Hamish McRae: A return to seeing thrift as a virtue means banks will play a smaller role

Economic view
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Banking is going to be different for a decade, maybe a generation. Step back from that grilling of the bank chiefs by the Treasury Select Committee last week and the fuss over the former HBOS chief who had gone to the Financial Services Authority and had to fall on his sword. Think, instead, about the substance of the debate. It was that banks cannot rely on wholesale markets to replace retail deposits.

That harsh truth is what changes banking, not the humiliation of the former bankers, nor the strictures about bonuses. If banks cannot rely on the markets to supply them with funds, they will have to collect the money themselves. They can do this in one of two ways, either in small amounts through a branch network, or in large dollops from commercial customers. But they must be aware of the fragility of both sources, with the second more fragile than the first because it is easier for customers to switch big deposits than to go round to a branch and take the money out.

To some extent, they will put spare cash back on to the money markets and to some extent they will be able to bid for deposits there. You cannot uninvent the money markets and a huge amount of effort is being made by the central banks to get them going again. The normal ways of doing this have so far pretty much failed and we are now promised unconventional methods, the so-called quantitative easing that the Bank of England may now adopt. If that sounds vaguely abdominal, you might recall, when the Bank was faced in the 1970s with the opposite problem (banks expanding their lending too fast), the measure used to squeeze them was called a "corset".

Eventually, the world's central banks will succeed in getting credit moving again. They have made the stuff cheap, but they have not yet made it plentiful. This is not just a UK problem. Credit has dried up in Europe, as well as in the British home-loans market. But it won't be back to business-as-usual because the whole attitude to credit will change.

A senior German official made the point the other day that Germany had never had a culture where people could borrow 125 per cent of the value of their homes on a mortgage. He was pretty contemptuous about British financial policy, and who could blame him. But, actually, we have already gone back some way towards the German home-loans model, where you have to put down a 25 per cent deposit before you can get a mortgage. The drying-up of the money markets has pushed us to that.

But the German banking model is not particularly robust either. They do not have the same personal lending exposure but, to generalise, they have more commercial exposure. The vulnerability there is that banks are closely engaged with their industrial and commercial customers, often having equity stakes in them, and in a downturn that leaves those banks vulnerable, too.

This will force change. When the dust settles and global growth resumes, probably some time in 2010, banks will remain cautious. The worse the downturn, the more cautious they will be. I have just been looking at some estimates by Goldman Sachs for the losses of European banks, and its general conclusion is that losses will be equivalent to something like 10 per cent of GDP. Losses equivalent to about 4 per cent of GDP have come out already, and Goldman expects rather more than that to come. It also makes the point, which seems to me to be on the button, that this is manageable within European governmental finances. If one did a separate exercise for the UK or US, I would guess the numbers would be of a similar magnitude.

Whether these losses are carried by taxpayers or by shareholders, the effect will be the same. Not only will taxpayers and shareholders alike demand bank managements behave differently; the career structure within banks will demand caution, too. You won't get promoted if too many of the loans you sanction turn out to be duds. The culture of banking, old banking that is, will return.

Central banks will reinforce this. Andrew Haldane, in charge of banking stability at the Bank of England, made an open speech on Friday about the failures of the banks' risk management and what needs to be done. Put at its simplest, the banks had risk models which were wrong, and they trusted the monetary authorities to bail them out if things went belly up. Instead of relying on their models (and the authorities), they should have relied on their common sense. And now the authorities would require a quite different approach, which emphasises testing banks' positions against all sorts of different stresses.

My takeaway from all this is that banks will now play a smaller role in financial intermediation both for individuals and for corporations. As individuals, we won't borrow as much. Before we buy something, we will save up for it, as we used to do. Many people who have become poor credit risks will find their access to credit more limited. Why, you might ask, should banks lend to people who are poor risks when there are people who are good risks who need the money?

For companies, the present emphasis on cash flow and finance from retained profits will become even more important. Smaller and more entrepreneurial companies will still flourish. but they will have to raise capital from investors rather than banks. As a result, the old separation between investment banks (which find investors with money) and commercial banks (who lend their own money) will return.

These changes will not be universally liked. But I cannot see any way round this. You can't, on the one hand, demand that banks be cautious and then blame them for being cautious. Individuals and investment institutions that control cash will, on the other hand, gain in their importance because they will make funds available when the banks cannot do so.

That leads to a final point: the return of thrift. We may be on the cusp of a big socioeconomic shift. We have had half a century when the developed world has gradually moved away from regarding thrift as a virtue. It has moved at different speeds in different countries, faster in the US and UK than in Germany or China. (Saving rates in China are huge.) We have created the institutional structure that has supported this shift: from credit cards to collateralised debt obligations (CDOs). The world has clearly reached a point where it can go no further down that road, and it would be natural to expect some reversal of the trend. The pendulum will swing back. How far and how fast we cannot tell, but we can be sure that debt will be regarded differently a generation from now.

The experts see light at the end of the tunnel – even if the markets don't

Things have plunged on down. The combination of the shaky path of the US stimulus package, dire forecasts in the new Bank of England Inflation Report, dreadful economic numbers for the eurozone and all the banking stuff made for a difficult week. So inevitably the question arises: where might the bottom be?

The Bank's view is worth a closer look. It was greeted as being profoundly gloomy and it was indeed much worse than the previous report three months earlier. But is this really the worse recession since the Second World War? Or for the past century, if you believe Ed Balls?

Actually, no. If you take the mid-point of the Bank's predictions and plot that against the three biggest recessions since the war, it turns out it is deeper than the early 1990s recession, but not as long, and not nearly as deep, as the 1980s one. True, it is worse than the first part of the 1970s recession, but that was a double dip and was in any event distorted by strikes.

Now it may be the Bank is still too optimistic and my own instinct is that we will not get back so swiftly to rapid growth. But if it is right that the bottom will be in the autumn of this year (again, I think that may be a bit early), we should be looking for a turning point in equities this summer as shares typically turn up three to six months before the economy does.

A number of investment banks and other advisers are now starting to write about this. Goldman Sachs has put out a paper noting this and suggesting shares are quite cheap by long-term standards. Smithers & Co, the London boutique adviser – which has been bearish up to now – has said the same.

If events now prove to be outside all post-War experience, of course, then all bets are off and it is hard to see any sustained recovery until it is clearer what is happening in the US. Still, that the people who had been bearish are now less so is fascinating. If there is no turning point in the markets in sight, there is a turning point in comment about them.

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