Sep 15 2007
A question of confidence
This has been a disastrous week for the Chancellor.
Just a few hours after his attack on the banks appeared in the Daily Telegraph he endorsed a decision by the Bank of England to make money available to any bank that needed cash from the lender of last resort. He lurched from saying “Institutions have in some cases been prepared to lend to people without checking if they were ever going to repay it” to having to reassure people about the safety of the banking system for depositors.
Perhaps he will now think more carefully about his overall responsibility for maintaining confidence and stability in the financial system, rather than indulging himself with grandstanding comments on alleged mistakes of the financial world. It is especially rich to hear about too much lending and borrowing from this government, which has so increased our national debt burden.
He has also concluded that we need more transparency. He told the banks that they need “to open their own eyes and be more honest”.
I agree that we need updates on the current profit forecasts of the main banks as soon as possible if any adjustment needs to be made. We had a profit revision from Northern Rock yesterday. Profit forecasts - revised where they need to be revised - could reassure markets, because the banks have to include bad debts and losses on financial assets they hold within their profit and loss accounts and would be able to show these are manageable.There does not need to be any change to the law or regulation - directors of quoted companies like banks are under a duty to keep the market informed of changes in their profit outlook.
This week has shown that more transparency is not always helpful.
It was helpful for the Bank to remind us it is the lender of last resort and it is prepared to make money available to banks that need it.
It was not helpful to learn the identify of the institution that had applied for a loan facility.
All banking depends on confidence. All banks to some extent borrow short and lend long. They can do so only because people do not all want their money back from any given bank on the same day. The Chancellor’s “good old fashioned banking” depended on raising lots of small deposits from individuals around the country through a branch network. Much of this money could be withdrawn on demand, or at relatively short notice periods. This money was then lent to others, often for longer time periods. The difference between the rate the depositors received and the interest charged on the loans made the bank profitable. For such a model customer confidence is especially important.
There is nothing wrong with lending and borrowing in sensible quantites - indeed it is crucial to a successful enterprise economy. Older people tend to have money to save and invest, and younger people tend to need money to buy homes and build businesses. It makes sense for banks to let this happen. The quantity of money lent is largely determined by the interest rate, which in normal conditions is fixed by the Central Bank. The current situation is the result of past government and Central Bank decisions, as well as the result of the judgements of the commercial banks.
It is vital that confidence is maintained in the system. If people become distrustful of banks then credit collapses, house prices fall, businesses cannot borrow to expand or even to continue, jobs are lost.
I just hope the Chancellor has learned this week that what he says matters, and that he above all has a duty to build confidence.
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John Redwood has been the Member of Parliament for Wokingham since 1987. First attending Kent College, Canterbury, he graduated from Magdalen College...
The Northern Rock bank went to the Bank of England, actually the Treasury, to ask for credit. It could do this because it is a British bank, but what will happen on mainland Europe if a bank that is, say French, or Greek, gets into the same state? Who do they go to for a credit extension? The European Central Bank doesn’t have the wherewithall or the instruments to back banks they are supposed to be serving.
Will the banks with whom we have our overseas mortgages on our overseas homes just close and hand the deeds of our holiday homes over to their debtors, likely the local tax collection agency?
Does HM Treasury have enough money to cover the requirements of Northern Rock?
Reply: The Bank of England does have enough money to cover Northern Rock’s requirements. Northern Rock will need to pledge its assets to the Bank if it does take out some of the credit on offer.
The European Central Bank has substantial resources, and has been making money available in Euro markets when needed. The German bank which got into difficulties was absorbed by another bank.
“It was helpful for the Bank to remind us it is the lender of last resort and it is prepared to make money available to banks that need it.”
I begin to wonder whatever happened to the mantra that is pushed to beginners in economics and accounting: “Cash is King”.
Without sufficient or with badly managed cash-flow, a company, e.g. engineering components manufacturer, can be declared insolvent, even with a very healthy order book - resulting in loss of jobs due to an unfortunate muddle with the books. Why is it that banks are such a special case, that they can simply be bailed out by the tax-payer ?
Clearly the banks are shielded by governments from the failure to adhere to basic accounting and economic principles. Surely such a practice should be condemned ?
Reply: To be safe a business both has to be solvent - assets greater than liabilities - and liquid - short term assets greater than short term liabilities. In other words, yes to be sure of day to day survival a business has to have cash to pay the immediate bills that fall due, as well as having a solvent position for the future. You should not trade when insolvent.
The difference between main commercial banks and an engineering company is the engineering company banks with commercial banks, whilst a large commercial bank banks with the Bank of England. A solvent engineering company which is short of cash should be able to borrow it from a bank. A solvent bank can borrow for emergency cash needs from its bank, the Bank of England, if it cannot get its cash needs directly from the market.If either a bank or an engineering company is insolvent it should stop trading to prevent that company entering new contracts it cannot honour, and to pay out as much as possible against the money it does owe from what assets it does hold.
No bank is shielded from adhering to proper accounting practises. Banking is a different kind of business model, because it always has an element of borrowing short to lend long, and is therefore dependent on confidence.
“All banks to some extent borrow short and lend long. They can do so only because people do not all want their money back from any given bank on the same day.”
Have they not seen It’s A Wonderful Life? “The money’s not here. Your money’s in Joe’s house…”
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