A story of two public sector owned banks

This week the Bank of England published figures to show just how its balance sheet has changed between 2008-9 and 2009-10. Its balance sheet has been swollen to a massive £223 billion, supported by just £4.2billion of shares and shareholder reserves. It is 50 times leveraged.

Its loans to banks have been cut dramatically by £124 billion. At the same time its gilt purchase scheme means effectively it has lent £200 billion to the government. Commercial banks now deposit £170 billion with the Bank of England, up from just £42 billion a year earlier.

In other words, over the last year there has been a huge swing at the Bank of England from financing the private sector banks to financing the government. The commercial banks as part of the regulatory drive to get them to hold much more cash and capital relative to their loans have changed their positions at the Bank dramatically in a way which makes them safer but also in a way which means much less money available for the UK private sector. No wonder the economy scarcely grew.

At RBS in 2009 the balance sheet was cut from £2.2 trillion to £1.5 trillion. In the first quarter of 2010, recently reported, the balance sheet did grow a little, from £1.522 trillion to £1.582 trillion. The increase came in derivatives. Loans to the private sector were static. On a risk weighted basis they stayed around £140 billion, or about 10% of UK GDP.

The policy of the last government and the RBS management was to cut their balance sheet by another £300 billion during 2010.

We need a more vigorous private sector recovery. This needs better balance in the amount of credit extended to the private sector relative to the public sector. Even RBS now has a Core Tier One Capital Ratio of 10.6% (including the effect of the Asset protection Scheme). Its leverage is well down on the high peak levels of 2007-8. The banking regulators need to allow the banks to finance a faster recovery.


  1. DBC Reed
    June 4, 2010

    What's the point ? All you get is house price booms.

  2. nonny mouse
    June 4, 2010

    [amatuer economist hat on]

    How does QE effect the amount of money in the system? Is it stashed away in the banks or is it swirling around the economy?

    One fear is that the QE money has not directly effected inflation because it just went towards bonds which are stored in the banks as capital reserves. Allowing the banks to ease their capital ratios lets the QE money escape into the money supply in the form of inflation.

    One way of detecting it might be by watching the money supply figures. As I understood it, money supply is (normally) a leading indicator for inflation. Are there any current figures for the various money supply (M*) online? If they stayed low or declined during the recession despite the QE and suddenly jump it could be an early warning of inflation. This could scare the monatarists (if there any left).

    Note: I'm not disagreeing with you, just suggesting caution.

    We are thirsty, so lets open the tap a little. But watch out in case the room floods because it is wet already and it has a history of flooding.

    [amatuer economist hat off]

    1. Mark
      June 4, 2010

      QE money is already in the economy: it has been spent by the government on pay for its employees, benefits, etc. The borrowing that should have occurred to finance that spending has not occurred in that the BoE has effectively just "printed" the money electronically. Only when the BoE sells the gilts held against QE will the real borrowing take place – that could well be at substantially lower prices than those at which the QE gilts were "purchased" with printed money. Incidentally, the BoE annual report confirms that all risks of loss on those gilts are for the account of government, not the BoE.

      Traditional monetary economics suggests that increases in the money supply increase inflation in a smeared out lagged fashion, with the peak occurring about 18 months-2 years after the increase. The present alarmingly high rate of RPI on an annualised basis suggests that we may be seeing that the present extraordinary circumstances haven't wholly overturned such conventional wisdom.

      1. nonny mouse
        June 4, 2010

        Yes, the inflation comes 18-24 months after the money starts circulating in the economy. Thing is, I do not think that all the QE money is circulating yet.

        The government/BOE gave large sums of money to the banks using newly printed money. The banks then bought government debt in the form of bonds whilst at the same time it increased the capital reserves for the banks, so the banks have to keep more money stored away in the BOE in the form of bonds.

        So the QE money is either:
        a) gone, used to reduce balance sheets (clearing their loan books of bad loans)
        b) on deposit at the bank as part of the higher capital reserves
        c) lent out to the wider economy, where it can cause inflation because there is more money in circulation

        Another way the BOE is giving money to the banks is via low interest rates. The BOE has a really low interest rate, but the banks have not reduced their rates by as much. The difference goes to the bank as extra profits, but takes money out of the economy at large. This partly explains the big profits the banks have been seeing this year.

        If you talk to home owners or businesses, the banks have not been making more loans in recent years. They have been using the money to pay down their debts or increasing their capital reserves instead.

        Everybody has been saying the banks need to loan more. As soon as they do the money supply will start increasing, so we need to watch out for inflationary pressures.

