Why don’t the banks work?

The government thought the following would lead to more normal lending levels:

1. £37 billion of new equity for 3 banks
2. Nationalisation of 2 mortgage banks
3. £450 billion of short term loans and guarantees for banks
4. Much lower interest rates
5. A big increase in money market liquidity and substantial open market operations by the Bank of England

They thought all of this would bring LIBOR down close to the base rate, in turn leading to banks lending again to home buyers and businesses.

Now it is not working they have added:

1. The reflationary package, based on a VAT cut
2. Much higher levels of public borrowing
3. Lecturing the banks

So why isn’t it working?

1. The banks still have to write off substantial bad debts. HBOS last week revealed an additional £8 billion of write offs, three quarters of the new capital the government is supplying. If all or most of the new capital just matches losses it cannot be used to lend more.
2. The Regulator has chosen this bad moment to demand more capital and cash to sustain existing levels of lending. As a result new capital above the write offs does not necessarily allow any new lending.
3. Banks are lurching from being too confident to being very cautious about new lending. They are now reluctant to lend as they fear more losses.
4. Further big losses are emerging, as we learn today concerning a large US Investment fund. Such losses hit confidence and in some cases impose more direct losses on banks.
5. The Regulators are requiring banks to rely more on retail deposits and less on wholesale money. Retail deposits are dearer, making it more difficult for banks to make profits. Loss making banks are weak banks, unable to lend more.
6. The two nationalised mortgage banks are effectively winding down their mortgage books. This means far less mortgage money is available in the markets, leading to further falls in house prices. This in turn leads to more mortgage loan losses for the banks.
7. The sharp deterioration in business conditions in the UK, US and EU in the fourth quarter of 2008 will create more corporate loan losses. Bank executives are busy fire fighting problems in many of their customer companies.
8. The Regulator is going to require the banks to hold a lot more in gilts so they are more liquid. In other words the banks are going to be made to lend more to the government!

What can be done?

It is not easy breaking a vicious circle of less lending, more losses, less lending. The government should summon the Bank of England, the Regulators and the lending banks. It should say it wants to change the terms of its £450 billion package to make it more effective. The Regulator should be asked how it could be more counter cyclical to make it easier for banks to lend in difficult conditions. At the moment regulatory and monetary policy are pulling in opposite directions. That needs to change. The government needs to find a market answer to allow Northern Rock and Bradford & Bingley to lend again. It needs to find a way to limit taxpayer risk in RBS.

If they carry on in current mode we should expect more property price falls, more bankruptcies, more job losses and more bank loan losses. This is not a great backdrop for recovery. Whilst it is important the government stands behind the main UK banks to avoid another Lehman disaster, it must avoid feather bedding them. Taxpayers should not be subsidising six figure salary executives and their bonuses. The financial sector generally has been paying itself too much. The sooner costs and charges are cut, the sooner more normal business can resume.

The serious allegations about a large US investment fund show us how little a big Regulator achieves. The very least we should now expect is Regulator help to solve the current problems instead of making them worse. Putting in tougher controls to prevent the excess they allowed a few years ago just digs us deeper into our current hole.