UK suffers from banks’ Darwinian hibernation

Britain’s banks are fulfilling their Darwinian role, to survive, rather than their economic one, to lend, and there is no easy or painless way out.

A glance at the latest Bank of England Credit Conditions Survey makes grim reading, with yet another marked tightening of lending conditions to households and businesses. Loans are harder to get and more expensive where available, which is hardly surprising given rising defaults and a hardening view that the UK will suffer a long and deep recession.

Mortgage approvals are running at a record low and there are widespread, though anecdotal, complaints of otherwise healthy small and medium sized businesses being squeezed to the point of failure by lack of finance.

On the face of it, Britain’s injection of 37 billion pounds of capital into three major banks and its guarantee of a further 250 billion pounds of interbank lending are not having the desired effects.

Banks, understandably, are hunkering down and trying to survive the next liquidity squeeze and minimize exposure to future risk, rather than taking risks and reflating the economy. While this may help individual banks, if they are sure footed enough, it will ultimately make the recession worse, defaults more frequent and lead to more bank failures in aggregate.

Given this, it is very likely that Britain will again have to intervene, either by further recapitalizing or nationalizing its banks, by providing some sort of state guarantee to lending, by forming a “bad bank” vehicle to fund or buy up doubtful assets, or some combination of all.

British Prime Minister Gordon Brown said that a second bailout was not the preferred option but that the government was exploring “other means by which we will try to get liquidity and cash into the system.”

Looking at the U.S. and British experience, it is hard to see what combination will restore lending and confidence and even harder to see that happening without an enormous cost and many unintended negative side effects.

For one thing, the very possibility of further government action means that private capital doesn’t know where it stands and may be reluctant to commit money to the financial sector.

Because there hasn’t been, and perhaps can’t be, a fully enunciated policy on who will be bailed out and under what circumstances, investors fear being wiped out if they commit capital to banks.

Investors may also be unwilling to buy up bad assets, like mortgage securities, from banks, because state intervention may be keeping unhealthy institutions alive and their dubious assets off the market. If these later fail they may disgorge and drive prices down further.

This isn’t an argument against state intervention — there really isn’t much choice — but we should be aware of its limitations and pitfalls.

Choose Your Poison

There is a sense however that governments, in Britain and elsewhere, have been playing for time, trying to keep banks and banking ticking over. Some major U.S. banks were arguably insolvent during the aftermath of the Latin America debt crisis, but time and a steep yield curve allowed them to fight their way back. We probably don’t have that much time now, much less the yield curve.

Governments can follow two main paths in recapitalizing and unlocking the banking system:

They firstly can act in the actual market for assets that are gumming up the system, guaranteeing the assets itself, such as the United States is doing explicitly with bank bonds and effectively with Fannie and Freddie issues, and can also wade in and buy up those assets with its own money, attempting to provide a floor for valuations and encouraging people to get in now rather than wait for cheaper prices later.

It can also directly inject capital into banks, as has been done in the UK and United States, shutting down or forcing mergers among those that don’t seem likely to survive. This is far from a comfortable position for a government to be in and tends to make lots of different people angry for lots of different reasons, hence perhaps a rather timid approach by both Britain and the United States.

University of Chicago professors Raghuram Rajan and Douglas Diamond point to a third possibility, a mix of the two, buying up illiquid assets while focusing on doubtful institutions that are likely to become distressed. In other words, taking a harder line with failing banks, biting the bullet and shutting them down and wiping out shareholders.

“Unless those entities fail or are forcibly taken over, those illiquid assets are not going to make their way on to the balance sheets of well-capitalized banks, allowing the overhang of illiquid assets to persist, and forcing lending to be subdued until the distressed entities actually fail, ” Rajan and Diamond write in a paper prepared for delivery at an American Economic Association conference on Monday.

It will make a lot of people angry for a lot of different reasons, but just might speed up the recovery.

[Source: By James Saft, Reuters, London, UK, 07Jan09]

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