Can you rescue and punish failing banks at the same time? I doubt it, which is why I am less optimistic about the success of the UK banking rescue plan than its US counterpart.

It may seem just for the rescuer to appropriate future profits due to ordinary shareholders but those earnings are required to attract new private sector capital and offset prospective uncovered losses.

Compare and contrast the details of the UK and US rescue plans:

• Bank recapitalisation: US - redeemable preference shares with 5% yield and attached common stock warrants, no requirement to stop paying ordinary share dividends; UK - 12% yield,  irredeemable for five years, no ordinary share dividends until repaid.

• Bank debt guarantees: US - free for first 30 days, subsequently charged at flat 75 basis points; UK - fee of 50 bp plus median five-year CDS spread in year to 7 October, implying range of 110-170 bp for major banks.

• Transfer of troubled assets from banks' balance sheets: US - remaining TARP funding of $450 billion available to purchase illiquid securities; UK - final Crosby report awaited but similar programme unlikely.

• Security swap facilities (private AAA for government): US - secondary to direct Fed lending, one-month term, fee determined by auction; UK (special liquidity scheme) - primary means of liquidity support, up to three-year term, fee set at opening three-month LIBOR / overnight index swap (OIS) rate.

• Central bank collateral requirements: US - wide range of assets eligible for discount window access, including performing subprime mortgages; UK - minimum requirement of AAA rating for all facilities.

• Direct central bank lending to corporate sector: US - Fed to buy three-month unsecured commercial paper at 200 bp spread over OIS rate; UK - over Mervyn King's dead body.
  

The penal conditions being imposed on British banks place them at a competitive disadvantage to their US counterparts, increasing the risk that they will require prolonged public support or even eventual full nationalisation.

Northern Rock remains on track to repay its borrowing from the Treasury / Bank of England by early next year, in line with the forecast made here. Net of deposits held at the Bank of England, the loan stood at £11.5 billion at end-September, down from £17.5 billion in June and £26.9 billion at end-2007. The £6.0 billion fall last quarter reflected ongoing mortgage redemptions together with retail inflows of £3.0 billion, with savers attracted by Rock's government guarantee and competitive savings rates (recently reduced).

The loan will be reduced by a further £3 billion when the Treasury converts part of the remaining debt into equity, as announced in August.

As argued previously, Northern Rock’s retreat from the mortgage market is exacerbating economic and financial stresses. Economy-wide net mortgage lending totalled £108 billion last year, of which Rock contributed £13 billion. This year net lending may fall to £40 billion, with Rock cutting outstanding loans by £20 billion. In other words, its U-turn accounts for about half of the fall in mortgage lending between 2007 and 2008.

The rapid liquidation of Northern Rock’s mortgage book, possibly to be followed by Bradford & Bingley’s, is clearly inconsistent with the government’s insistence that banks participating in its recapitalisation scheme maintain lending to homeowners and small businesses at 2007 levels.

Similarly, official exhortations to banks to increase their interbank lending sit uncomfortably with Rock’s hoarding of cash at the Bank of England. Deposits stood at £7.1 billion at the end of September, equivalent to 7-8% of assets. Other banks currently hold less than 2% of their assets in reserve balances with the Bank.

The UK's credit guarantee scheme is designed to unclog markets rather than offer banks cheap funding.

The Debt Management Office has announced that the guarantee fee will be 50 basis points per annum plus the median five-year credit default swap spread for the borrowing institution during the 12 months to 7 October. Averaged across banks, this spread is likely to be in the region of 100 bp (see Chart 1.3 in the August Inflation Report), implying a total fee of about 150 bp.

According to Bank of England, the one-year interest rate on unsecured commercial bank borrowing stood at 5.8% late last week, 240 bp above the rate on government borrowing. A fee of 150 bp would therefore allow a significant reduction in banks’ cost of funding compared with recent extreme levels.

Also welcome is that the fee will be not be linked to current CDS prices. As previously argued, the effectiveness of the special liquidity scheme (SLS) has been reduced because it becomes more expensive when LIBOR rates rise – the time banks most need to use it.

However, an all-in cost 150 bp above government borrowing rates still represents expensive funding by historical standards – the differential between one-year rates for unsecured bank and government borrowing averaged 30 bp in the 10 years to mid-2007, before the credit crisis erupted. This suggests the spreads of household and corporate borrowing rates above Bank rate will remain under upward pressure, while banks’ efforts to rebuild capital from retained earnings will be constrained.

The new scheme will be a big earner for the Treasury: 150 bp on an expected £250 billion take-up equates to £3.75 billion per annum. The SLS is likely to generate a further £1.5 billion (based on an assumed average 75 bp fee on take-up of £200 billion), suggesting a total payment from banks to the Treasury / Bank of England of about £5.25 billion pa.

