Britain risks deflation unless banks start lending, warns King

Britain's economy could slide into full-scale deflation unless the banks return to a normal flow of lending, the Governor of the Bank of England, Mervyn King, warned yesterday.

Speaking to MPs on the Treasury Select Committee, Mr King refused to rule out further state aid – recapitalisation – of the banks (where the Government buys shares in them); "direct intervention" to make them lend to small businesses and others; and even full scale nationalisation, should that be deemed necessary.

Mr King offered his backing for the Chancellor's pre-Budget report but stressed that returning the financial system to normal was "more important than anything else at present". He said: "Domestically, the most pressing challenge is to ensure normal bank lending is resumed. Without that, the downturn in activity could become protracted and extremely damaging." He added that the economy "would see deflation come to pass" if lending continued to dry up. He denied suggestions that ministers had influenced the Bank's interest rate policy.

Mr King indicated his willingness to support a range of measures to encourage the banks to lend, some of which would be more welcome than others in banks' boardrooms.

First, Mr King said, the authorities needed a much better system of "monitoring" the banks' lending activities. He said evidence from the Bank's network of regional agents and other sources suggested the lending to the "real economy" has begun to slow markedly in recent weeks to a stage where it had become "extremely weak". The Treasury said yesterday that the Lending Panel and a "discussion forum" comprising the regulators, ministers, and the banks would "look at how banks and other financial institutions can work better in the interests of consumers and society as a whole".

Mr King pointed out that, while it might make sense for a single bank to shrink its balance sheet and reduce lending because of pressure on its share price, such a move would prove disastrous for the economy as a whole.

The second move suggested by Mr King to deal with the drought in lending was a further recapitalisation of the banks to give them a "cushion" against further losses from the recession and other bad debts: "We may not have come to the end of recapitalisation," Mr King said. "We should not shy away from that if that proves necessary."

The Governor also seemed happy to relax the "capital adequacy" rules that restrain the banks from lending on prudential grounds.

Last, he refused to rule out nationalising more financial institutions, having already seen Northern Rock fully in the public sector, parts of Bradford and Bingley, as well as stakes in Lloyds TSB, HBOS, and Royal Bank of Scotland.

A spokesman for the Prime Minister said Mr Brown was "in close contact" about bank lending with the Bank of England and the Financial Services Authority: "We want to work constructively with the banks, we want them to fulfil the commitments they themselves entered into. It would be foolish to rule out any options at a time like this when there is so much change and these are such extraordinary times."

Mr King seemed more sceptical about the Government's policy of having banks return to 2007 levels of lending, albeit to more creditworthy customers. Mr King said much of the lending business entered into last year was probably only just profitable, and that it was legitimate for the banks to try to rebuild their margins – the difference between the rates they pay to borrowers and to lenders – after a period when they had become dangerously small.

He also suggested that the plan put forward by Sir James Crosby to offer UK government guarantees on mortgage-backed securities needed more thought. Mr King was "not entirely confident" about "resurrecting" an instrument that had "fallen out of favour".