Leading article: The Government's banking policy is a confused mess

Ministers urgently need to decide what their priorities are

The great banking bailout is far from over. Yesterday, the Government unveiled plans to pump an extra £39.2bn of public funds into the domestic banking system; £33.5bn for the Royal Bank of Scotland and £5.7bn for Lloyds. Putting money into these banks represents an investment. But make no mistake: this investment represents a very real risk to the public purse. It by no means guaranteed that the state will break even when it comes to sell its stake in the banks in the coming years.

The Government did the right thing when it first injected capital into these banks last autumn. The financial sector was so evidently bust that such an extraordinary intervention was the only way the panic could be stemmed. But having taken a public stake in these banks, ministers never devised a clear strategy of what to do with it.

Government policy with regard to its new acquisitions (and indeed the wider banking sector) has been a sorry and confused mess ever since. Ministers stress that the banks need to be run on commercial lines, yet they have also attempted to intervene at various times over lending policies and employee remuneration. One arm of government pushes for a build-up of capital, which implies a contraction of lending. But then another arm demands that the banks keep credit flowing to hard-pressed businesses.

The problem is that ministers have never come to terms with the uncomfortable reality that the Government's interest as a shareholder in these banks is in conflict with its interests as a steward of the wider economy. The purely commercial impulse for the banks in the present slump is to hoard cash and rebuild their capital. But, as recent lending reports from the Bank of England and others have emphasised, that contraction of credit is prolonging the recession.

There has also been a stubborn refusal from ministers to face up to the fact that the entire financial system - not just these two banks – is now effectively underwritten by the state. Consider the farce over the toxic asset insurance scheme. Yesterday, we learned that the only bank which will participate in this programme is RBS. But that means the Government, which has a majority stake in RBS, is selling insurance to itself. Moreover, the Government is already effectively insuring even those banks that have eschewed the scheme thanks to their "too big to fail" status. And none are paying a fee for that implicit but valuable guarantee.

Such confusion is the consequence of one crucial misjudgement. The Government ought to have nationalised the entire UK banking system last autumn when it was clear that no institution would survive without considerable public support. Ministers could then have restructured the industry rationally by establishing "good" banks (able to lend to sound businesses) and taking responsibility for their toxic loan books. Then we would have avoided all the present public/private conflicts of interest.

But we are where we are. And as they prepare for the second leg of this staggering bailout of private interests, ministers must, finally, make up their mind up about what their priorities are. In the immediate term, do they want the banks in which they have a stake to concentrate on rebuilding their capital? Or do they want them to keep their lines of credit open to viable small and medium-sized businesses? Do they want a profitable banking sector or a healthy economy? Because it is increasingly clear they cannot have both.

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