Hamish McRae: Merlin's all very well, but other banking changes are set to shape all our futures

Economic View
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So the Government has nudged the banks into lending more to industry.

Project Merlin, as it is called, is an agreement whereby banks will lend about £190bn to businesses this year – including £76bn to smaller firms – curb bonuses and reveal some salary details of their highest paid people.

Perhaps unsurprisingly it was not greeted with great acclaim by anyone. The banks found themselves landed with an extra tax the day after they had signed, the Opposition claimed that it was inadequate, and a Liberal grandee managed to get himself sacked for attacking it too.

Standard stuff. But actually there are two things happening in the world of banking that will shape all our futures and are surely more interesting than the argy-bargy over bonuses. One is that banking is becoming less international; the other that banks are playing a less important role in financial intermediation.

The first is happening at several levels. One of the reasons why banks got into such a mess is that they started lending outside their national boundaries. For example, Bank of Scotland plunged into Irish property at crazily low interest rates, regional German banks bought swathes of US sub-prime mortgages, and many European banks hold sovereign debt of Greece, Ireland and Portugal. Here in Britain, the main reason why the number of new mortgages has halved is because the fringe lenders, mostly foreign, have pulled out, leaving the main UK lenders the only suppliers of credit.

It goes further. The deal that brought down Royal Bank of Scotland was buying ABN Amro, a Dutch bank, while even the mighty HSBC was severely damaged by losses of an ill-judged acquisition in the US.

There is the obvious moral that you should not go into markets you don't understand, and this will inhibit cross-border mergers for a decade, or longer. As a result, there will, inevitably, be less competition in commercial banking. There is already less competition in British banking, which is why the Government has stepped in to try to boost lending. As you can see from the right-hand graph, net lending to small and medium-sized businesses went negative towards the end of 2009 and has remained so. Lending to small businesses is running even lower. (The stats come from different sources, the Government and the banks, and the bank figures cover a narrower segment of the market, hence the different profiles.)

So one inevitable result of this withdrawal of foreign and fringe banks from the UK market has been a fall in the level of competition in banking. Were there a decent level of competition, the Government would not be trying to nudge the banks into increasing their loans. Governments don't have to nudge car makers to sell more cars, or supermarkets to sell more food.

If you are not convinced by that, consider one further point. Obviously banks will not lend money, indeed should not lend money, if they think the borrower is unlikely to be able to repay. But if you look at delinquency rates on different types of loan the two areas where they have risen least have been mortgages and loans to businesses. Both have gone up a bit, as you can see from the main graph. But they are still lower than during the early-1990s recession. The form of lending that has become most dangerous, from the lenders' point of view, is consumer credit. Some 7 per cent of loans go sour, more than double the percentage of the early 1990s. Indeed, even during the boom years of 2006 and 2007 delinquency rates were rising. Yet there seems to be no shortage of consumer credit now. The rates are high enough to make it profitable and as a result non-British banks are still active in the market. There is no government pressure for them to lend more because there is no need for it.

The second big change is disintermediation. It is a horrid expression, so a word of explanation. If you or I deposit money in a bank and that bank uses it to make a loan to a company, it is the intermediary between the two of us. It carries the risk of default. If on the other hand a company makes a new share issue and we buy shares, we pay the money to the company and we carry the risk. There is no intermediary. So a shift from bank finance to market finance is known as disintermediation.

As it happens I have been chatting recently with a couple of people who help run huge enterprises, one in New York and the other in London. In both cases they went out and raised a large wodge of money from the markets, the thick end of a billion dollars in the US case, because they did not want to have to borrow from their banks. There is plenty of money around; it is just that people would rather lend it directly to sound companies and carry the risk themselves rather than deposit it at a bank, get a dreadful rate of interest on it, and hand the profit to the bank.

Of course this is more awkward to do in our personal lives: you cannot go to the stock market and issue some bonds rather than get a mortgage. But at a family level – parents lending to children to buy their first home – this does seem to be happening more and more.

Now the interesting question is how far this goes. Until the 1960s UK companies relied much more on market finance, with banks only lending for short periods on overdraft. That all changed with fixed-term loans, the development of the money markets, the growth of syndicated lending and so on. Clearly we are going back some way towards that older model. You cannot uninvent all the new lending techniques developed by the banks over the past half-century, even if you wanted to. But you can use regulation to curb the excesses and, even more important, it may be that people will try and avoid using banks as intermediaries insofar as they can do so.

Don't get me wrong. Banks are not going to disappear by any means. Quite aside from continuing to carry the risk of loan defaults, they will continue to organise fund-raising on the equity and bond markets. But it is plausible that their relative position will tend to shrink over the next generation. Quite simply, we will come to rely less on them.

London lacks vision and is the deserved loser in the stock exchange mergers

So the London Stock Exchange teams up with Toronto while the German Stock Exchange joins with New York. You don't need to know anything about stock exchanges to think this a bit rum.

The London Stock Exchange has failed strategically while the NYSE has played its hand well. The main London error was its failure to take over Liffe, the London futures market, foolishly allowing Euronext, a merger of its Amsterdam, Brussels and Paris competitors, to do so for a small premium. New York then merged with Euronext and now proposes to extent its footprint further if the regulators agree: Euronext owns Liffe while the German Borse has Eurex which would mean they control 90 per cent ofl Europe's derivatives trading.

There are three further issues. One is to what extent it actually matters who owns a stock exchange, or indeed anything else. You could argue that what matters is where the business is done rather than the ownership, but it is hard not to feel uncomfortable at the eclipse of the LSE.

The second is what will happen in Asia. The dominant exchange will be in China, and Goldman Sachs has projected that the capitalisation of Chinese stock markets will be greater than North American ones within 20 years. But will the winner there be Hong Kong or Shanghai? And how will Mumbai fit in?

The final issue is whether there are really practical advantages in having a single global stock exchange, or maybe two or three competing ones. The very idea would have seemed absurd a decade ago but we are in a world where brand and culture matter more than physical location. Exchanges are still branded by the cities in which they were originally located.

Maybe that is an idea of the past, in which case London might be able to claw its way back. But I suspect we lack the strategic vision for something like that.