Ben Chu: Will the authorities ever tire of flogging this dead banking horse?

Outlook What goes through the head of someone when they're flogging a dead horse? Do they imagine that if they only put more vigour into the beating the beast will advance? Perhaps they think a different whip will do the trick. Or maybe a juicy carrot will induce movement. Such questions put us in mind of the Funding for Lending Scheme.

The Coalition has been attempting to cajole and tempt our banks into increasing lending to the small business sector for two years now. First, in 2011, we had Project Merlin, in which the banks agreed gross lending targets with the Treasury for SME lending in return for a free hand to pay large bonuses to their heroic traders. Gross lending to the sector did indeed rise. But net lending fell. This was followed a year later by the National Loan Guarantee Scheme, in which the Treasury offered to guarantee banks' wholesale funding in return for an agreement from managements to boost SME lending. Net lending continued to fall.

Then, last summer, the Bank of England took charge of the effort with the FLS, offering the banks cheap loans from Threadneedle Street in return for more SME loans. Over the first five months of the scheme net lending to businesses has continued to decline, even though the banks availed themselves of £14bn of cheap loans. We were told by the Bank's Governor, Sir Mervyn King, last October that the scheme provided "powerful incentives" for the banks to lend. Well they clearly weren't powerful enough, because yesterday the FLS was relaunched with even bigger incentives for lending to SMEs. The Bank of England and the Treasury are trying out a new carrot.

But the commercial banks have already been playing down expectations that lending will rise, claiming, as usual, that the problem is that small firms just don't want to borrow. Thus speaks the dead horse.

What should be clear by now is that our big banks are dead set on deleveraging. These institutions – undercapitalised, mostly run by investment bankers, lacking in confidence in the recovery – have no interest in expanding small business lending.

That depressing mentality was on display in the Co-operative Bank's decision yesterday to pull the plug on its deal to buy a tranche of Lloyds' branches. The lender cited the UK's dire growth prospects and a fear of possible future loan impairments. If even the Co-op – one of our more enlightened banks – takes such a depressingly short-sighted view, it is no wonder that bigger lenders, with their vast books of questionable assets, are hunkering down.

Yet it's also clear by now that there is a need for more SME lending. Even Lloyd Blankfein, head of Goldman Sachs, rejects the mantra of his UK counterparts that there is a lack of demand for lending. "Businesses are starving for cash and banks have cash idle," he said on a visit to the UK this week.

So how to help those starving SMEs? The authorities first need to wake up to the fact that going through the existing banks is not going to work. The Archbishop of Canterbury, Justin Welby, is thinking on the right lines when he recommends the recapitalisation and break-up of one of our semi-nationalised lender into a series of regional lenders. Or the authorities should create a dedicated small business bank, as the former Monetary Policy Committee member Adam Posen proposed way back in September 2011.

But first things first: let's recognise that the horse we are presently trying to ride is deceased.

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