Jeremy Warner's Outlook: Brown needs to be more bold in dealing with banking crisis

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The Independent Online

The politics of the credit crunch have become almost as interesting as the economics, not just in the US, but here in Britain too. For the first time since he ducked out of calling a snap, early general election a year ago, Gordon Brown has the chance to seize back the political initiative with some bold decision-making that restores the reputation he once enjoyed as the "iron Chancellor".

David Cameron's electoral renaissance, meanwhile, is being overshadowed by events in the markets. Can the Prime Minister rise to the occasion, or will he fall back into the state of indecisive nothingness which has so far characterised his premiership? The events of the last couple of weeks certainly seem to indicate renewed vigour, even if the attempt to portray Mr Brown as "the man you can trust in a crisis" continues to look somewhat incredulous. That judgement can only be made when we know the outcome.

Yet the lessons of Northern Rock have plainly been learned. There was no similar faffing around with Bradford & Bingley, where swift and effective action has been taken to safeguard depositors' money. The Government also acted boldly in suspending competition rules to allow the takeover of Halifax Bank of Scotland by Lloyds TSB. Without this takeover, HBOS would almost certainly have ended up in national ownership too.

Unfortunately, none of these actions has solved the problem. The financial crisis remains as acute as ever, with credit markets almost completely frozen and confidence in the banking system at rock bottom. Post the collapse of Lehman, the only lending of any significance going on is overnight money. Deposits are fleeing private-sector banks to be stuck into anything regarded as even remotely lower risk, from gold to government bonds and now, thanks to the state guarantee, even Irish banks.

Meanwhile, evidence of serious knock-on consequences into the wider economy continues to mount at an alarming rate. The latest example is Marks & Spencer, which is sharply reducing its capital spending to conserve cash and cope with the downturn in sales. According to figures released yesterday, housing starts have slumped to close to a 50-year low. And, according to a Bank of England survey also published yesterday, the supply of credit to the real economy is contin-uing to tighten across the board.

More, plainly, has to be done, to restore confidence in the banking system and to mitigate the consequences of the financial crisis for the wider economy. But what? One thing seems certain. Tomorrow's "summit" in Paris of the leaders of Europe's four biggest economies won't provide the answer. Vague proposals for a European version of the Paulson plan to buy bad debts off troubled banks have already been shot down by Germany and would in any case be inappropriate for European markets, where there is no comparable bad-debt problem.

European leaders will huff and puff over the rights and wrongs of Ireland's unilateral decision to guarantee all bank deposits but everyone knows that in extremis they would do exactly the same, and Ireland's ability to suck in deposits from the rest of Europe will become self-limiting once it is realised that in a small country such as Ireland there are limits to the government's ability to underwrite these funds with taxpayers' money.

It's hard to see anything else of any practical significance coming out of the summit. It's far too late for measures such as the suspension of mark-to-market accounting to have any positive effect. Removing the transparency of these accounting rules at this late stage will only further undermine confidence. In any case, the urgency of the situation requires much swifter action than European leaders are capable of collectively. The whole banking system will have collapsed in the time it takes to reach a consensus. As Ireland recognised in guaranteeing its deposit base, each nation state has to act for itself.

So what should Mr Brown do? Let's nail the deposit guarantee idea first. This would only be appropriate in circumstances where one of the major UK banks, such as Royal Bank of Scotland or Barclays, came under threat. Such an eventuality shouldn't altogether be discounted. If HBOS can be subjected to a wholesale and retail run, so too can others. HBOS's ratio of loans to deposits is around 170 per cent but RBS and Barclays are not so very far behind, and, in absolute terms, their reliance on short-term wholesale funding is much higher, as they both have balance sheets of considerably bigger size. They will be struggling in these markets too.

As I say, if one of them started to go the same way as HBOS, the Government would be forced to hit the guarantee button, as it did before nationalisation with Northern Rock. But at this stage, it is intent on avoiding such action, if only because of the cost to the public finances of underwriting bank liabilities on such a scale. Nor is it a good solution anyway, for it amounts to part-nationalisation. The taxpayer would be on the hook for all the liabilities but without any apparent call on the assets.

So what about a UK version of the good bank/bad bank mechanics of the Paulson plan in the US? In its US form, this is not such a great idea either, for it is not apparent at this stage that there is a bad-debt problem in the UK of anything like the severity being experienced in the US.

Mortgage defaults and arrears are still running at less than 25 per cent of the level they were at in the last housing crash of the early 1990s. This rate of default is bound to get worse but is also likely to remain within the ability of all UK banks to cope.

If there is no problem with bad debts, there is, unfortunately, a severe difficulty with funding the debts, and this in turn has made the banks look critically undercap-italised. As long as there was an excess of liquidity in the system, banks didn't need a whole lot of cap-ital. As soon as this liquidity dries up, they need much more of the stuff to pay their liabilities as they fall due.

One possible solution for the Government would therefore be a version of the Paulson plan where illiquid assets are bought or borrowed from banks at a set discount to maturity values in return for liquidity. There is already a template for such a plan in the Special Liquidity Scheme (SLS). This might be adjusted to accept a wider range of collateral on different terms.

To safeguard the taxpayer against the possibility of a sharp deterioration in the quality or value of the assets, the Government would be issued with preference shares in the banks that participated. In this way, both the funding and the capital problems of the banks might be addressed at the same time. The taxpayers' particip-ation in the equity through preference shares would start the process of recapitalisation the banks need.

It's too late to cry over spilt milk now, but the strong ideological stance adopted by the Governor of the Bank of England on moral hazard hasn't helped matters. It is all very well to make bankers suffer the consequences of bad lending decisions but to extend the idea of punishment to issues of liquidity and funding was plainly a mistake. Though the Governor has listened, learned and adapted, it seems to have been reluctantly. Allowing confusion to reign over whether the SLS might be extended, or what might replace it if it wasn't, further damaged already shattered confidence in money markets. It is now obvious that, if anything, the scope and size of the SLS need to be greatly expanded.

The authorities believe that, in dealing with Bradford & Bingley, they have lanced the last of the "problem banks". This doesn't seem likely. The problem in funding mortgages has moved on to other forms of lending, from car loans to credit cards and some forms of corporate debt.

If, at the start of the crisis, the Governor had made clear that, in conditions where liquidity dried up, the Bank would always be there to make up the difference, HBOS and others might not have been reduced to the penury they are in today. The Bank can't be blamed in any way for the crisis, which is at root down to Westerners living beyond their means on borrowed money. Yet the crisis might not be as bad if the response had not been so ideologically driven.

The Bank of England has been an outlyer among central banks in believing that the principles of moral hazard need defending in all circumstances, including those where the very fabric of the banking system is threatened. The 19th-century economist and journalist Walter Bagehot observed that, when the banking system gets sick, the authorities have no option if they want to ensure the continued prosperity of the economy but to treat the patient until the fever goes away.

Bagehot drew a distinction between banks that were merely illiquid and therefore deserving of support, and those that were insolvent and should be left to fail. In today's highly connected money markets, that distinction might no longer be possible. The authorities must bail out good and bad banks together.