        The inflation we do have right now is largely caused by input cost inflation because we devalued the pound making all our imports more expensive. Output costs have been relatively restrained by weak demand. As soon as demand picks up there is going to be inflation caused by companies raising prices to make higher profits. There are also going to be demands for wage increases to make up for the lost earning ability.

        A little bit of inflation is good. A lot of inflation is really bad because it tends to spiral out of control and requires interest rate rises to fix.

        One thing to recognize here is that government gave up control of interest rates which were the normal way of controlling money supply. Now they have obtained another way, which is changing bank lending of privatised banks.

        Anyway, dont take what I say as gospel, i've never studied economics, I just read a lot.

        1. Acorn
          June 4, 2010

          Currently the Banks have £150 billion of QE deposited at the BoE. This money is not "in circulation". It will not be, until the Banks lend it out. It is safer for Banks to leave it their, earning interest, than lend it to dodgy customers. Meanwhile, they are borrowing cheap and lending expensive; making a very large margin to rebuild their balance sheets. All at the expense of the dumb arsed saver / taxpayers.

        2. Mark
          June 5, 2010

          The full three card trick of QE works like this:

          The DMO auctions new gilts to banks. The proceeds are given to the Treasury for government spending. The BoE buys "old" gilts with money it has "printed", so that the amount of gilts held outside the BoE is the same as it was before the DMO issue. The result for the banks is the cash they had before buying the new issue is the same (except for deposits by the Treasury of the cash raised by gilts, paid out for government spending), and the amount of gilts they hold is the same. Effectively, if you net out the redundant transactions, the Treasury is spending cash "printed" by the BoE, which will turn that into a loan to government when they finally sell the gilts they have bought.

          Of course, how effective government expenditure is in the economy depends on what the recipients do with the money in terms of generating Keynesian multiplier effects. A high leakage into imports hasn't helped.

    2. Denis Cooper
      June 4, 2010

      It's clear that more or less all the QE money has been dispersed into the economy through government spending, insofar as:

      1. The Bank of England created £200 billion of new money, and used £198 billion to buy previously issued gilts from the private investors who held them;

      2. In parallel, the Treasury borrowed a slightly smaller total sum by selling new gilts to much the same set of private investors, at much the same rate as the Bank was buying up previously issued gilts;

      3. So overall the position of the private investors was virtually unchanged, except they'd turned a marginal profit by selling old gilts to the Bank and buying new gilts from the Treasury;

      4. While the Bank now holds gilts to the value of ca £198 billion, in respect of which the Treasury is paying interest and will eventually have to repay the principle;

      5. While the Treasury got the £198 billion, less the marginal profits for the private investors, which money it has now used to help pay the government's bills.

      It would have been much simpler if the Bank had simply bought new gilts direct from the Treasury, but apart from being too obvious it would also have contravened the EU treaties – specifically, now, Article 123 of the Treaty on the Functioning of the European Union:

      "1. Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments."

      Where the QE money is now could really only be answered by finding out where any other money goes after the government has paid it out to settle its bills.

  3. Andy
    June 4, 2010

    You seem to have reversed your position. When talking about government you say that we do not get out of a crisis of debt by creating more debt; and yet here, talking about the private sector you say that we need more debt.

    I say not. I say that what we need is what is happening. Banks should not be the main supply of capital for enterprise. Banks are simply debt machines and we will end up in exactly the same place as we are now. What we need is for investors to become the source of long term capital; and banks to become the short term source — the "overdraft" if you will.

    In a country that has been drowning in debt, we are now suffering the pain of dry land. There is a big hole and some of our growth is being dedicated to filling that hole. There is no point filling that hole by digging another though.

    Banks being harder about their lending policies is exactly the way to achieve that — businesses need to change their attitudes to where they get funding; and more investors need to be encouraged. Government has a role here: in the same way that privatisation of utilities in the 90s led to a growth of small investors, we now need to make it easier for small investors to invest in small investments.

    I have a modest share portfolio in the form of an ISA — a few hundred pounds. However, in order to break even on any investment the growth has to be in the 10-15% range. Why? Because the dealer fees and stamp duty are an overhead. In the Internet age, this is utterly unacceptable, and makes it damned near impossible for me to do anything but choose based on long-term high-dividend investments.

    Want a legacy as a government? Make it easier for me (a raving capitalist) to invest in a small company. Make it easy for small businesses to get investment from places other than banks — from the private investor. At the very least, get rid of the transaction charges — if you want less of something you tax it, and you tax the act of investment.

