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Vincent Cable: Don't be fooled... the banks aren't victims of bad luck

They lent too much, based on the irrational belief that house prices never fall

There was a certain unhappy symbolism yesterday, in a Labour government conjuring up billions to help the banks while insisting that low-paid workers pay billions more in tax. The Government's deference and indulgence to the banks is extraordinary.

The Bank of England's liquidity scheme is designed to counter a severe contraction in bank lending stemming from a collapse of trust originating in unidentified "toxic", bad loans. It seems sensible to try to unplug a blockage in the plumbing before taking action to confront the cowboy plumbers who caused the problem. But the two issues cannot be totally separated since a key question is how to stop the problem recurring.

The commercial banks admit to being guilty of major points of weakness in business practice including bankers' pay and the management of risk. They are not hapless victims of bad luck. British banks, in particular, lent too much, too quickly, too carelessly, based largely on the optimistic but irrational belief that house prices can only increase and never fall.

The big losses now have to be identified and then covered by bank shareholders. But bank executives fear asking their shareholders for money – rights issues – since they risk being sacked. It is easier to rattle a begging bowl in Whitehall and ask the Government for the money. They have.

Under the Bank of England's scheme an attempt is being made to protect the taxpayer from the risks of swapping the banks' dodgy assets – based not just on mortgages but, unbelievably, on credit cards – for risk-free government securities. The banks will take a "hair cut" in the form of a discount.

But the discount will have to be hefty if the taxpayer is to be properly protected. The IMF has suggested that the UK domestic property market is 25 to 30 per cent overvalued and the discount must reflect that. The Government says that only AAA rated securities will be accepted. But after the disastrous experience of rating agencies badly miscalculating risk, such assurances are unconvincing.

If there is to be any departure from the traditional terms on which the Bank of England lends to the banks there must also be tough, binding, explicit conditions not vague assurances.

Firstly, the banks must acknowledge their losses. Their shareholders, not the taxpayer, must absorb them. Once all banks believe each other's assessment of the quality of their own assets trust will be restored to the market and the costs of inter-bank lending will come down. RBS/ NatWest, to its credit, has already led the way, by its announcement of a rights issue. Other banks with big losses should not be eligible for funding unless they commit themselves to a comparable course of action.

Secondly, if banks are to receive state support they must act in a responsible manner. A key area is repossessions. The first stage of the process – repossession orders – is running at levels similar to the early 1990s. Many families face the loss of their homes in an environment where there is a paucity of social housing. All lenders, not just the major banks but also the companies in the sub-prime and secondary loan market, must agree to binding procedures to stop a repeat of what happened in the Tory recession of the 1990s.

Third, there will have to be a fresh approach to regulation. The banks are already required to observe capital adequacy rules but these take no account of cycles – indeed they amplify cycles of boom and bust. Banks should hold more reserves during upturns and less during downturns to neutralise boom and bust. I have argued, for several years, for counter cyclical measures of this kind. Their time has come.

These are technical points. But there are deeper lessons from this financial crisis. There has been a free-wheeling culture in the financial services industry, the City, which was tolerated in a boom period but grates badly when it contributes to wider instability and gross inequality. There will be need for a careful balance between tighter control to prevent excess and not suffocating genuine innovation.

Banks and their executives are rightly excoriated for their cynicism in offloading risk and losses on to the taxpayer while pocketing large profits and bonuses. But they are correct to say that there are willing borrowers as well as reckless lenders. Much of the lending boom has been based on property and the belief that houses are not just our homes but the main source of family wealth: a pension, a bank account and a dwelling rolled into one. The Government's emergency package is at least partly designed to stop house prices finding a more sustainable level: a costly and ultimately fruitless objective.

The writer is the Liberal Democrat Treasury spokesman