Leading article: We are all paying the pricefor the banks' mistakes

The best way to repay taxpayers is by protecting small businesses

We were always warned that share prices can go down as well as up. But there was one star that was supposed to be fixed in the investment firmament: major high street banks do not make losses. Well, if yesterday's hints from Stephen Hester, the new head of the Royal Bank of Scotland, are anything to go by, that verity has become yet anothercasualty of the credit crunch.

Mr Hester, parachuted in last month to replace the recently departed RBS head Sir Fred Goodwin, said in an interview yesterday that in 2008 "profits will be difficult to achieve" and that it "wouldn't be a surprise" if analysts forecast a loss for the bank. Mr Hester seems to be preparing the financial markets for the announcement that RBS has made its first loss in the bank's 281-year history.

The first thing to note is that this represents a truly damning indictment of the previousmanagement, led by Sir Fred. The reason for RBS's difficulties is no mystery. It has had to write off billions of assets linked to the Americansub-prime mortgage market. Sir Fred also pushed through a takeover of the large Dutch bank, ABN AMRO, depleting RBS's reserves to dangerously low levels and leaving it ill-placed to withstand the present crisis of confidence. And now RBS is being hit hard by impairment charges on its conventional business and home loans, asrecession begins to bite. So what we have here is a spectacular tale of managerial incompetence, which has wiped out shareholder value on acolossal scale.

But, as we know, this is part of a much bigger story; and one that affects all of us, not just RBS shareholders. Many British businesses are in trouble as banks such as RBS, which lent with irresponsible zeal in the boom years, now tighten their lending requirements in a desperateeffort to shrink their balance sheets. The normal way for the monetary authorities to give a boost to the economy in a downturn is to cut interest rates. The transmission mechanism for this relief has always been the private banks. But these institutions are in such a parlous state that many are failing to pass on the rate cuts toordinary borrowers, using the cheaper credit to rebuild their own balance sheets instead.

Let there be no doubt that this is a horribly complicated situation. Three British high-street banks, including RBS, have been bailed out by £37bn of taxpayers' money. To recoup that money in full, the Government needs the rescued banks to return to health as soon as possible and pay back their borrowings. The quickest way for the banks to recover is to shrink their balance sheets and reduce their exposure to bad loans. Yet here is the dilemma: the country also needs the banks to maintain lending to small businesses, if we are to avoid widespread bankruptcies, mass redundancies and a long, deep recession.

The latter concern must take precedence, even if it means the banks adopting more generous lending standards than they would like in their present circumstances. The clinching argument is that the banks themselves will lose more money in the event of a prolonged downturn than arelatively shallow one. This does not mean going back to the kind of recklessly loose lending to businesses and homeowners by the banks that contributed to this crisis. But it does mean that ministers need to instruct the managements of banks to continue lending to the wider economy on a reasonable scale. And, most importantly, those rate cuts must be passed on in full.