Sean O'Grady: Banking relies on confidence – and there isn't any

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The most precious commodity in the financial world isn't oil or platinum or gold – it is confidence. Banking is built on it. In the case of HBOS, the most valuable item on its balance sheet wasn't the mortgage book of £256bn or its £160bn on deposit; it was the trust the public and other banks and businesses lent it. Once that began to be devalued, the end arrived astonishingly quickly, as it did in the recent other dramas. Lehman Brothers, Merrill Lynch, AIG and HBOS – all in a week. Trillions of dollars-worth of businesses disappeared or transformed. We may remember this week as seven days that shook the financial world.

The cost in jobs and the destruction of wealth is likely to be heavy. Some predict more than 100,000 job s in financial services will disappear in Britain alone. Like car making and the airlines, banking has far too much capacity. Rationalisation is inevitable and capitalism's tendency towards "creative destruction" is being played out with its customary brutal ferocity. The independence of proud, venerable institutions, analysts and economists, rocket scientists who dreamt up new derivatives, IT specialists, branch staff – all will go. The New York Times calculated that every Lehman Brothers job in Manhattan supported three more. Collateral damage will be felt in Edinburgh, London, Halifax and elsewhere.

All that is bad enough; but the consequences will be more profound still. A successful economy depends on a healthy banking system for a supply of credit. As with the cogs of a machine, credit lubricates the movement of funds around the system, from savers to borrowers. We need loans to start new businesses, to buy homes, to buy machinery for farms, factories and offices. We need overdrafts to help get us through university. Starve the economy of credit and you starve it of lubrication; one cog begins to stick, the rest turn more slowly. When confidence in an individual bank and then a nation's banking system starts to evaporate, a much more widespread and painful disruption in the economy threatens.

As we have seen, it can start as an "institutional run". Suddenly, a bank's trading partners decide it is a bad risk. They no longer wish to do business with it. They won't lend it money at any price, so it has to go to the central bank for assistance, an unsustainable solution. If they've invested in its bonds or shares, or have money on deposit, they will sell their securities and withdraw their cash, causing the bank more problems. The share price quickly crashes. There's the threat of a run. No bank can survive that, as we saw with Northern Rock, and as might have happened at the Derbyshire and Cheshire Building Societies before they were taken over by the Nationwide; and of course at HBOS. Without intervention, lack of confidence in a bank becomes a self-fulfilling prophecy. That the hedge funds can trigger such a process is a terrifying reality.

The worry now is that the credit crunch will intensify. Heavy losses from the over-lending into and subsequent collapse of the US property market, have damaged many institutions' capital strength. Rights issues, and appeals to Sovereign Wealth Funds in China, Singapore and the Gulf by the likes of Citigroup and Barclays have probably secured their futures. Some £20bn was pumped in; but it is not enough, and the signs are that those sources are drying up. The banks may simply have no option but to restrict their lending more. That will mean even fewer home loans, student overdrafts, car loans, new business start-ups. There has not been a real terms reduction in bank lending in the UK since the slump of 1973-74. Some economists put the banks' "capital gap" at £65bn. If that were reflected in a contraction in the banks' lending, it would push the economy into a heavy and prolonged recession, rather than the shallow, brief affair now predicted. It is, more or less, the fate that befell the world after the Wall Street crash of 1929, the bursting of another credit bubble. The failure of the mighty Austrian bank Creditanstalt in 1931 which followed had its origins in American banks calling in their loans to it, and the collapse hit Germany especially hard. It helped Hitler to power. Too alarmist? Yes, as the authorities seem conscious of the lessons of history; but confidence is becoming a rare commodity.

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