Dec 15 2008
Why don’t the banks work?
The government thought the following would lead to more normal lending levels:
1. £37 billion of new equity for 3 banks
2. Nationalisation of 2 mortgage banks
3. £450 billion of short term loans and guarantees for banks
4. Much lower interest rates
5. A big increase in money market liquidity and substantial open market operations by the Bank of England
They thought all of this would bring LIBOR down close to the base rate, in turn leading to banks lending again to home buyers and businesses.
Now it is not working they have added:
1. The reflationary package, based on a VAT cut
2. Much higher levels of public borrowing
3. Lecturing the banks
So why isn’t it working?
1. The banks still have to write off substantial bad debts. HBOS last week revealed an additional £8 billion of write offs, three quarters of the new capital the government is supplying. If all or most of the new capital just matches losses it cannot be used to lend more.
2. The Regulator has chosen this bad moment to demand more capital and cash to sustain existing levels of lending. As a result new capital above the write offs does not necessarily allow any new lending.
3. Banks are lurching from being too confident to being very cautious about new lending. They are now reluctant to lend as they fear more losses.
4. Further big losses are emerging, as we learn today concerning a large US Investment fund. Such losses hit confidence and in some cases impose more direct losses on banks.
5. The Regulators are requiring banks to rely more on retail deposits and less on wholesale money. Retail deposits are dearer, making it more difficult for banks to make profits. Loss making banks are weak banks, unable to lend more.
6. The two nationalised mortgage banks are effectively winding down their mortgage books. This means far less mortgage money is available in the markets, leading to further falls in house prices. This in turn leads to more mortgage loan losses for the banks.
7. The sharp deterioration in business conditions in the UK, US and EU in the fourth quarter of 2008 will create more corporate loan losses. Bank executives are busy fire fighting problems in many of their customer companies.
8. The Regulator is going to require the banks to hold a lot more in gilts so they are more liquid. In other words the banks are going to be made to lend more to the government!
What can be done?
It is not easy breaking a vicious circle of less lending, more losses, less lending. The government should summon the Bank of England, the Regulators and the lending banks. It should say it wants to change the terms of its £450 billion package to make it more effective. The Regulator should be asked how it could be more counter cyclical to make it easier for banks to lend in difficult conditions. At the moment regulatory and monetary policy are pulling in opposite directions. That needs to change. The government needs to find a market answer to allow Northern Rock and Bradford & Bingley to lend again. It needs to find a way to limit taxpayer risk in RBS.
If they carry on in current mode we should expect more property price falls, more bankruptcies, more job losses and more bank loan losses. This is not a great backdrop for recovery. Whilst it is important the government stands behind the main UK banks to avoid another Lehman disaster, it must avoid feather bedding them. Taxpayers should not be subsidising six figure salary executives and their bonuses. The financial sector generally has been paying itself too much. The sooner costs and charges are cut, the sooner more normal business can resume.
The serious allegations about a large US investment fund show us how little a big Regulator achieves. The very least we should now expect is Regulator help to solve the current problems instead of making them worse. Putting in tougher controls to prevent the excess they allowed a few years ago just digs us deeper into our current hole.
18 Responses to “Why don’t the banks work?”
John Redwood has been the Member of Parliament for Wokingham since 1987. First attending Kent College, Canterbury, he graduated from Magdalen College...
It needs to find a way to limit taxpayer risk in RBS.
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It’s called less lending, lending to higher quality borrowers, RBS increasing capital which means charging more to borrowers and paying less to savers. The option of more capital injections from the private sector went out the window with the threat to nationalise.
Everyone seems to be looking for a magic answer, there isnt one! We spent 10 years printing money and putting it into housing so it drip fed the consumer without creating inflation. In addition we gave a load of IOU’s to China in return for ever cheaper goods. The cycle has run its course and now the economy needs to adjust back to reality.
Of course some will respond that this is negative thinking, we need to slash rates to 0%, print money etc etc. In the end it is just another way of bringing the economy back into equilibrium and whichever way you go you will be poorer, its a zero sum game!
Lending will only resume once risk, asset prices and general price levels are back in line! The sooner they get there, the quicker the recovery.
The Halifax have written to advise me that my SVR has been reduced from 5% to 4.75% (9th Dec 2008).
What they actually mean is that my Halifax SVR has been increased from 2% above BOE Base Rate to 2.75% above BOE Base Rate.
A 37.5% increase in their margin!!!
In other words they have only passed on a fraction of the Governments recent 33% reduction of the BOE Base Rate (3% to 2%)to the customer and increased their margin by a whopping 37.5%.
What is particularly annoying is that their correspondence is worded in such a way as to make this huge increase in cost to the customer very unclear.
