Hamish McRae: We're back to the world of tight credit and miserly banks

For those who can remember them, it will be like the 1950s and 60s

Wednesday, 1 October 2008

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The banking crisis is getting worse and it will go on getting worse until the authorities, principally in the United States but also in Britain and Europe, take full charge and start to help rebuild confidence in the world banking system.

The longer this takes and the more botched the interventions, the more damage there will be to the world economy. That is what matters most. Some kind of slow-down is inevitable and it may be that some, maybe most, developed countries will experience a recession. Denmark and Ireland are Europe's founder members of that club but expect more to join them soon. But there is no need for these recessions to be particularly serious.

We have a lot of experience of financial and banking crises over the ages, for they predate the Industrial Revolution. The rule, painfully learnt over the centuries, is that it is cheaper and less destructive to intervene early and nip the trouble in the bud.

The job is now being done. It is not being done well but it is hard to do it well. This is a global crisis but in practice it is the national authorities of the various countries involved that have to fix it. Different countries have chosen different paths. The most wholehearted step, taken by Ireland yesterday was to guarantee all the deposits and debt of six major Irish banks. That is committing the full resources of the state into supporting the banking system, incurring a theoretical liability of double the size of Ireland's GDP.

The most messy has been the response of the US authorities, about which 'nuff said. The British response has been uneven, with the Government reluctant to intervene too forcibly but also unable to let depositors lose money. There is an implicit government guarantee on the deposits of every bank in the UK but because it is not explicit you still have people pulling money out of any bank deemed dodgy, as Bradford and Bingley found last week. Looking ahead, I don't like the way the Halifax Bank of Scotland situation is developing. We are not through this one yet. The deal may have to be renegotiated.

But history tells us that bank crises do not last forever. Confidence eventually returns and banks feel secure enough to start lending money again. Unfortunately there is an asymmetry here. Confidence evaporates suddenly and dramatically. It returns gradually and maybe painfully. My own judgement remains that we are at a turning point, but I have been premature in thinking that the conditions for a recovery in confidence would be in place by now. I thought the authorities on both sides of the Atlantic would do things better and I was wrong.

So what will happen? It is easier in a way to see the situation in a year or two's time than it is to call the detail of the next few weeks. What we can see is a world where it will be much more difficult to borrow money. For those who can remember, it will be more like the 1950s and 1960s. Then, if you wanted a mortgage, you had to have built up a deposit in the building society or bank that might lend you the money. People would open an account with two or three societies and stick as much money as they could in each so that if one would not give them the loan they could try another.

Consumer credit was limited to hire purchase, where the product belonged to the lender until the final payment was made. To get an overdraft you had to have an interview with the bank manager, who would scrutinise your outgoings – and maybe refuse. For companies there was an even harsher discipline. The only form of bank credit was on overdraft, for there were no fixed term loans, and in theory at least an overdraft was repayable on demand.

As a result, individuals and companies were forced to be prudent. There were no credit cards flooding unsolicited through the letter-box; there were no credit cards at all. People were forced to save; companies were forced to manage their finances within the parameters set by their owners, family or shareholders. Interest rates were low so credit was cheap, but you couldn't easily get it.

The world will not go back to that. You cannot uninvent the credit card or for companies, the syndicated medium-term loan. You can't uninvent securitisation, the parcelling up of loans and selling them on to other holders. But we will, I think, go back to a world where banks will be battered, so scared, that they will lend only to their most credit-worthy clients. You might welcome that. What right have banks to shower money on people who are unlikely to be able to repay?

But anyone who would like to see the banks punished for their profligacy has to accept that there will be a cost to this new financial conservatism. Taxpayers around the world are understandably outraged at having to bail out what they perceive as fat-cat bankers and they want them to pay for their errors. But if you cane the banks, don't expect them then to be able to lend you any money.

So people who are deemed bad risks, such as the self-employed and people in flashy professions, will find it harder to get a mortgage. Have a bad credit record and that will be a shut-out. First-time buyers will have to have saved for a 10 per cent deposit, or more. Small companies will find it more difficult to raise capital. Start-ups will find it harder to get going. Big companies, even profitable ones, will have to pare back their investment plans and cut their staff levels. Everything will slow down as a result.

If this sounds tough, well, it is pretty much what happened in Japan in the 1990s after their great lending bubble and a botched rescue of the banks. The country had a lost decade with virtually no growth at all, sliding property prices, rising unemployment and falling living standards.

Actually I don't think we are in as big trouble as that, not here nor in the US. Assuming our political masters behave more or less sensibly in the coming weeks, the banking system will be put on a stable basis and in another year or so will be functioning reasonably well again. Quite aside from any specific support for banks that might be heading into real difficulties there are ways that the authorities can take general pressure off the system.

For example, here in Britain there is a powerful case for cutting interest rates and I would not rule out the first cut next week following the Bank of England's regular monetary committee meeting. There are technical improvements that can be made to the Bank's Special Liquidity Scheme making it easier for them to swap mortgage debt for tradeable government securities. That does not solve the underlying problem for the banks that the money markets remain gummed up, nor does it solve the specific problems of individual banks such as Halifax Bank of Scotland. But it all helps.

So banking will eventually find a new form of normality: not back to the 1950s but to something more like the middle 1990s before the madness of the past few years. But for another decade, maybe a generation, banks will be very much more cautious. And as a result the economic recovery, starting perhaps in 2010, will be a slow pull out of a darkish valley. There is sun on the hills beyond but they are still a long way off.

h.mcrae@independent.co.uk