The Treasury statement on recapitalisation plans states that the banks concerned have agreed to maintain lending to homeowners and small businesses at 2007 levels over the next three years. While helpful, this begs the question of why the government is allowing Northern Rock to shrink its mortgage book by £20 billion per annum in 2008 and 2009. Rock borrowers forced to refinance their loans are absorbing a significant portion of other banks’ lending capacity.

In 2002 a colleague suggested I compare the bear market then under way with previous big falls in share prices. The three largest peak-to-trough declines in UK shares over the prior 100 years were 1929-32, 1936-40 and 1972-74. I rebased the respective bull market peaks to the FTSE 100 peak in 2000 and calculated an average of subsequent performance. Smoothing this average generated our “three bears forecast”.

As the first chart shows, the three bears forecast proved remarkably accurate in pinpointing the level and timing of the low in share prices in the early 2000s as well as the tracking the recovery over the subsequent four years.

The second chart decomposes the forecast into its three historical components. The latter began to diverge significantly in late 2007, suggesting the forecast – based on the average – would break down, as it has indeed done.

There may, however, be some life left in this data-mining exercise. As the second chart shows, stocks seem to be following the pattern of the interwar years. The early 2000s bear market tracked the 1929-32 decline while recent falls so far mirror the 1936-40 bear.

The third chart extends the interwar comparison over the next five years. Share prices are now below the historical template, suggesting a near-term rally. An extended plateau is then indicated followed by a final lurch down to a bottom around the levels reached in 2003. A sustainable recovery occurs only in 2011.

The 1936-40 bear market initially reflected a US recession but was extended in duration and magnitude by the onset of the Second World War – the final move down in 1940 coincided with the Battle of Britain. The current financial crisis is momentous but it is hard to believe it represents a threat to the British economy on a par with Nazi invasion.

It would be unwise to place strong weight on mechanical historical comparisons but the suggestion of an imminent base followed by an extended sideways movement is plausible. Valuations are now low – the price to book ratio of UK non-financial stocks is at levels last reached in 1992 – but buyers are likely to be slow to return after the confidence-shattering events of recent months.

The success of the UK banking rescue plan will depend importantly on yet-to-be-announced terms and conditions. The authorities need to strike a balance between protecting taxpayers’ interests and providing some upside for equity holders – necessary to stem the downward spiral in share prices and attract new private sector capital.

A key issue is the fee to be charged by the government for guaranteeing an expected £250 billion of bank debt. As argued previously, the effectiveness of the special liquidity scheme has been reduced by its perverse fee structure. The Bank of England charges banks the spread between three-month LIBOR and the three-month rate on government borrowing. This means the scheme becomes more expensive when LIBOR rates rise – the time banks most need to use it.

The fee charged for guaranteeing debt must reflect the strength of the institution concerned but should not depend on volatile market assessments, such as credit default swaps. One possibility would be to base the charge on the amount borrowed and the credit rating of junior bank debt.

Similarly, the terms of new government-subscribed capital issues should not be unduly onerous. Demanding a Buffett-style 10% yield along with interference in dividend policy and other decisions affecting future ordinary shareholder returns might generate short-term political plaudits but could prove self-defeating.

The £100 billion expansion to £200 billion in the special liquidity scheme does not represent a new initiative, since there was no previous upper limit on banks’ access to the facility. The extension of the definition of eligible securities for the scheme to include new government-guaranteed bank debt also appears of little consequence – it is unclear why banks would wish to pay a fee (charged on top of the guarantee fee) to swap such government-backed paper for Treasury bills of the same credit rating.

Unlike the Fed and the ECB, the Bank of England has yet to allow securities rated lower than AAA to be used as collateral in its money market operations. This may partly explain the undersubscription of its £40 billion auction of three-month funds this week. It is doubtful that the long-awaited plans for a new discount window facility, to be revealed next week, will loosen collateral requirements further.

The one percentage point rate cut in Australia overnight has increased speculation that major central banks are planning to “shock” markets with large-scale and/or co-ordinated interest rate action.

When analysing past interest rate decisions in order to construct the MPC-ometer, I found the MPC had behaved unusually following the 9/11 terrorist attacks, cutting rates earlier and by more than suggested by economic and financial data. This was counterbalanced by a less dovish stance than warranted by incoming news in later months. I accommodated this behaviour in the model by including a 9/11 “dummy variable”.

Escalating financial turmoil in recent days risks damaging economic confidence in a similar way to the 9/11 attacks, suggesting the MPC will again choose to bring forward easing as insurance against a worst-case scenario.

In terms of the MPC-ometer, this can be analysed by “switching on” the 9/11 dummy variable. Using the model to predict this week’s decision based on the current level of Bank rate, the forecast then changes from a quarter- to a half-point cut. If three-month LIBOR is used instead of Bank rate, a three-quarter point move is predicted.

If the post-9/11 period is a guide, however, any shock move this week will represent a shift in the timing of MPC action rather than implying a lower ultimate level of official rates.

A week ago most economists thought it was too early to cut rates. Now there will be disappointment with a half-point reduction.