Sean O'Grady: Credit crunch: 'It's just the end of the beginning'

Here's some "big picture" numbers on the state of the world's financial system. According to ING, the total value of assets written down by Planet Earth's big banks is $502bn. The total value of capital raised by the same: $351bn. That deficit, of $151bn could easily get much much bigger. No wonder the Deputy Governor of the Bank of England, Charlie Bean, said the other day that the slowdown may "drag on for some considerable time", while the IMF has called it "the largest financial shock since the Great Depression".

Now, shortly after the unhappy first birthday of the credit crunch we are at what we might call "the end of the beginning". Even though Ken Rogoff, a former chief economist at the IMF, has chillingly warned that a "whopper" major bank will go under in the next few months, at least we know the rough parameters of the sub-prime problem – usually neatly and memorably rounded to about $1 trillion ($1,000bn). It may even be a little better than that: house prices are still falling in the United States, but mostly at a gentler pace. So some of the gloom may be lifting over there.

What's next? Well, there are two new looming threats to keep us awake at night. First, the certainty that what one might term the "normal" writedowns and losses associated with an economic downturn will add to the strains on banks' balance sheets just when they are at their weakest.

In the UK, we know these are on the rise because some banks have already declared such difficulties; because of the rising trend of redundancies, arrears and repossessions; because of the collapse in sentiment in the housing market and because the first-round effects of the credit crunch are now creating their own second-round effects, through the "mortgage famine" for first-time buyers, the main source of new funding to the residential property market.

That, by the way, is now being exacerbated by a fall in demand for new mortgages from those same first-time buyers, who judge that a falling market is one where they can afford to rent, wait and see. No matter, though; the picture is one where more people will find it more difficult to service their debts, from credit cards to car loans and mortgages, the banks will have to wait longer for their money and may see some of it lost for good.

Which brings us to the second nightmare. Will the banks be able to raise the capital required for them to regain their strength as losses mount? Now for the banks what we've seen is rather like suffering from a bad case of flu (sub-prime) and then catching a cold (normal downturn losses) on top. Result: financial pneumonia. For which the well-known cure is plenty of liquidity fed to the system by assiduous central banks (see the Bank of England's patent Special Liquidity Scheme among other miracle cures) and a strong course of capital injections.

The latter is proving steadily more tricky to administer, as we see from those big numbers I quoted at the beginning and from the rights issue flops at HBOS and Bradford & Bingley, among others. It has been a laborious task even to raise the £20bn the British banks have now garnered for their balance sheets. The team at Capital Economics calculates that £65bn more is needed in the way of fresh capital, that is if the banks are to carry on functioning at their current rates of lending and to sort out the remaining damage from the credit crunch.

Alternatively, the banks could simply reduce their lending. But that would mean an even bigger brake on growth than we have seen so far. Capital Economics says that for the banks to correct their balance sheets in this manner would imply a reduction in lending of £440bn (17 per cent of the balance sheet), a truly terrifying sum. Some mixture of the two seems more likely, but even that has some nasty consequences.

If the banks manage to raise another £20bn from disposals, conventional rights issues, Sovereign Wealth Funds in China and the Gulf subscribing for equity, and stake building and takeovers by foreign banks relatively unscathed from the mess (e.g., Banco Santander/Alliance & Leicester), this would still mean a contraction in balance sheets of £180bn, or 7 per cent – equivalent to 13 per cent of the UK's GDP. I mention that just to illustrate the scale of the phenomenon, and is not meant to be a read off for the wider economic effects. Much of the contraction in lending will hit foreign entities, and bank credit is not the only source of spending in the economy. That is, despite appearances in recent years; some rebalancing away from our reliance on debt to fund growth is overdue and welcome, though it will be painful.

However, if UK bank lending drops by just 5 per cent, that will easily be enough to tip the economy into recession. Capital Economics says that it would mean business investment also down by 7 per cent, that housing market activity would "grind to a halt" with a 50 per cent drop in prices, and consumer spending down by 1.4 per cent, shaving 0.6 per cent off growth per annum, where it is already expected to be stagnant. We last saw real terms lending by the banks go negative in the mid 1970s – not a happy precedent. So recession here we come.

Is there a way out? Well, things may not turn out to be as bad as the pessimists anticipate. But a third option, not up to the banks but available to the regulators, internationally, would be to ease the banks' capital requirements, altering the ratios to allow them to lend more on thinner capital, so-called "counter cyclical" regulatory action. Risky, perhaps, but maybe more welcome than their fourth option, of direct state intervention to support lending. That, we can confidently say might well be the beginning of the end.

