Sean O'Grady: So who's going to take the blame for triggering a second credit crunch?

This looming funding gap is a hulking great iceberg that ought to be worrying ministers and the rest of us as much as it worries the bankers
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The Independent Online

There are, in truth, two coalitions running Britain. One is the Liberal Democrat/Conservative affair; the other is the Government/Bank of England alliance. As with the purely political version, relations between the partners have had an encouraging start.

The Bank's Governor, Mervyn King, came out in favour of the Chancellor's £6bn in immediate cuts. The Government returned the compliment by pledging to give the Bank more oversight of the financial system and long-sought powers to manage credit (Mr King mentioned it again in the Bank's Annual Report last week).

Both agree on the desirability of getting house prices into the CPI target for inflation – if only anyone could figure out how to do it. The new Banking Commission will also help deliver the mutually agreed aim of breaking up the banks. All very chummy.

Yet one hulking great iceberg may yet sink the Threadneedle Street-Downing Street relationship – the future of £310bn of official support to the banks due to expire over the next couple of years.

This is the looming "funding gap" that ought to be worrying ministers and the rest of us as much as it worries the bankers. It means stagnant property values (or worse), and very sluggish economic growth – meaning fewer jobs and lower pay rises than we might otherwise have enjoyed. Mr King has been adamant that there will be no extension of the Bank's special lending to the commercial banks. So the question is: can ministers force the Bank to change its mind and extend its support to the banking sector?

Some £185bn has been lent to the banks under the Bank of England's Special Liquidity Scheme (SLS). The SLS was closed last year, and was supposed, as the name implies, to be a one-off series of loans to the banks on much longer terms than the Bank usually offers – though the fees and "haircuts" on the collateral the Bank demands were costly to the banks, and apparently profitable to the Bank of England (about £7bn worth of extra revenue, according to the Annual Report).

The SLS closed to new business in February 2009, but the loans are still out there: they are due to be repaid between April 2011 and January 2012 – not so very far away when you're trying to plan the funding needs of a large bank. It's a lot: about 10 years' worth of mortgage lending at current levels.

Another £125bn of support is currently supplied under the Treasury's Credit Guarantee Scheme (CGS). This was another extraordinary piece of intervention during the crisis, which saw a British government guarantee attached to securities issued by banks and building societies. This scheme won't come to a juddering halt quite as quickly as the SLS.

There is a limited rollover facility, but the CGS will be run down by 2014 – again not so very far away in the world of finance.

Quite a chunk of these guarantees were given to banks that have since been nationalised and therefore have a state guarantee anyway, but the point stands: should the Treasury extend this method of funding to the banks and, thus, to business and home-buyers, or should they follow the Bank's lead on the SLS, and abandon it?

The Council of Mortgage Lenders has been the most vocal in calling for the Government and the Bank to think begin about extending these schemes, but all the banks are worried. Mr King has been adamant that the SLS will end and that there will be no so called "Son of SLS". All he says is he will offer the banks is the new, a more flexible, "discount window" of short-term money.

But the political pressure on banks and lending will intensify. Last week the Business Secretary, Vince Cable, called on the banks to honour the lending agreements they entered into when they received state support – not least the SLS and CGS – and tougher lending targets seem likely.

Whoever is right, forcing the banks to lend while depriving them of the funds to do so makes no sense. Mr King's attitude to the banks is harsh but logical: they must not rely on the state for their funding, for all sorts of reasons; they must rebuild their capital. That probably means a further shrinkage in their lending. So be it.

But for ministers the prospect of such a credit squeeze coinciding with their planned fiscal squeeze must fill them with horror. Even if the Bank maintains its ultra-low interest rate regime and quantitative easing, the banks will still be much more picky about whom they lend to. Their extreme caution towards entrepreneurs and would-be homeowners will mirror their recklessness in the boom, and with similarly grim results. None of this would matter much if wholesale credit markets and capital markets were returning to whatever passes for normal. They are not. Investors' appetite for risk is receding, and the most immediate risk remains that of "contagion" from Europe.

The Spanish banks are in especially dire straits, for obvious reasons, but European banks of all shapes and sizes are exposed to what are now recurrent crises in southern and eastern Europe, and British banks are, in turn, exposed to them. The danger is that the wholesale market for funding – not in the healthiest of states anyway – could freeze up. As in 2007 , no bank knows with any certainty who is harbouring the biggest losses (though this time with sovereign debt in place of books of sub-prime mortgage backed securities). The drying-up of credit in 2007 led to the financial crisis of 2008 and the worst recession in three-quarters of a century in 2009. It could easily happen again.

So the danger is clear: a new credit crisis - "Credit Crunch 2".

The Queen spoke for many when she asked in 2008 why no one saw the first one coming. The bankers, regulators and politicians were all castigated for their lack of foresight. They had some excuses then for such a "black swan" event; but a second time round...? And when they themselves are turning the funding taps off? Well, what would Her Majesty say?