Avoiding bank bailouts: it's not that simple

The Franco-Belgian-Luxembourgish bank Dexia, which was always a mongrel beast, has become the first European bank to fall into state hands as the sovereign debt crisis rumbles on. The bank is to be broken up, with the viable bits recapitalised. If you believe in the cockroach theory, Dexia is unlikely to be the only Eurozone bank to meet this fate.

Here in the UK, of course, the previous government undertook a major recapitalisation of the UK banking system back in 2008, a process that Gordon Brown immodestly claimed in the House of Commons had "saved the world". Despite last week's Moody's downgrades, most UK banks are now considered to be at much less risk than their Eurozone counterparts. However, that isn't stopping some commentators from contemplating what should be done if the worst were to happen, and the banks came back to Downing Street cap in hand, looking for a second bailout.

One man who has come up with a detailed plan is the right-wing doomster Andrew Lilico, whose profile has risen sharply in the past few weeks despite his resemblance, both in appearance and in manner of speech, to Mitchell and Webb's character "Sir Digby Chicken-Caesar". Lilico has laid out his ideas in a column in today's Daily Telegraph.

In brief, Lilico wants no further taxpayer injections into the banking system. He wants unlimited liquidity support for fully solvent banks; forced conversion of senior debt into equity for banks that are heading for insolvency but have a viable business model; and break-up or winding down of clearly insolvent banks.

Can anyone seriously doubt that Messrs Brown and Darling would have chosen such a course back in 2008 if it had been at all practicable? It's not as if they wanted to hurl huge wads of taxpayers' money into the RBS/Lloyds abyss, but the tight timeframe they were faced with and the uncertainty over the true viability of the banks left them very little choice in the matter.

There may seem to be more time to plan for a Lilico-style tough love approach now, but if another crisis really does come along, it's unlikely that the government will have the luxury of sorting the banks into the three categories Lilico describes and dealing with them accordingly. Banks are by their very nature extremely complex black boxes that are all but impossible for outsiders to understand, let alone understand quickly.

Even Northern Rock might well have looked solvent to an outside observer just before it failed. Its asset portfolio, mainly consisting of its mortgage book, was of good quality, and this alone might have been taken as evidence that the bank was solvent. Its main area of vulnerability was its funding model, which relied far too heavily on wholesale deposits, and caused the bank to collapse when interbank lending abruptly dried up.

All of the UK's banks have been busy drawing up "living wills" to be filed with the regulatory authorities. These are meant to be plans for orderly wind-down of each institution in the event that it runs into serious trouble. In principle, the existence of these "wills" would make Andrew Lilico's approach more feasible -- though of course, there's zero chance of any bank's "will" admitting that the institution is close to insolvency. If (heaven forbid) a UK bank finds itself teetering on the brink of insolvency some time in the coming months, with depositors lined up outside its branches, it would be a brave government that would opt to let it fail just to prove a point of principle.