Stuart Fairney Reply:
December 15th, 2008 at 7:40 pm
It must be the time of the month, because the Grand Admiral knows better than this. The MPC these days is no more than a bunch of guys sat in a room having a theoretical talk about what they might like interest rates to be, (just as Donitz and I might and sometimes do enjoy a glass of wine and a discussion of economics). Neither discourse will impact on LIBOR.
If the bank balance sheets are so week why can’t they be re-structured by forcing bond holders in the banks to swap their holdings, at a discount, for equities?
oooops can’t spell ‘weak’. One mark off for Lola
It seems inevitable that a business which has got itself into problems through bad practice will first want to eliminate that practice and ensure it does not creep back in. The bad practice of many banks was to lend too much against too little security. They know that sustainable profit can only come from lending sensible amounts against solid security. They also know that accumulated bad debts must be written-off, thereby delaying the time when they can be profitable again.
During a period of falling house prices taking a charge over a house is riskier every day. To add to the problem, recession risks jobs which risks the value of the borrower’s personal covenant to repay. That covenant is the first line of security relied on by every lender, although it is rarely referred to as such.
The natural course of events is for banks to limit their lending to the very best risks until their business is stable and then push at the edges to see whether slightly more risky loans can be justified. This necessarily means that new lending will be restricted below historically safe levels, perhaps for quite some time. All steps taken by government must be assessed against that background.
If lending both for house purchase and for business is to recover from its present low levels it will be necessary to persuade banks to take risks they would not otherwise feel comfortable taking at the moment.
The general thrust of the Conservative’s approach must, I think, be correct. As I understand it they propose giving guarantees so that banks can make loans of a type that have been considered safe in the past even though they contain more risk than the banks consider prudent in current circumstances.
My concern with this approach is that it can mask problems which really need to be out in the open. For example, there can be no doubt that house prices were inflated way above their true value and a significant bubble element still exists. That can only be removed by restricting lending to a sustainable multiple of the borrower’s income, say 3 times main income or 2.5 times main plus 1 times second income. Allowing greater latitude than that will keep prices above true value and store further problems for the future.
“The serious allegations about a large US investment fund show us how little a big Regulator achieves.” (JR)
Is this the guy who allegedly walked into work one day and informed his staff that the $50 billion hedge fund they thought they were working in was really a bankrupt ponzi scheme?
I would have thought the first thing regulators should do about collective investment vehicles was check that they are not ponzi schemes?
Is this not common sense or am I missing something?
In a current climate the Government should do:
1) Stabilise house prices – use NR and B&B. Nobody wants just bought car to wreak their home. Northern Rock and Bradford & Bingley are doing exactly that! wrecking the whole market after the pyramidal scheme they created collapsed (With 125% mortgages, 6+ annual salaries – they wanted to get as many customers as possible and didn’t ask about the consequences. Even worse, they knew it will run for long enough as people were forced to buy properties to live as it is very simple for a landlord not to extend a contract).
2) Cut expenses – military budget, benefits, salaries in the Government and Government related services. Local governments should also follow the lead. Possible savings – up to £100 billions annually (more than £16 billions on military budget, 30-40 on benefits, the rest on salaries and pension costs).
3) Invest savings in infrastructure (transport, power-plants (Golf stream plants, wind-plants)) and technologies like high speed computers. That will also create jobs and provide needed investments at the moment when it is needed.
4) Cut company taxes – that will leave more capital and be an incentive for companies to invest wisely, hence employ more people.
Hi John,
I think your analysis of the problem is accurate; – banks have impaired loan books, damaged capital adequacy ratios, limited opportunities to raise fresh private capital, and a loss of appetite for further loan risk. Their ‘business as usual’ model is broken. As the banks rein in their commission agents and stop writing loans, their client base starts to die of thirst in the credit drought.
So, banks sup with the devil and turn to HMG for help. UK.gov morphs from supplicant to savior like some 21st century Shylock, advances the money, then demands their pound of flesh.
Your solutions to free up the banks to lend more easily are as wrong headed as those promoted by HMG. Banks cannot ‘work’ the way the used to – ‘free’ money was part of the problem.
The elephant in the room is the fact that the boom was fools gold – houses were never ‘worth’ 5 times average earnings, about 3 times that benchmark has been the mean. We will now see a reversion to the mean, and for that to happen house prices have to drop below 3 times earnings for a while until the mean is reestablished.
Every initiative to ‘unlock’ credit to make houses more ‘affordable’ is designed to make sure they stay expensive by driving down the cost of borrowing. Quixote is tilting at the wrong windmill – the dragon is overpriced housing, not lack of credit. Similar issues affect many business models that relied on credit to expand, or credit to sell.
