Banks to lend to government

In the UK the government are revealing how they think they can borrow £157 billion this year, followed by another high borrowing year next year. They will tap into three sources of demand for government paper.

The banks will need to be substantial buyers, as the authorities are currently consulting on proposals to “significantly” tighten liquidity standards for banks. That means they will have to lend more to the government through the gilt market.

The pension funds will need to be buyers. Market declines in the value of many assets will create more large black holes in their funds. As company contributions are increased to make up for the losses the regulators and actuaries will direct the money to a considerable extent into gilts. Some pension funds will unfortunately end up in trouble where the sponsoring company has gone bankrupt. These are likely to be put into government bonds to a greater extent, directly or indirectly.

There will also be some volunteer buyers, concerned about the risks of other investments and taking note of the large buying demand from the first two sources. Many investment managers who held large positions in equities during the 2008 collapse are now increasing their government bond holdings.

The trouble with this approach by the regulatory authorities is that it makes increasing bank lending and getting things moving again in the real economy that much more difficult. Compare these two regulatory statements:

“We continue to expect Basle II to result in a reduction in our regulatory capital requirement compared with Basle I” (Northern Rock Accounts published in 2007)

“Firms will be obliged to hold sizeable buffers, and we would expect a marked increase compared with holdings under the predecessor regimes” (FSA December 2008)

In the heady days of 2007 before the August tightening of the money markets, many banks like Northern were lending large sums, and were concluding that they could either lend even more or return some capital to shareholders under the future regime. The Rock Directors in Spring 2007 were happily discussing how to handle their regulatory windfall of being told they needed less capital for their volume of business. Today banks are told that they need to hold a lot more in liquid government bonds, lending to the government at low rates of interest, to have a buffer against bad news.

The FSA itself says that its new policy will entail a substantial revenue loss for the banks. Capital that could have been employed lending to companies and individuals at higher interest rates will be lent to the government at low rates. The FSA says of bank turnover

“diminution in revenues – this diminution could be in the order of £1-5 billion (or even higher if the spread between the yields on government bonds and other debt widens).

This change to banking capital is a fundamental one and will mean less lending and therefore a slower economy. The Regulators no longer like much reliance on wholesale market funding, where banks borrowed through the money markets. Instead Regulators wish banks to rely more heavily on deposit taking from the High Street and the web. Paradoxically it was the High Street deposits which pulled Northern Rock down, for it was only when that run became apparent that action had to be taken. Aware of this the Regulator says a bank needs more cash and government bonds as a buffer. That means lower bank profits, which in turn means the banks have less capacity to lend to others. Gaining deposits will also require the banks to offer a lot more than 2% to draw in the funds.

The round trip of money between banks and government which I have described before should be seen in this context. If we take the example of the money lent to 3 of the banks as Preference capital by the government at 12%, we can see what this does to banks profits and therefore to their future balance sheets. The money effectively has to be lent back to the government at around 4%, leaving the banks with a loss of around 8% each year, or £1100 million of losses between them. Far from strengthening the banks, this adds to their problems.

If the government is serious about wanting an early recovery it needs to revisit the banking problem. Its current strategy of bolting the banking stable long after the horses have gone is not going to get us back to sensible economic trotting let alone to the races. It has now designed a regulatory system for both pensions and banks which will provide a substantial supply of lending to the government, but which will make it more difficult to kick start the productive economy again with the right amount of new lending to business and equity investment. The sad truth is we need more profitable banks if we are to get the economy moving at a sensible pace. Given the way some are fanning the dislike of banks and bankers, few are going to like this uncomfortable truth even though as shareholders we are all now part owners with a stake in their profits and losses.