Applying the Chinese model

Last weekend’s litany of financial news clearly shows where the power in the system has shifted to over the past year: into state hands.

On Friday afternoon, the House of Representatives approved the US Treasury’s US$700bn banks rescue package at the second time of asking. On the same day, the Dutch government took control of Fortis’s assets, including ABN AMRO, in the Netherlands.

Then, over the weekend, many European governments, most notably Germany, decided to follow Ireland’s lead and guarantee all retail deposits in banks. In Iceland, the government looked as if it would go one step further and end up running the nation’s remaining banks.

And by Monday morning, the UK government was reported to be considering filling the banks’ funding gap between deposits and loans by providing capital in return for stakes in the country’s major lenders.

For some time, or at least as long as the wholesale banking market has ceased to function in any meaningful sense, banks have faced a stark choice of how to finance their activities: increase customer deposits or raise new capital from third parties.

Of course, there is a limit to how much privately held cash there is in the country, and how much of this savers are prepared to put in banks. Who can blame them when there are safer alternatives, such as government bonds or government-guaranteed banks like Northern Rock or any Irish lender?

It seems that there is also a limit to the amount that cash-rich capital providers are prepared to stump up for Western financial institutions with deposit-light balance sheets. The number of willing state funds has shrunk after many got burnt stepping in too early last year, to assist Merrill Lynch for example. And Warren Buffetts don’t grow on trees.

The next port of call is better-capitalised banks, prepared to buy out rivals at knockdown prices. Hence, BNP has rescued Fortis’s Belgian and Luxemburg banking operations and Bank of America and JPMorgan Chase have played important roles in the US. And Lloyds TSB is coming to the rescue of mortgage bank HBOS.

However, all these actions may seem insignificant if the banks still continue to mistrust each other and not borrow from anyone but central banks. A combined Lloyds TSB HBOS will still rely to a great extent on wholesale bank-to-bank loans.

If that is not forthcoming, there is only one option. Rather than allowing the Bank of England to keep filling the gap with loans below commercial rates, the government must step in and fill the gap with capital with greater equity characteristics.

Government intervention on such a scale merely puts the UK, Europe and the US in line with the state-sponsored capitalism of many emerging markets, such as China, most Gulf states, and, to a degree, Russia.

Observers have said for some time that sovereign wealth funds would be significant players in M&A over the coming decades. Few would have thought that quick-fix domestic state funds would be involved in distressed situations so soon themselves.

Where does this leave private equity? The lack of leverage has impacted on all sponsors of buyouts but, unlike lenders, many are in strong capital positions, having raised significant funds just before the downturn.

General partners might have to see if their limited partners are prepared to accept lower gearing, longer holding periods and reduced returns for the investments they back, if, as looks probable, the leverage drought continues.

However, some private equity firms have already sought support from sovereign wealth funds: notably Blackstone, which has the China Development Bank as a major shareholder, and Carlyle, backed by Abu Dhabi.

Such capital providers could replace banks as alternative sources of leverage, leaving these firms in a good position to pick up bargains thrown up by the market turmoil.