If you tell banks they must be safer, don't be surprised if they cut back their riskier forms of lending. This inconsistency in public policy has just been highlighted by an outburst by Vince Cable, attacking the Bank of England for being "capital Taliban" in imposing higher capital requirements on banks, requirements that impair their capacity to lend to business.
I have some sympathy for his view because, as you can see in the top graph, the flow of funds to the UK private sector is abysmal. Indeed there is no net lending at all, and while the 12 per cent annual increase in lending at the height of the boom was bound to end in tears, having banks that won't lend anything does explain the sluggish nature of the recovery. But while there can be genuine concerns about the speed at which the Bank is requiring the banks to increase their capital ratios, the harsh truth is that having adequate capital is the core strength of any bank. It is the first line of defence when loans turn sour and if you want a system that will never have to be propped up by governments again, one of the two things they have to have is a solid capital base. The other? Cautious lending policies.
There is a genuine, and actually very interesting, debate about the balance between capital and caution. Some people argue that having a lot of capital is a less effective path to safety than lending only to people who are likely to pay back. Others prefer to stress capital adequacy. Of course, you have to have both and, of course, the key is pricing risk. There is nothing wrong with risky lending, for example for consumer purchases, provided you charge enough for the loan to cover the inevitable losses. You can see the write-off rates for different categories of lending in the other graph. Lending on property in the UK is inherently safe, whereas lending to consumers isn't. That is why we pay such high rates on credit cards. Lending to small business is somewhere in between, but note that while write-off rates on consumer lending have fallen back, those on business loans have not. Lending to a small business would now seem to be almost as risky as it was in the early 1990s slump, and more risky than at any time since the mid-1990s.
No wonder banks are cautious. It is an inevitable and understandable response to their over-exuberance five and more years ago and nothing Mr Cable says will change that. Indeed by attacking, as he put it some time back, "casino banking", he probably contributed to their present attitude. He intended by that remark to refer to investment rather than commercial banking, but their greatest losses have not in general been in investment banking but rather in commercial lending. The casino was, so to speak, a property development in the middle of Ireland.
This is not the only inconsistency in public policy towards the banks. The Government, reasonably enough, wants the best price for taxpayers' investments in the banks it rescued. Lloyds' share price is now higher than the price of the Government's investment, so we are in the money. Lloyds, incidentally, is now the second most valuable bank in Europe, having just nudged ahead of Santander. This is a tribute to its chief executive, Antonio Horta-Osorio, who was previously head of Santander's UK business. When the first tranche of our shareholding is sold, probably this financial year, he will have earned his bonus.
But the share price of Royal Bank of Scotland languishes. Why? Well it is partly that there was more rubbish to clear out, but also RBS has been subject to attacks by the Government and the Bank of England. Some of it was private over the lunch table: "Of course, they can cut back, but they have no vision for the future – that is why we will have to get rid of Hester," I was told by someone very senior in the world of officialdom.
The public attacks are something else. Thus Sir Mervyn King, when still Governor, called for RBS to be split into a "good bank" and a "bad bank". That was picked up by the Chancellor, and the Treasury is examining that. We will learn in September what they plan to do. Splitting off the duff loans from the ongoing banking business is a standard practice and can work perfectly well. But while there is a reasonable argument that RBS should have been split back in 2008, to bring it up now when it is three-quarters of the way through sorting itself out is nuts.
It is worse than that – it is destructive of the value of the bank. If you think there is a case for cleaning up things before the sale, you look at that quietly in private; you don't undermine management and staff with a half-thought-through proposal.
The big point here is that we have to patch the existing system rather than build one from new. It is unfortunate it is so damaged, though not as gravely as much of European banking, but there is no point in endlessly playing the blame game. If people have broken the law, that is one thing; if they have merely been stupid, that is another. There is always a choice between having a banking system that prioritises the safety of depositors and one that takes risks lending to businesses that may not be able to repay. We got the balance wrong one way and now we are probably getting the balance wrong the other. But we are inching in the right direction, and the sale of the first bit of Lloyds will be a signal of that.