The Prime Minister may be in denial, but we have just lived through another week when many people’s living standards have been falling. The pound fell again, now trading at 87 pence to the Euro, and down at 136 yen. This has cut our purchasing power further for all those goods that are imported. There were large job losses announced. More companies put their employees onto three or four day working, or extended holiday closures. Pay rises remain below price increases.
The worrying thing was the immediate response to the 1% cut in the Bank’s base interest rate. The share market fell a little, when you would normally expect investors to see interest rate reductions as good news. Sterling fell, unlike the dollar when they slashed interest rates. International investors seemed to regard the monetary action in the US as good news, but here they are more concerned about a variety of issues, including the rapid build up of public borrowing.
The Bank of England’s latest weekly publication shows that its balance sheet has ballooned to a massive £260 billion as it tries to stimulate banking activity. The Bank of England has share capital of just £14.6 million, provided by taxpayers. At the 2007 annual balance sheet it had share capital and reserves of £1.86 billion. It is interesting that at a time when the Regulator is making the commercial banks put up more capital to improve the ratio between their share capital/ reserves and their total commitments, the Bank of England is going dramatically in the other direction. Of course it is not a worry, as the taxpayer stands behind the Bank, and the Bank concentrates on buying high quality and short term assets. It shows just how hard the authorities are trying to get something to happen, that the central Bank now has a balance sheet around 130 times its core shareholders funds when commercial banks are being asked to get their balance sheets down to around 12 times their shareholders funds. Restrictions on commercial bank capital ratios help prevent more of the injection being passed on to new borrowers.
For the time being the large monetary infusions into the markets and the active approach of the Bank of England are not inflationary. The tight regulations on the commercial banks, the poor state of the wholesale markets and their new caution means this money does not get passed on through the banks and multiplied by their lending. The authorities will need to be vigilant to withdraw this large liquidity when things do start to work again, otherwise it will become inflationary.
Today’s chosen subject for debate by the political classes is why the full interest rate cut by the Central bank is not being passed on by all the commercial banks. It gives politicians a marvellous opportuntiy to feel useful, by demanding that the banks cut their rates. They should try to understand why this is happening. There are some obvious reasons why some of the banks will not pass on some of the cut to some of their borrowers:
1. Savers need a reasonable rate on their savings. Banks need to keep and increase the deposits they take from the public, as other sources of money for the banks have dried up.
2. Banks need to make more profit to meet the Regulators’ demands for more shareholders funds (which include retained profit) to maintain their existing level of lending, let alone increase it.
3. Some people have signed contracts to borrow at fixed rates, so they do not get the benefit.
4. Banks think lending to people is becoming more risky, as many more people are unfortunately likely to lose their jobs as the recession bites harder, so banks feel they need a better margin and more reserves to deal with future losses on bad debts.
5. State owned banks(N Rock, RBS) have been losing money in the first half year and presumably at some point will be required to make a profit for the new involuntary shareholders.
It is ghastly watching the speed and size of the collapse now going on in much of the private sector. If the government does not mend the banks quickly, the recession will deepen more. That is why they do need to revisit their £450 billion package of loans and gurantees to see how it can be better spent to get some health back into the commercial banks, and why they need to review the regulatory framework again as it is clearly reinforcing caution and parsimony by banks. I hold no brief for the banks, and understand their current unpopularity. I do think, however, when something is n’t working well those in power should consider how to change the signals and the framework to alter conduct as they wish, rather than engaging in a public slanging match.