    Reply: We do need more lending to solvent and enterprising businesses and to back profitable projects.

  4. oldtimer
    June 4, 2010

    I read that Mr Cable has said that the banks should lend more to the private sector. Perhaps you should refer him to this post you made today so that he is better informed about the reason. We need less preaching about what others "should" do and more action by government of what it "will" do to enable more bank lending.

    1. Michael Lewis
      June 4, 2010

      why? I think its a bit odd that so many people I had assumed were in favor of free markets, now think its time to step in and force banks etc…

      1. oldtimer
        June 4, 2010

        I am in favour of John Redwoods idea of relaxing capital ratios to enable more lending. Sorry if my post was confusing and/or ambiguous in this respect. I favour free markets.

      2. StevenL
        June 5, 2010

        LOL, I think you'll find that the free market idealists are either gravitating around the gold standard or abolishing central banks these days.

        The facts is, everyone is looking to the central banks as the saviour of their folly – and people are losing confidence in the central banks' liabilities now (or money itself).

        Look at the gold price staying stubbornly above $1,200.

  5. Blank Xavier
    June 4, 2010

    Inflation is a monetary phenominon.

    Create more money, then the value of money is reduced, and so the cost of other items, when measured in money, must rise, since money is worth less.

    The State has by a round-about method created a vast amount of money.

    The value of money accordingly falls. Prices accordingly rise. This is inflation.

    Inflation is extremely harmful. One major problem is that savings and debts are not adjusted for inflation. So if you have 100,000 euros and then inflation kicks in, after a few years, you still have 100,000 euros – but the actual worth of that money is much less.

    On the other hand, if you had a *debt* of 100,000 euros, the same process occurs; but now, the real value of your debt is far less.

    In other words, inflation, over the whole of the economy, transfers wealth from those who save to those who borrow. This is unethical. It is uninvoluntary theft.

    Another problem is that inflation makes it harder to predict future prices. This increased uncertainty makes it risker to make investments and harder to plan ahead, financially. All of this discourages the creation of wealth, which in turns acts to make us all poorer.

    Only a fool prints money; unfortunately, that's what we had.

  6. David B
    June 4, 2010

    A frightening picture which sums up the dreadful economic legacy left by the last government. This shows that the private sector has been starved of funds, stamping out any growth and a wall of funds being thrown at an unproductive, inefficient public sector.

    This brings back bad memories of the 1970’s. Our inflation is rising and growth is nonexistent. Are we looking at the ingredients of “stagflation”.

    One thing is certain, radical action is needed to stimulate the private sector and the public sector is going to have to take the pain and significantly reduce its borrowing requirement because the government demand for funding is diverting funding away from the private sector.

  7. Acorn
    June 4, 2010

    Good news about the Treasury COINS database being opened up for taxpayer access. Hopefully, lots of think tanks will be developing applications for extracting data themes from it, that may even rival i-phone apps.

    Perhaps George O can encourage the BoE, to make its balance sheet more revealing. The Special Liquidity Scheme trades are stock lending transactions; they are off balance sheet. I would like to know what is the state of the collateral the BoE is holding. What exactly are the £220 billion of "other assets" that represent 88% of its balance sheet. Can you imagine a set of company accounts saying such. Who is auditing the BoE?

    What about our latest sovereign wealth fund – sorry, debt fund; UKFI. We taxpayers have got £65 billion invested in RBS and Lloyds, plus some others public sector zombie banks. What's happening to that lot?

    1. nonny mouse
      June 4, 2010

      I took a (very) quick look at the data on COINS. As far as I could tell it's very cryptic, with lots of obscure line items that only mean something to those already in the know. I thought about writing an app to play with the data, but I'm not sure if I could get anything meaningful out of it.

      So good for Cameron et al. for getting it out there, but we need to get someone to interpret it for us before it is actually usefull.

  8. Peter Turner
    June 4, 2010

    When is the Bank of England going to give a fair deal for savers? I am sorry to bring this up once again but nobody appears to be giving any consideration to the plight of savers, many of whom are pensioners. In the meantime, mortgage holders are being heavily subsidised by the same Bank of England even though, in the main, they were and are responsible for their own overstretched borrowings.

    1. Simon2
      June 4, 2010

      Hear hear, there are also younger people like myself who don’t have a home due to insane prices, who rely on savings income to help pay rent and scrape together an eventual deposit.

