Jeremy Warner: How to get banks lending once more

Outlook: To act as a substitute for the banks in credit provision might undermine the Government's perceived creditworthiness

Tuesday 06 January 2009 01:00 GMT

The Government and the Bank of England have tried flooding the system with cash, they've tried cutting interest rates, they've tried the special liquidity scheme, they've forced the banks to recapitalise, and they've tried guaranteeing interbank, small business and export lending, yet still the banking system won't lend in the way and in the quantities it used to. What more can be done?

In comments made over the weekend, Gordon Brown, the Prime Minister, suggested that further policy action could be expected over the next month, yet even by his own admission, it's going to be quite a challenge.

As part of last October's recapitalisation, mainstream British banks agreed to maintain their mortgage and small business lending at 2007 levels, and by and large they've kept their promise. Indeed, most of them claim actually to have increased their lending in these categories over the past year.

So how come lending is still being squeezed? In the main, it's down to the withdrawal of more marginal players from the market. The nationalisation of Northern Rock alone removed a player which at its peak was writing around one in five UK mortgages. Foreign-owned banks have also largely withdrawn from UK corporate and SME lending.

At the same time, wholesale money markets remain largely closed to all mortgage, consumer and SME lending. Taking all these factors together removes around 20 to 25 per cent of small business and mortgage lending from the British market.

In order to compensate for the gaping hole left in the credit markets, the mainstream banks need to lend not just a bit more than they used to but a lot more. At the same time, these banks face their own "deleveraging" challenge. None of them are able to borrow with the ease that they used to, so nor can they lend in the same way either.

Even if they had the capital and the inclination to fill the gap, persuading them to do so would remain a big ask. You might reasonably think that, during the boom, banks abandoned all standards of prudential lending, but all of them will still have rigid rules, now being applied much more vigorously than they were, on what may be lent to whom and in what quantities.

For practical and prudential reasons, it's not realistic to expect the mainstream banks overnight to expand their lending by the amount required to return credit conditions to boom-time levels. And is that really what the banks would want to do in any case?

For the time being, the big British banks are trying to square the circle by applying the deleveraging not to ordinary domestic lending but to international and capital markets business. The process is particularly visible at Royal Bank of Scotland, where the new chief executive, Stephen Hester, has put the expansionary ambitions in capital markets of his predecessor, Sir Fred Goodwin, sharply into reverse.

As these businesses are shrunk down to size, that should free up more capital for plain vanilla British lending. Yet as I say, it's just not practical or prudential for any bank to let rip and greatly increase their exposures to particular types of domestic lending, especially when there is a recession in full swing.

Pressurising banks to apply their deleveraging to international and capital markets business so they can lend more domestically is in any case pretty much a zero-sum game if all countries do the same thing. What countries gain by forcing their banks to lend more domestically they lose when foreign banks are forced to play the same game.

Mr Brown rightly warns against a slide into protectionism, yet what is forcing banks to trim their international lending so that they can apply more money to their home markets other than a form of economic protectionism?

So what does the Treasury intend to do about it all? As Mr Brown seemed to suggest over the weekend, another recapitalisation would not be the first port of call. The Government has done it once, and although it may have saved the banks from oblivion, it hasn't made the banks lend appreciably more. That may be because the rising tide of bad debt is already swamping out the new capital. Yet in circumstances where it is an absence of funding as much as capital which is causing credit to shrink, it is not certain that obliging the banks to raise yet more of the stuff will significantly ease the problem.

Sometimes it seems as if policymakers are living back in the 1970s when most bank lending was domestic and funded by locally generated retail deposits. Yet today, most banks are heavily international in their lending and have come to rely on international money markets for their funding. These markets remain problematic. You can pile up the banks with all the capital you like, and still the money markets might be reluctant to fund them.

The British authorities may have acted decisively in recapitalising the banks, but throughout this crisis their approach to the funding, or liquidity, issue, has been piecemeal and reluctant. This needs to change if the Government is to stand any chance of getting on top of the crisis. There are a number of ways in which the Government can address the lending famine.

One possibility would be simply to ease the rules on capital so that the banks could operate with lower ratios. In theory, this would allow the banks to lend more. On the other hand, markets might react badly to the smaller capital buffers, making it even more difficult for the banks to fund themselves than it is already.

Another would be to set up "bad bank" arrangements under which the toxic debt would be bought up by a Government agency and held to maturity. Yet as has been discovered in the US with the "Troubled Asset Relief Programme" (Tarp), defining which assets should be bought and at what prices is a minefield.

With UK banks, it would be particularly awkward, as some of the worst-performing debts are in overseas mortgage and commercial lending. Applying UK taxpayers' money to buying up US sub-prime mortgages would be controversial, to put it mildly.

It therefore seems to me quite likely that the Treasury will eventually settle on something close to the idea that has been taken up by the Tories, of guaranteeing a bigger pool of new mortgage and business credit. We are in any case halfway there with the scheme that guarantees interbank lending.

Such an approach would not be without its dangers. The implicit state guarantee carried by securities issued by Fannie Mae and Freddie Mac are these days regarded in the US as one of the root causes of the whole crisis. Do we really want to recreate state-subsidised credit machines of potentially such monstrous proportions?

The Government is already up to its neck in debt. To act as a substitute for the banks in credit provision might further undermine the Government's perceived creditworthiness and could potentially end up bankrupting the entire country.

All the same, the Government has to do something to ease the lending famine, and this may well be the least worst solution. A variation of the same idea would be the one suggested by Jim O'Neill, chief economist at Goldman Sachs, whereby the Government would set up an entirely new, state-sponsored bank which would provide the same purpose of injecting more credit into the system.

It's a strange kind of solution which attempts to cure a crisis caused by an excess of debt by providing even more of the stuff, yet it is hard to see how else to ease the deleveraging process.

In any case, I hope Treasury officials managed to get themselves some rest over the Christmas break. If they aren't already again burning the midnight oil, they soon will be. The immediate financial crisis may have abated, but the wider crisis in an economy which has become overly dependent on now scarce credit has only just begun.

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