Outlook: A classic political fudge as Hoon mixes battlefield enemies

Banking bad debt; Solvency blues

The French had the champagne on ice but it was the Brits who were quietly toasting success after yesterday's aircraft carrier carve-up presided over by the increasingly implausible Geoff Hoon. Quite how it can be good news for the defence of the nation to select Thales to design the biggest warships ever built in a British yard, but then give the prime contractor's job to the rival bidder BAE Systems is a mystery known only to the Defence Secretary. Perhaps it will help get M. Chirac on side when the bombs start falling on Baghdad.

This blatantly political fudge is a recipe for disaster as the chief of defence procurement Sir Robert Walmsley surely knows only too well. But then he retires in two months time and will be long gone when the Franco-British alliance begins to crack. Sir Robert's political masters have promised the French a third of the work. But no one seems to have told the prime contractor BAE which began telling the world there will be no such thing as guaranteed workshares before the ink was even dry on yesterday's hastily cobbled together entente cordiale.

BAE wants to build the giant carriers in three separate bits, but Thales' design calls for them to be constructed in five pieces. The French will also be in charge of something called the "ship-air interface", even though BAE and not Thales is building the F35 fighter jets which will arm the two carriers.

The list of contradictions goes on but Mr Hoon seems more interested in the 10,000 jobs the contract will safeguard than whether it will be remotely good value for the taxpayer. Rashly, the Ministry of Defence has decided to take a 10 per cent stake in the "industrial alliance, hoping to share in the cost-savings when the contract comes in under budget. Experience suggests it will be cost overruns the taxpayer will be sharing in. No wonder Sir Robert says he doesn't expect this method of procurement to be repeated in a hurry.

Banking bad debt

Weakness in bank shares has been one of the main drivers behind the recent, renewed plunge in the stock market – of which more later – but the bigger picture remains quite how resilient the clearers and mortgage banks have been to the sell-off elsewhere. With the notable exception of Abbey National, where there have been some serious management failings, banking stocks are in general still a lot higher than the lows they sank to during the Russian debt crisis of 1998. Few other shares can boast similar long-term strength.

In the past, banks have invariably been some of the biggest casualties of any business downturn. Traditionally, they are generally a key ingredient of the boom and bust of the economic cycle. Credit is expanded as asset prices rise, then it is withdrawn again as prices tumble, usually greatly exaggerating the subsequent downturn. Banking profits collapse and inevitably one of the big players goes bust or needs to be bailed out. It hasn't happened this time, or at least not in Britain or the US. Both bankers and supervisors must have learned something from past mistakes for this to be the case. The reasons are instructive.

Historically low interest rates plainly help in easing the pain on business and thus reducing bad debt experience, but they aren't the only, or even the primary reason for the comparative calm, as the ongoing banking crisis in Japan and the gathering crisis in Germany amply demonstrate. In both countries interest rates are exceptionally low, almost incredibly so in Japan.

Japan's failure to grip the banking crisis which enveloped the country after the equity and property bubbles burst in the late 1980s has helped turn what might otherwise have been a relatively short, though admittedly very painful recession, into a prolonged economic malaise. There is a real danger of the same thing happening to Germany.

By British and American standards, margins in German banking are extraordinarily thin. Costs are also high. There are simply too many German banks, which means that any significant increase in bad debts easily wipes out profits. Add to that the fact that German industry is more heavily bank financed than elsewhere, and you can see the risks. Germany is finding it difficult enough to confront structural and labour market reform. It won't easily allow banks to go to the wall, or the businesses they finance, necessary though such a corrective might eventually be.

In Britain and the US, it seems doubtful that bankers are any better than they ever were at judging credit risk. Few can claim entirely to have escaped the folies des grandeur of the last boom, though this time around they have avoided the excessive commercial property lending of previous economic expansions.

On the other hand, bankers do genuinely seem to have got better at spreading risk, both among themselves and out into the capital markets. Most corporate and commercial property lending is these days securitised in some shape or form. As a result, bad debt experience hasn't been as concentrated among the major players as in previous downturns. Growing bad debt provisions have in any case been compensated for by the profits being made on mortgage lending and consumer finance.

Many would argue these are credit fuelled bubbles in themselves, and therefore an accident waiting to happen. That's one reason why bank shares have been slowly but relentlessly heading south for six months now. With the bank reporting season about to begin, there has been a further pronounced lurch downwards in recent weeks. None the less, the chances of a fully blown banking crisis, of the type that has accompanied past recessions, continue to look remote, and if that's the case, then the economic slowdown won't feel as bad as the gloomsters are predicting. Profits will suffer as consumer spending and the housing boom slow, but you can reasonably bet against a British banking crisis.

Solvency blues

It is hard to be as sanguine about the life assurers, many of which are now in the most terrible mess. Fifty life funds have been forced to close to new business and perhaps half as many again are in practice closed to new business because they can no longer afford to finance it. All of them have seen once buoyant capital reserves hugely eroded and even the biggest and financially strongest have been forced severely to cut their equity holdings. Public trust and confidence in the industry are shot to bits.

The ever growing number of policyholders seeking compensation for mis-selling merely deprives others who make no such claim. Solvency rules designed to protect the interests of policyholders as a whole have meanwhile only succeeded in damaging them further. In both cases, regulation has failed to protect savers from the consequences of past mis-management. There was a brief respite yesterday, as the FTSE 100 bounced 2.7 per cent, but the pattern has been that the more shares fall, the more life assurers are forced to sell, deepening and exaggerating the plunge in markets. The present solvency regime was largely drawn up in response to the last great bear market in the mid-1970s, when many life companies were essentially bust, in the sense that their assets were lower than their liabilities. Regulators were powerless to do anything other than turn a blind eye, but eventually the market recovered and the life funds became solvent again.

This time around, there is no danger of insolvency, because the rules require insurers to dump volatile equities before they ever get to that position. Only one problem. As a result, they've had all the upside removed. The rules have condemned life funds to years, possibly decades, of poor returns. The only real beneficiaries have been short selling hedge funds.

It's too late to do anything about it now, but the rules need to be profoundly rethought for the future. Either that, or the whole concept of the smoothed, with-profits life fund needs consigning to the dustbin of history. The rules have been tested, and they've failed. They've only made a bad situation even worse.

jeremy.warner@independent.co.uk