Life and Style
Arts and Entertainment
Southern charm: Nicolas Cage and Tye Sheridan in ‘Joe’
filmReview: Actor delivers astonishing performance in low budget drama
Arts and Entertainment
While many films were released, few managed to match the success of James Bond blockbuster 'Skyfall'
Arts and Entertainment
Up my street: The residents of the elegant Moray Place in Edinburgh's Georgian New Town
tvBBC's The Secret History of Our Streets reveals a fascinating window into Britain's past
Albus Dumbledore, the headmaster of Hogwarts School of Witchcraft and Wizardry has been the teaching profession's favourite teacher
ebookA unique anthology of reporting and analysis of a crucial period of history
Luis Suarez looks towards the crowd during the 2-1 victory over England
Life and Style
Cheesecake frozen yoghurt by Constance and Mathilde Lorenzi
food + drinkThink outside the cool box for this summer’s frozen treats
John Barrowman kisses his male “bride” at a mock Gretna Green during the Commonwealth Games opening ceremony
peopleBarrowman's opening ceremony message to Commonwealth countries where he would be sent to prison for being gay
Sir Bradley Wiggins removes his silver medal after the podium ceremony for the men’s 4,000m team pursuit in Glasgow yesterday
Commonwealth games Disappointment for Sir Bradley in team pursuit final as England are forced to settle for silver
Alistair Brownlee (right) celebrates with his gold medal after winning the men’s triathlon alongside brother Jonny (left), who got silver
England's Jodie Stimpson won the women’s triathlon in the morning
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Junior Research Analyst - Recruitment Resourcer

£18000 - £20000 per annum + OTE £25K: SThree: SThree Group has been well estab...

Senior Analyst - Financial Modelling

competitive: Progressive Recruitment: This really is a fantastic chance to joi...

Associate CXL Consultant

£40000 - £60000 per annum + BONUS + BENEFITS: Harrington Starr: CXL, Triple Po...

Business Anaylst

£60000 - £75000 per annum + BONUS + BENEFITS: Harrington Starr: Business Anal...

Day In a Page

Backhanders, bribery and abuses of power have soared in China as economy surges

Bribery and abuses of power soar in China

The bribery is fuelled by the surge in China's economy but the rules of corruption are subtle and unspoken, finds Evan Osnos, as he learns the dark arts from a master
Commonwealth Games 2014: Highland terriers stole the show at the opening ceremony

Highland terriers steal the show at opening ceremony

Gillian Orr explores why a dog loved by film stars and presidents is finally having its day
German art world rocked as artists use renowned fat sculpture to distil schnapps

Brewing the fat from artwork angers widow of sculptor

Part of Joseph Beuys' 1982 sculpture 'Fettecke' used to distil schnapps
BBC's The Secret History of Our Streets reveals a fascinating window into Britain's past

BBC takes viewers back down memory lane

The Secret History of Our Streets, which returns with three films looking at Scottish streets, is the inverse of Benefits Street - delivering warmth instead of cynicism
Joe, film review: Nicolas Cage delivers an astonishing performance in low budget drama

Nicolas Cage shines in low-budget drama Joe

Cage plays an ex-con in David Gordon Green's independent drama, which has been adapted from a novel by Larry Brown
How to make your own gourmet ice lollies, granitas, slushy cocktails and frozen yoghurt

Make your own ice lollies and frozen yoghurt

Think outside the cool box for this summer's tempting frozen treats
Ford Fiesta is UK's most popular car of all-time, with sales topping 4.1 million since 1976

Fiesta is UK's most popular car of all-time

Sales have topped 4.1 million since 1976. To celebrate this milestone, four Independent writers recall their Fiestas with pride
10 best reed diffusers

Heaven scent: 10 best reed diffusers

Keep your rooms smelling summery and fresh with one of these subtle but distinctive home fragrances that’ll last you months
Commonwealth Games 2014: Female boxers set to compete for first time

Female boxers set to compete at Commonwealth Games for first time

There’s no favourites and with no headguards anything could happen
Five things we’ve learned so far about Manchester United under Louis van Gaal

Five things we’ve learned so far about United under Van Gaal

It’s impossible to avoid the impression that the Dutch manager is playing to the gallery a little
Screwing your way to the top? Good for Lana Del Rey for helping kill that myth

Screwing your way to the top?

Good for Lana Del Rey for helping kill that myth, says Grace Dent
Will the young Britons fighting in Syria be allowed to return home and resume their lives?

Will Britons fighting in Syria be able to resume their lives?

Tony Blair's Terrorism Act 2006 has made it an offence to take part in military action abroad with a "political, ideological, religious or racial motive"
Beyoncé poses as Rosie the Riveter, the wartime poster girl who became a feminist pin-up

Beyoncé poses as Rosie the Riveter

The wartime poster girl became the ultimate American symbol of female empowerment
The quest to find the perfect pair of earphones: Are custom, 3D printed earbuds the solution?

The quest to find the perfect pair of earphones

Earphones don't fit properly, offer mediocre audio quality and can even be painful. So the quest to design the perfect pair is music to Seth Stevenson's ears
US Army's shooting star: Lt-Col Steven Cole is the man Hollywood calls when it wants to borrow a tank or check a military uniform

Meet the US Army's shooting star

Lt-Col Steven Cole is the man Hollywood calls when it wants to borrow a tank or check a military uniform