The banking mess

Three-and-a-half years have passed since the banking run on Northern Rock in the UK, two-and-a-half since the collapse of Lehman Brothers in the US. And we’re still waiting for the government’s decision about what to do with the banks.

There’s been some tinkering. The Financial Services Authority, which bore more than its fair share of criticism for the banking crisis, has been broken up. Responsibility for financial stability has been given to the Bank of England: it has a new committee to look after it. The Chancellor has agreed Project Merlin with the banks: a deal that combines bonuses, transparency and lending. The Independent Commission on Banking has made some menacing noises about a possible restructuring of the banking sector; we’ll find out what that might mean in April, when it publishes its interim report. But given the scale of the banking disaster, and the general consensus that Something Must Be Done, it is remarkable that so little has been done so far.

Let me remind you how bad things have been. The 4 days in September 2007 saw the first run on the retail deposits of a United Kingdom bank since Victorian times. Since then, the UK government has committed at least £1.2 trillion to support the banking sector: equivalent to 85% of GDP, over 20 times the annual spend on education, over 10 times annual expenditure on health. Despite all this support, banking is still broken. The latest Bank of England figures are shown in the figure below: the annual change in the amount lent to small businesses (the blue line) and all small-and-medium enterprises (the orange line). With access to credit choked off, it’s not hard to understand why UK growth is so weak.

lending

It gets worse. The Bank of England estimates that UK banks will need to raise up to £500 billion over the next two years just to replace existing funding. That is, none of this funding would be used for new lending: the banks have to run this hard just to stand still.

The underlying problem is that the banks’ capital is still at risk. About half of all loans issued since 2004 are in breach of their covenants. Commercial real estate accounts for about half of the loans outstanding in the UK; and commercial property values are currently around 35% below their peak.

So, something really does need to be done. (But we knew that anyway, even without all of the figures that I’ve just thrown at you.) There seems to be general agreement that banks cannot be allowed to be “too big to fail”. That leaves 2 broad options. The first is that banks gain enough capital that they are never again in any serious risk of failing. One of the causes of the crisis is the extent to which UK banks “levered” themselves: that is, lent more money than they actually had at any given moment. Banks have always done this, but the practice really took off over the last 10 years. The figure below (taken from the Bank of England’s financial stability report in December 2010) shows UK bank leverage over the last 50 years.

leverage

The second option is that banks are simply allowed to fail. In practice, that means that holders of senior debt in banks will lose some or all of their money, rather than having their investment protected by taxpayers. Unsurprisingly, they dislike this option. And being, on the whole, wealthy and influential individuals, they have done a pretty good job in convincing policy-makers that this option would simply cause investors to withdraw their money and invest elsewhere. But Denmark has chosen to go this route: when Amagerbanken failed on 7 February, bondholders lost 41% of their investment.

We shall see which option we go for in the UK. We are in the hands of John Vickers, who is heading the Independent Commission on Banking. The bad news is that’s he’s firmly part of the establishment (currently warden of All Souls College in Oxford, former head of the Office of Fair Trading and member of the Bank of England’s monetary policy committee). This may not bode well for taking on the might of the bankers. The good news is that he has some experience of taking on the establishment: he was, after all, behind the move to eliminate the notorious All Souls’ three-hour exam on a single word. The hope is that sorting the banks will be easy in comparison.

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