Lender of first resort

The financial crisis has prompted a reassessment of the British economy and the role of the financial sector. Though the causes of the crisis are complex, a consensus has emerged that regards bankers’ greed and recklessness as the ultimate cause of the debacle. Any long-term solution must entail reforming the banks, and imposing restrictions to prevent similar disasters in future. While politicians in many countries have exploited anti-bank sentiments, they have also realised that “punishing the banks” can have damaging consequences, and may abort hopes of recovery.

These dilemmas are particularly acute in Britain. London is one of the two leading global financial centres, and finance has probably played a disproportionate role as a source of the country’s growth and tax revenues. This background reinforces conflicting policy pressures.

Since Britain’s deep recession and the slowness of the recovery are being attributed to the economy’s over-dependence on finance, many support radical banking reforms, which would reduce the importance of finance and facilitate a “rebalancing” of the British economy towards other areas, primarily manufacturing. In the aftermath of the crisis there were calls for less financial, and more real, engineering.

But this view, though appealing, can be dangerous. Britain still has a comparative advantage in banking and finance, a sector with good growth prospects in spite of the recent fiasco. For Britain, it could be folly to pursue harsher reforms than our competitors, and damage an industry that may thrive in future. The French would like nothing better than to see Paris replace London as the pre-eminent European financial centre. Manufacturing, though very important, will not become the leading British sector.

The independent Vickers Commission is proposing raising bank capital requirements, and a new system of internal ring fencing, aimed at separating retail activities—which are vital to the economy—from more speculative investment banking. These proposals would make British banks safer, and reduce the risk that taxpayers would have to bail out banks again. But we have to beware of unintended consequences.

Banks would become less profitable and less able to lend at a time when growth is slow. If we try to make the banks safer too quickly and too abruptly, we risk a new recession. The government has repeatedly criticised British banks for unduly low lending to business. These criticisms do not make sufficient allowance for the fact that weak lending is partly due to lack of demand and a reluctance to invest, not simply lack of supply. It is illogical to urge the banks to lend more and at the same time to rebuild their capital.

But the banks are not blameless. Over the years, traditional relationship managers, who knew their business customers well, have mostly been replaced. Instead, relatively inexperienced people, who tend to use credit scoring and other box-ticking techniques, are now making lending decisions.

Small and medium sized businesses (SMEs) are suffering from inadequate bank competition, which raises costs. While large businesses can borrow in the capital market, the SMEs have a restricted choice of only four or five suppliers: that is, the high street banks. In the longer-term, British industry, and manufacturing in particular, will benefit from banking relationships similar to those that exist in Germany between medium-sized regional banks and family-owned firms. But it is not certain that we can get there.