Friday, 10 October 2008

Have the banks been saved?

Wednesday's package of measures to stimulate the banking industry might help to bring some confidence back into the system. There are those who are sure it won't work because it is too timid and those who say it won't work because it is simply misguided, I am not yet convinced by either camp but I am doubtful whether it can achieve anything like the grand claims being made for it.

One of the major problems at present is an unwillingness of big players to trust each other because they cannot be sure anyone they lend to will be able to repay. The result is stagnation of high street lending causing cash flow problems for businesses left-right-and-centre and difficulties for individuals as they seek a mortgage loan.

What is it that causes big lenders not to make money available to the banks? As I understand it, the main factor is that the security offered by the banks is not trusted. In the current climate banks are not being trusted to service massive loans out of their ordinary day-to-day turnover because increasing levels of default by retail borrowers put turnover at risk. This, in turn, means that it might be necessary to call on security the banks offer. I find it surprising that little attention has been paid to this point because it is a real biggy. Security exists to step in and fill the breach when someone is unable to service a loan. That lenders are unwilling to lend to banks is an indication that they fear the banks will not be able to repay them. Concerns about the level of back-up security is one thing, concern about the ability of a bank to receive sufficient income to service a loan is another entirely.

Of course lending a vast sum to a bank over three months is not the same as lending to an individual over twenty-five years to support the purchase of a house. In the former case not only must interest be serviced but the huge loan must itself be repaid in three months' time, in the latter case the risks are different because a twenty-five year mortgage loan allows a capital fund to accrue or small amounts to be paid-off the capital each year and, through the combined effects of inflation and career progression, £100,000 lent today might equate to four-times the borrower's income whereas a quarter of a century later it might be less than one year's income. Repayment of the sum borrowed is inherently easier over a very long term than over a short term. Nonetheless, a strong income stream makes refinancing an existing loan relatively simple, doubts about the income stream make it extremely difficult.

Government-backed guarantees of bank borrowing can give reassurance that short term loans will be repaid, but no lender is going to be keen to rely on a government guarantee unless the bank's business is sound. Where that business is over-reliant on the income from loans which are likely to default, the addition of a government guarantee is of little comfort. Say a pension fund has £20million to invest and it has the choice of investing it with Bank A which will be able to repay and Bank B which might not be able to repay but has the benefit of a government guarantee, what is the pension fund going to do? It will want to lend to Bank A rather than run the risk of having to claim under the guarantee with all the delay and uncertainty that involves. In order to attract the business, Bank B will have to offer the pension fund a better return than Bank A, so that the risk of calling on the guarantee is out-weighed by the greater profit. This inevitably means that those banks who need the guarantee most will only be able to borrow money at high rates thereby reducing their profitability. We then reach the stage where the banks with the weakest portfolios of loans suffer a double-whammy, not only is their income stream at greater risk but their outgoings are larger.

A government guarantee could certainly allow transactions to be entered into which the big lenders would not otherwise have entertained, but it does not solve everything. The systemic weakness caused by a lot of bad lending in the last decade can only unravel over time. Unfortunately time does not seem to be on the banks' side because the national economy is either in recession already or will be very soon. Recessions cause businesses to fail and people to lose their jobs which, in turn, causes defaults on loans of all sorts including mortgage loans. This will flush-out the weakest of the banks' lending decisions and cause capital losses on many of those mortgage accounts, turning potential losses into real losses. Had the borrower kept his job he might well have been able to struggle-along paying the mortgage for its full term even though he should not have been given the loan in the first place. The exact degree of additional default will depend on the length and depth of the recession but what is certain is that defaults will increase and the banks will be hit. Those with the weakest business will then find it even more difficult to raise money, government guarantee or no government guarantee.

The only way the banks can trade their way out of the problem is by cutting their margins, quite possibly for many years to come. They will have to be very particular about who they lend money to and require far more solid security than in recent years. Inevitably this tightening of credit on the high street will add to the recessionary pressures, but there is no other sensible thing for the banks to do. They have to flush-out the effect of their past mistakes and will only be able to make credit more widely available once their businesses have been restored to order. And we must not overlook the stupendous amount of credit-card borrowing still in the system. The credit bubble as a whole must be deflated substantially before the banking industry can be stable again.

In all of this there is a great unknown. What effect will the necessary tightening of credit have? How long will it last and how deeply will it impact on the ability of small businesses to trade and individuals to pay their debts? We can be fairly sure that yesterday's package of guarantees and loan will encourage renewed lending to banks but we cannot be sure that the long term effects of a decade of loose lending, encouraged by a profligate government, will not be so great that a small recovery in the banking world is swamped by old impoverished chickens coming home to roost.

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