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October 30 2008 Financial Times
Editorial
Persuading banks to lend again
Memo to bankers everywhere: Taxpayers did not rescue you because they love you. They rescued you because they need you. The rescues were intended to ensure the flow of credit to creditworthy businesses; yet that flow of credit seems to be slowing to a trickle. How should governments respond?
Let there be no mistake: government support for the banking sector was necessary. Without it, several large banks looked at risk of collapse, and the panic among banks and their creditors could have brought down the entire financial system. Yet just because the rescue was necessary, it was never guaranteed to be sufficient.
It is hard to be sure quite how serious the credit squeeze is for small and medium-sized businesses, but the signs are not good. The UK growth rate collapsed in the third quarter, which is ominous, given that the most acute phase of the credit crunch -- following the failure of Lehman Brothers -- began just days before that quarter ended. The Bank of England revealed on Wednesday that corporate deposits of cash with UK banks are at their lowest since 1980. Anecdotal evidence also paints a bleak picture.
Naturally, many people are wondering why the UK Treasury -- and the US Treasury, which faces a similar situation -- is not doing more to force the banks to lend after their expensive rescue. It is easy to tell a tale of greedy banks and complaisant governments; but the true story is less of a pantomime and, sadly, more intractable.
The fundamental question is why banks are reluctant to lend. One possibility is pure fear: the banks lent too much before, destroying their reputations and tens of billions of pounds of their shareholders' wealth, and now are erring on the side of caution.
A second possibility is that banks face a co-ordination problem. No bank wants to be the only one extending overdrafts and rolling over loans, but each might be emboldened if others did likewise.
If these are the only reasons why banks are not lending, then wheedling, cajoling and arm-twisting from the Treasury is not only justified, it might also do some good. Banks might get over their collective paralysis. Solvent businesses would not fail for lack of funding and the worst consequences of the credit crunch would be contained.
The trouble is that, while fear and lack of co-ordination are partial explanations for the drying up of credit to businesses, they are not the whole story. It seems likely that many of the loans banks unwisely made in the good times are now intrinsically unprofitable. They were predicated on cheap credit, ample risk appetite and a growing economy. Now that banks cannot borrow cheaply or raise capital, those loans cannot be rolled over without losing money.
If that is the problem -- and to some extent, it must be -- then there are no easy options for the government. Bullying will make little difference. Targets can be sidestepped easily: a demand to lend more money to small businesses might well simply mean less lending to medium-sized businesses.
The UK government could step in directly and order the banks to lend to small and medium-sized businesses, effectively nationalising the whole sector and taking both the credit decisions and the credit risk. That may yet be necessary -- but only a hopeless optimist would expect that story to end happily. Loans would become political, the government taking responsibility for who survived and who went under. This remains the last resort.
The government could also encourage banks to lend by lowering the price of the capital and credit insurance offered to them. Taxpayers would be paying to subsidise loans to businesses. Some of those businesses would be saved, and so too might other businesses that depend on them. Yet much of the money would go to businesses that need no subsidy, or businesses that are beyond saving. There is no simple answer and the problem is made yet worse by the fact that one bankruptcy can cause an avalanche of others with little warning.
This is the tragedy of the great deleveraging. Since credit was unsustainably loose, it must inevitably tighten. Policymakers cannot prevent that; they must aim instead to prevent chaos and overshooting.
For now, the focus shifts instead to the Bank of England, whose next decision on interest rates is due on Thursday. With inflation worries soon to become a distant memory, a dramatic cut in rates is needed. Two per cent would not be too much.
Meanwhile, the government should stick to persuasion and leave more drastic plans on the shelf. It might be worth reminding the banks that, should persuasion fail, public outrage will ensure that those drastic plans gather no dust.
Copyright The Financial Times Limited 2008