Business view: When a sick borrower is just what the doctor ordered for the bank

One indignant shareholder at Barclays' AGM last week was so incensed by the pay deal given to Matt Barrett that he queried whether the bank's genial Canadian chief executive was really worth the same as "10 high court judges". It could have been 30 doctors, 70 milkmen or 100 nurses. It doesn't matter. The rewards for running Britain's big corporations are beyond the comprehension of most people.

However, if Barclays, Royal Bank of Scotland or Lloyds TSB emerge from the current world economic malaise unscathed, you won't see too many shareholders complaining about the big pay deals. Abbey National has already spilt the red ink over its profit and loss account, HBOS is more exposed to the housing market than anything and HSBC and Standard Chartered, as we pointed out last week, will see their profits squeezed by the Sars crisis.

The big corporate lenders are in the business of funding business. And business, as anyone will tell you, is suffering. Exporters are pained by the problems of some of their biggest markets, notably Germany (which, I should remind those Eurosceptics out there, is a bigger buyer of UK goods than America). And at home, regardless of David Beckham's shopping spree last week, consumers are either staying away from the high street or keeping their credit cards on a tight leash when they go out. What with the war, Sars and the impact of last year's tax rises, it is not surprising that there are quite a few hospital cases in the UK corporate sector.

The thing is, for the banks, hospital cases are not necessarily bad news. It is when they go to the mortuary that the suffering begins.

What has happened over the past decade or so is that the banks have started taking out credit insurance for their larger corporate lending. How this works is that a third party, typically an insurer (but not necessarily as I will explain), will sell the bank cover for the loan so that it pays out if the borrower defaults.

In the world of high finance, nothing is quite this simple. When Enron went bust in late 1991, some insurers tried to wriggle out of paying out to the banks, and in the end a compromise was reached. This gave a massive boost to the traded credit insurance market, which essentially used sophisticated derivatives to cover the loans rather than boring old insurance policies. This was because the rules built up in the derivatives world over a number of years set out when and why someone should pay out, so avoiding the post-Enron wriggling.

Now here comes the bit when you see why poorly companies are good for the banks. If a company has, say, an "A" rating from the credit agencies, the insurance might cost x. But if the company has a lower rating, say "BB", the cover might cost y, which is more than x.

If a bank has bought credit insurance for a company that gets into some difficulty and has its credit rating cut, it can actually declare a profit. As the credit insurance is a tradable instrument, and banks value these instruments "market to market" (ie according to the price they are trading at when the financial year ends), they can say "this insurance which I bought for x is now worth y, so I have made a profit of y-x".

And it gets even better. The finance house that sold the insurance can say "I have a stock of financial products which were worth x but are now worth y, so I can raise my expectations of future profits by y-x". In other words, if a company goes from being healthy to a hospital case, everyone wins.

The problem, of course, comes if the situation gets worse. If the companies head towards the mortuary, needing a financial restructuring like Marconi or even going into administration, then all bets are off. Both the bank and the insurer have to declare a loss.

But one more thing makes this bizarre game even more insidious. A recent report by Fitch IBCA, the credit rating agency, showed that banks are now selling a third of all the credit insurance in the market. In other words, one bank is assuming the risks of another in order to make a fast buck. This means that if the world really goes into recession, the banking system is in desperate trouble.

Of course this is not to say that any of the UK banks are either selling credit insurance or using these excitable accoun- ting practices. But it is worth asking the senior executives about it before you sanction their multi-million-pound pay deals.

j.nisse@independent.co.uk