This boom was built on a sea of cheap credit and funny money, little real wealth was created. The bust is just recognising that reality. Mitigations will only ensure that the dead still walk amongst the living. Broken business models have a right to die – it is not necessary to send them on a stretcher to Switzerland – they can expire here if they are denied morphine and left to fade away.
Many normally sound business models will be swept away in the firestorm that will eventually purge the system. Real people will suffer real hardship. It will be bloody, awful, mayhem. The mess is unfolding now – Canute cannot hold back the tide of woe that is coming our way.
It is time to start thinking about how to organise the future, not revisit the past or resist the present. The choice for the executive, the legislature and the electorate is denial or deliverance: House prices like 2007 are over for a decade or more. EZ Credit is a thing of the past.
Get used to it.
mikestallard Reply:
December 16th, 2008 at 6:09 pm
In the 1930s, the economies were allowed to “be swept away in the firestorm”.
This may well happen here now. A lot of sensible commentators are saying that it will.
The problem is that chaos ensues as people get hungry, they want to work, they see their families suffering. Then along comes a(word left out ed) strong man who can see exactly what to do.
(Piece refers to dictatorships in 1930s and worries of something similar today ed)
The problem is that we have lost our independence. So where can we run to?
Thank you for your comment and for your invaluable blog. I wonder if you could comment on this issue. The government seem to want to act in a way which sustains and promotes consumer expenditure, in order to avoid deflation. It also wants the banks, as you comment, to rely less on wholesale money markets and more on retail deposits. Any individual can either spend or save their assets. There isn’t a third option. All seem to agree that savings levels have been too low in the recent past. All this raises two questions in my mind:
1) Since the government wants us both to spend and to save, why bother trying to do anything, as that is exactly what we will do anyway.
2) How can it possibly be right, if one wants to rebalance lending towards retail (Joe Public’s) deposits, to try to reduce the interest rate he is offered either drastically or at all?
Reply: You have pointed to another contradiction.
I do not know anywhere else where you can get such a short, effective and, yes, simple summary of the present banking problem – with the suggested course of action added on!
I am sure that Mr Brown does not read this blog.
If only he could put it into practice instead of just being dismissive!
Looks like a job for The Sweeny. Get your trousers on son your nicked. Regan and Carter would sort them out. Loosen your tie, pour yourself a scotch and tell yer bird to shut it. Do you see today’s modern working man necking a bottle of scotch during the course of his eight hour day then going to the pub? Regan would makes some phone calls shout a lot and George would phone in and they would agree to meet in the pub, somewhere on the way a major revelation occurs and the case would be blown wide open.
The Alistair Darling and Gorden Brown lame Cop double act need to learn who the Gaffers are.
Even Big Vern could not imagine blagging £450 billion.
Banks do work, they are doing precisely what fractional reserve banking was designed to do, consolidate the wealth of the world into the hands of a few elites.
http://uk.youtube.com/watch?v=_3__kZScZV4
http://uk.youtube.com/watch?v=AwIncF3yrpQ
How can the Labour government expect the banks to lend more when the banks still do not know the extent of write offs.
This tells you all you need to know about Labours understanding of the situation.
As more and more problems emerge the banks will be very careful about future commitments.
Only when they are convinced they they have delt with it all will anything like normal service commence.
Why does the government not understand this.
Q. Why do the government not give loan guarantees to the banks.
A. As just like the banks they do not know yet the full extent of the problem.
So the government is behaving just like the banks.
If the pyramidal scheme called house bubble is allowed to burst completely, it will affect:
1) All recent buyers as they will have to either pay to the pyramidal scheme player to get out of the deal or to stay at SVR (expensive).
2) The whole UK economy as it is oriented at housing market.
3) With recession/depression will come brain drain that will affect recovery in the future.
Sterling is just a sign how investors perceive the UK economy and because of globalisation caused specialisation weak sterling will not help so much the whole UK economy as the UK doesn’t have a lot to offer. One reason why the UK doesn’t have a lot to offer is a failure of Business Link to help good idea business to grow – it was more service oriented and service supply is not easy to increase fast (needs educated personal, and that needs time and good salaries).
Why would “4 Much lower interest rates” work? Don’t lower interest rates discourage the supply of credit? Are people and businesses in difficulty because they can’t afford the interest on their loans – or because they can’t get loans at all? Aren’t there first time buyers who would happily arrange a mortgage at a higher rate than the rates on offer now – if they could get one at all?
Surely given the enormous amount of government borrowing in the UK and US and the fact that the Chinese are now more reluctant to fund it, we actually need higher rates not lower. Or better still a big reduction in government borrowing!