The UK’s very dangerous banks

Banks are being asked to lead the recovery despite the fact that they continue to pose the biggest single threat to the British economy

Helen Thompson
Helen Thompson

Probably nothing matters more for the immediate future of the UK economy than what is happening in the banking sector. In macro-economic policy terms most of the attention devoted to restoring growth to the economy has been focused on the supply of credit from banks. The Bank of England base rate has remained at 0.5 per cent for more than four years.  This has been supported by £375 billion of quantitative easing.  In addition, in the summer of 2012, the government and Bank of England introduced the Funding for Lending programme to provide banks with funding at below market costs in exchange for more lending to businesses and households.

With all of this showing only a modest return, the government turned to the Help to Buy scheme in the 2013 budget to support mortgage lending.  By any historical standards, monetary policy is extraordinarily expansionary and certainly makes a mockery of the idea that there is a straightforward politics of austerity in the UK at the moment.

Yet, for all the policy effort expended, bank lending remains weak.  In part, this outcome is exactly what should be expected after a recession produced by a banking crisis.  Why? Because banking crises paralyse the process of channelling money from savers to investors.  But it is also testament to just how deep the structural problems of UK banks are.

This was, and remains, no ordinary banking crisis.  UK banks operated very differently during the decade leading up to the financial crisis than they had previously done.  They became dependent on borrowing in international wholesale markets, rather than relying on deposits to fund their lending.  Once they were shut out of those wholesale markets their entire business models were broken.  Those that were bailed out have been looking to reduce their dependency on these markets, which means lending less.  They also found in 2011 and most of 2012 that the cost of ongoing borrowing in these markets rose, which left them unable to lend at anything like the Bank of England rate.

Meanwhile, during the decade leading up to the crisis UK banks also accumulated massive balance sheets with a vast array of international assets and liabilities.  Of the G20 states, only Switzerland has banks that have balance sheets as large in relation to the economy. The composition of these balance sheets is extremely problematic.  UK banks are deeply exposed to private sector debt in Ireland, Spain and Italy and to bank debt in Germany and France.  This ties their prospects inexorably to the euro-zone crisis, and that is an ongoing burden on their creditworthiness in wholesale markets.

These problems have been compounded by the ways in which both the economics and politics of the banking crisis and short- and long-term considerations have interacted.  The politics of recovery demands that banks lend more and be seen to do so.  But trying to prevent another banking crisis demands equally that banks meet much tougher capital and liquidity standards, set aside more funds for pay-outs and fines on past misconduct, properly value the very risky assets sitting on their balance sheets, and recognise the scale of likely future losses on loans to the euro-zone.

The shadow banking system that flourished before the crisis is still allowing the banks to obfuscate about these ongoing risks that their pre-crisis borrowing, lending, and crooked practices have bequeathed to them.  These deliberate mystifying tactics almost certainly mean that the banks themselves, let alone policy-makers, have incomplete knowledge of the risks in play.

Whilst the coalition government is devising new schemes to create incentives for more bank lending, the Financial Services Authority, and in particular the Bank of England, have been pressing banks to prove their safety.  Last month the Bank of England’s Financial Policy Committee complained that UK banks are overstating their capital by at least £25 billion, with much of that represented by Royal Bank of Scotland in which the state has an 83 per cent holding.  What appears as a shift towards prudence from banks, and looks responsible for weak lending, disguises just how toxic the balance sheets of UK banks still are.

The present political hope that the banks will rescue the UK economy blithely ignores the fact that it is the banks that pose the greatest threat to the economy.  The political narrative today is all about the recovery and what policies will bring it about. The Conservative/Liberal Democratic government wants the banks to regenerate the economy through lending because it has tied fiscal policy to deficit reduction, seen that the benefits of exchange rate depreciation are largely exhausted, and is well aware that the UK has nothing like the multiple sources of credit beyond banks that are available for small- and medium-sized businesses, for example, in the United States.  But it is quite probable that the more urgent practical task for UK policy-makers is to try to prevent another banking crisis, or at least militate against the most catastrophic scenario of bank collapses when the moment of truth for UK banks hits.