilitate price discovery of the illiquid assets. Banks would be rid of the assets and the government hoped to recoup its losses over time. This plan was abandoned when the government announced very recently that it would rather inject capital directly to the troubled banks. After the latest package was announced share markets around the world rebounded sharply.

According to the package, Citi’s shareholders will have to pay a price: the dividend on common stock will be restricted to not more than one per cent a quarter for the next three years. Their executive compensation packages will be subject to regulatory approval. Citigroup’s predicament is a symptom of a deeper malaise, caused by a combination of housing, mortgage markets and the overall economy. The bank, one of the world’s largest, has been in the forefront of “financial innovation”.

That would have counted as a major virtue in more normal times. With the financial crisis showing no signs of abating, innovation has a pejorative meaning as it is held responsible for the very large exposure to the toxic assets which are at the root of the problems. The rescue of the Citigroup draws attention to the point that no single banking business model can be commended in times of crisis.

Traditionally, U.S. banks were supposed to be legally barred from undertaking both commercial and investment banking services. It is not clear whether the amalgamation of several types of banking business has served the Citigroup well. In September, when Lehman Brothers went down, there were indications that universal banks, including the Citigroup were better equipped to deal with the crisis. Unfortunately, it did not take long to disprove that thesis.

C. R. L. NARASIMHAN

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