      1. Simon2
        June 4, 2010

        I've done everything the supposed 'right way', lived within my means, been sensible with money, yet the ones who get ahead seem to be the those who do the opposite.

  9. Andy Bugden
    June 4, 2010

    I find all references to "greedy bankers" amusing – it really was a distraction from "greedy politicians". The fact is Banks take risks all the time. The problem was EXPOSURE. The credit reference agencies were incorrect in their assessments of risk. Banks make more margin on higher risks and rightly so. But some "lower risk projects" were in fact higher risk because of the incorrect assessments. This meant that the banks had higher exposure to certain risks that they did not know at the time.

    The problem we have is moodys and standards are reference agencies much in the same way as Dunn and Bradstreet. If it goes wrong they don't have to pay.

    If we look at insurance companies such as Euler/Gerling etc – as insurance companies they have to put their money where their mouthes are.

    I find it very strange that we want to stop banks making excessive risks whilst at the same time insisting that the 2 that the tax payer has a large stake in, have a target to lend money.
    If you cannot get a loan from the other banks, the only reason you deserve a loan from RBS etc is if the other banks are at the limits of their exposure. If you are risky, why should you get a loan?

    1. nonny mouse
      June 4, 2010

      There were plenty of companies that were not very risky who could not get loans. The problem is that the banks were using the money for other things.

      1. Andy Bugden
        June 4, 2010

        indeed – but it's not actually about the risk. every time a bank lends money there is a risk – there are companies there that might not be so risky, but the problem main problem through the crisis was bank's exposure. Unfortunately the politicians in seeking to deflect blame from the expenses, and also to defelct blame in lack of regulation, created the "greedy risk taking bankers". If you have an overdraft of 1 pound – that is a risk. yes it is a small risk but when you multiply it by 1 million people then you have to look at the exposure to the 1 pound risk – how many will repay it and do we have too many 1 pound debts out there. The same comes with larger sums of money to businesses. Standards and moodys dont have to pay when they get it wrong – banks do. so we must trust the banks more with their management of the risk and their total exposure to each type of risk

  10. FaustiesBlog
    June 4, 2010

    What happened to the Tory policy of the government lending directly to small businesses, by-passing the banks entirely?

    Alaska's state bank:

    … is funded entirely by local deposits and does not practise fractional reserve – it lends out only monies held on deposit.

    Its obvious advantage is that it is virtually recession-proof – all that can happen in a recession is that the deposit base decreases.

    But think of the further advantage of the bank (the state) being in a position to collect interest on loans. Isn't the scheme worth considering?

    1. StevenL
      June 5, 2010

      I think you misunderstand. If a bank lends out its' deposits it is 'fractional reserve' – the reserve being the fraction it keeps ready to meet depositors demands for withdrawls.

      A non-fractional reserve bank would have to charge depositors for keeping their money safe and just lend out shareholders capital – at a much higher interest rate than we are used to.

  11. Michael Lewis
    June 4, 2010

    Sorry comrade but forcing banks to become an arm of the state isn't a solution. The banks need to shrink their balance sheets. You can't solve a problem of too much debt and consumption with more debt and consumption.
    Banks should become safer and then should be allowed to fail.

  12. StevenL
    June 5, 2010

    I don't care how much 'tier 1' RBS has, I still wouldn't go near it with a bargepole.

  13. Mark
    June 7, 2010

    I tried to get my head around the BoE Annual Report and some of the statistics on lending that they publish, but I haven't had the time to try to disentangle the copious revisions to the data on lending as the bases have changed, or to try to dedcue a little more of what isn't printed in the Annual Report. Suffice to say that the BoE accounts give due warning in the notes (pp 51/52) that they are incomplete and thus not a true and fair view. I gather the ECB got upset over the accounting tricks being used by the Greeks: it is as well they don't have the powers to get upset over the tricks being used here.

    One of the things that does appear through the gloom is how little lending is made to manufacturing industry in the UK: You could double it, and it would still be smaller than the total lent to BTL mortgages. Lending appears to be dominated by over-priced property (both private and commercial), and by "finance".

  14. christina sarginson
    June 15, 2010

    It seems that the banks are nervous about lending money to anyone, including private enterprise now after the disaster of 2008-2009. I am a director of a small business (social enterprise) and have experienced the public sector cutting back for approximately 6 months.
    The business has been going well for 10 years and when asked for help from the bank, (RBS) the result has been either no, or an enormous amount of red tape is in the way of any help. It does make my blood boil when I think of how much help they had from the tax payer I will be very pleased to see their practice relaxed and help small business to recover.

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