Hamish McRae: Project Merlin has yet to work its magic, but banks will have to start lending soon

Economic View
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The Independent Online

How on earth are we going to get banks to lend more to businesses? And if we can’t, what then?

On Monday, we get the first numbers from the Bank of England for bank lending following the agreement between the Government and the main lenders in February – the deal that came to be known as Project Merlin. As part of the deal, the banks agreed to lend £190bn of new credit to businesses this year, with £76bn going to small- and medium sized enterprises. If there was demand for more funds, the banks agreed to increase the numbers beyond those totals.

So we will see if Merlin seems to be working. These are early days yet but the row last week, with both David Cameron and Vince Cable attacking the banks, does not bode well. Looking at other data it seems that lending to large companies has indeed been climbing, but small and medium-sized ones are still finding it hard to convince bankers of their credit-worthiness.

Even if the initial lending numbers have nudged up a bit, do not expect the concerns to go away. The worries may well intensify for a number of reasons.

To catch a feeling for what is happening, the best place to start is with the mortgage market, for it too has experienced a collapse of lending. The main graph tells the story: gross mortgage lending is running at about £10bn a month, less than one-third of the level at the peak in 2007, and lower than it was in 2002 when house prices were half the level of today. So relative to house prices, mortgage lending is running at the lowest level for a generation. But the result has not been an absolute collapse in house prices.They came down from their peak, recovered a bit and now are more or less stable, maybe down bit, as the right-hand graph shows.

So why have prices managed to stay reasonably stable when the flow of new money has virtually dried up? It is partly that people who don’t need to sell have taken their homes off the market. Demand has fallen but so has supply. It is also that people are finding other ways of financing a house purchase: using spare cash earning near zero interest, borrowing from family, selling assets, whatever. But the mortgage famine has not attracted as much political aggro as the business loans famine. I am not sure why. True, the whole recovery depends very much onsmall and medium-sized firms taking on more people. (There is a rule of thumb that big firms tend to cut jobs while small ones create them.) But the dearth of mortgages is the main reason why house-building has slowed so much, and building a house creates jobs too. You don’t need to want another housing boom to want reasonable availability of mortgage finance.

What is happening to company lending is very similar to mortgage lending. The boom sucked in more lenders, foreign banks in particular, and there was a huge amount of financial experimentation with new, complicated lending products. When the banking crash began, most of the foreign banks withdrew from the UK, and the complex-products business collapsed. Worse, the ability of banks to fund themselves on the money markets was severely weakened. They did not quite reach a situation where they had to rely on their branches to collect retail deposits and fund themselves that way, but for some it came close.

It gets worse still. The banks are buying huge slugs of government stock because they have to hold these “safe” assets to comply with capital requirements. You could almost say, vastly over-simplifying, that because the Government has to borrow so much, that leaves less money for commerce and industry to borrow. But beyond that, there is an inevitable worry among bankers that having lost large amounts of money to duff borrowers they should only lend now to completely sound ones. It is human nature to over-compensate for your past mistakes however regrettable that might be.

Human nature also shapes borrowers’ attitudes. If you, running a small firm, found your friendly banker suddenly difficult last year, clamping down on overdrafts and threatening retribution if you did not cut your borrowings, you would be determined not to put yourself in hock again. Banks have done themselves huge reputational damage by flipping from spraying the money around to clawing it all back. That damage will last a generation.

So what’s to be done? Well, the first thing to recognise is that we will need more bank lending as the recovery deepens. As growth comes through, companies need more working capital. It may seem counter-intuitive but the early stages of recovery put companies under financial pressure: yes, they have more demand for their goods and services, but they have to gear up to meet it. So let’s see how Project Merlin develops, because it is a fundamentally useful approach.

But there are also concerns about the UK’s banking structure. We have too few banks to ensure reasonable competition. It was clearly a disaster to allow Lloyds to take over HBOS, and the question is towhat extent that merger should be unwound. The received wisdom is that it is too late to split the banks completely and that to attempt to do so would cut the price that the taxpayer would get for the rump shareholding held by the Government. That judgement needs to be tested. As for Royal Bank of Scotland, the issue is whether forcing it to sell a few branches is sufficient to boost competition in business banking.

There are other ideas too. The new British retail banks, for one. There is a case for seeing whether the foreign banks that withdrew from the British market could be enticed back. And there is a strong argument for supporting all the initiatives whereby companies should rely less on bank finance and more on other sources of capital. Why are taxes skewed to make loan finance cheaper than equity finance? Opening capital markets to smaller companies should be a top priority.

And if banking is going to be, in relative terms at least, a smaller industry, then we have to accept that firms will find it harder to get bank loans. That is elementary maths. So do we really want a smaller banking industry?

Eurozone battle will steal the spotlight from latest British borrowing figures

It is a busy week coming up. It is always silly to be over-influenced by any one set of data but one worth watching will be the first figures for government borrowing in the new financial year, the figures for April to be published on Tuesday.

The Office for Budgetary Responsibility projects that public borrowing this financial year will be £24bn lower than last and this will give us the first feel as to whether the Government is on track for that. Leave aside the spending and focus on the tax: is the extra revenue coming in and which bits of the tax-gathering net are doing their bit? Or is there push-back, as people adjust to higher tax rates by changing their habits?

The other thing that will attract headlines will be the second estimate of GDP for the first three months of the year. You may recall that the initial estimate was for growth of only 0.5 per cent, disappointing after the fall recorded in the final quarter of last year.

Given the reasonably strong rise in employment, including full-time jobs, you might expect an upward revision, but while that would be welcome, remember that these figures get revised up to three or four years after they come out. We will not know the full picture for some time.

But I suspect that the UK economy will not be in the front line this week: the star role will be reserved for the eurozone, and in particular for Greece. I am afraid that the row between the German government (which wants holders of Greek debt to agree to extend the maturity of that debt) and the European Central Bank (which says Greece must stick to its agreed schedule) will get worse.

As a result, both Ireland and Portugal are also finding the market interest on their debt rising – in the expectation that they may have to restructure too. We are not through this yet, as we will be reminded in the next few days.