Published: September 18 2008 03:00

Yesterday morning Lloyds TSB's prospective takeover of Halifax Bank of Scotland stalled the downward spiral of the HBOS share price. By the time the London market closed, shares in Britain's biggest mortgage lender had fallen another 19 per cent. In the current volatility perhaps only a full statement of the terms of a deal would have provided enough reassurance to investors that HBOS's woes were over. So last night's deal for a private sector bail-out, encouraged by Gordon Brown, the prime minister, offer the best way forward.

The steep decline in HBOS's share price after Lehman Brothers's implosion on Monday meant time was running out for Britain's biggest mortgage lender. The collapse of the US investment bank put it in a very difficult position. HBOS's wholesale funding commitments of £278bn and an estimated funding gap of £197.8bn made it vulnerable when banks became wary of lending to each other. As interbank lending rates soared, the markets' belief in the bank's ability to meet those commitments dimmed. It was a crisis of confidence, rather than just speculative short-selling by hedge funds, that drove the bank's shares sharply lower.

Simply to let events run their course could have led to a catastrophe. The potential financial and economic repercussions of a run on a bank with 22m customers do not bear contemplation. If Northern Rock was bad, ministers are well aware this would be far worse. An HBOS collapse would turn a property downturn into a crisis. Credit lines to millions of households and businesses would be cut. The bank's 2m private shareholders would be left with nothing. Worst, the failure of the bank could bring down other banks forced to make asset writedowns as a result.

With nationalisation a last resort in the event of such a loss of confidence, the prime minister and Alistair Darling, chancellor of the exchequer, were understandably keen to facilitate a private deal. With Northern Rock already on the government's books, there would rightly be little appetite to take on HBOS's £600bn-plus balance sheet as well.

The Bank of England's extension until the end of January of its special liquidity scheme, a temporary facility through which banks can swap mortgage loans for more liquid government bonds, will provide short-term relief to the battered sector. But for a merged Lloyds TSB and HBOS, a more durable solution to the funding gap will be needed.Lloyds TSB's strong retail deposit base makes it relatively robust. But the bank's balance sheet is only about half the size of HBOS's, suggesting it may struggle to absorb its bigger rival unaided.

For Lloyds TSB, the prize is a share of the UK savings and home loans market it would - rightly - not normally be able to buy. Indeed, in 2001, the bank's bid for Abbey was blocked on competition grounds.Now the government appears ready to override those concerns - which is understandable in these circumstances. A bigger share of the UK property market may seem a doubtful benefit right now. But, assuming the housing market stabilises at some point, the deal should give the merged bank dominance of the sector. That will need careful monitoring.

So far, the authorities' handling of the HBOS crisis suggests they have learnt lessons from Northern Rock. This time, instead of dithering over a sale while savers queued to withdraw their money, they have acted promptly. In doing so, they appear to have found a way forward that leaves something for 2m shareholders.A merged bank, moreover, rather than the Treasury will have to take unpopular decisions on the job losses and branch closures needed for this deal to make sense. But the underlying test will be whether this private sector solution can work without support from the taxpayer.

Source:- http://www.ft.com/cms/s/0/870143c0-8519-11dd-b148-0000779fd18c.html