The second bailout for British banks was dead on arrival. The markets greeted the 19th January announcement with sharp falls in both bank shares and sterling. Investors fretted over the rapid deterioration in public finances. They should have worried more about the faulty logic underpinning the scheme.
The assumption that banks are not lending is wrong. They are, but only to other financial corporations, like leasing companies, hedge funds, pension funds, brokers and so on. These organisations have been unable to access the wholesale financial markets since the collapse of Lehman Brothers and the downward spiral in house prices. So they are borrowing from banks instead. Far from credit drying up, in the first 11 months of 2008 banks lent these groups £252.8bn.
The real trouble is that banks are still not lending to businesses or households. In the three months to November last year, lending to non-financial corporations fell by £2.4bn and to households by £5.6bn. Over the same period loans to financial corporations rose 42.7 per cent to £101.7bn. Meanwhile, normal businesses are being hit by a steeply rising cost of borrowing. In 2008 the average cost of borrowing on the corporate bond market peaked at nearly 29 per cent for riskier companies. The Bank of England (BoE) has too often ignored this critical barometer. It also doesn't appear to understand that, at a time of uncertainty, issuing more "risk free" government bonds—in order to buy up toxic assets—will crowd out corporate borrowing.
In other capital markets, however, the interest rate is far higher than 3.5 per cent, even for much shorter periods of borrowing. Ungumming these "wholesale markets" is critical to getting the entire financial system working. But, crucially, this can only be done by making corporate debt more attractive than government bonds.
At present investors are keen on the high yields from low risk government debt, and much less keen on corporate bonds. One way to fix this is for a central bank to print money (quantitative easing) and use it to buy government bonds, lowering yields, making company debt more attractive, and encouraging institutional investors to shift into riskier, higher yielding assets to meet their investment targets.
Sadly, the recent commitment of more taxpayer money to support the banks—and an unquantified sum too—has done the opposite, sending government yields shooting up. The reason for this is that the British economy looks in even bigger trouble than before. The markets are further away than ever from being able to refinance the huge wall of existing liabilities due in 2009. The threat of rising defaults by companies, triggering more job losses, is real.
The failure of the BoE to find a way to reopen capital markets is the most serious policy failing of the credit crunch. This failure, in turn, has its roots in the tardy response to the early stages of the financial crisis—which began in December 2006 when the first US mortgage originators defaulted. Big losses, mainly from the property market, clogged up the banks and precipitated a massive unwinding of leveraged loans, driving corporate bond yields, and loan rates, through the roof.
The resulting logjam is similar to that which confronted America in the spring of 1932. Business borrowing costs soared after the 1929 crash, and eventually congress forced the federal reserve to buy government bonds. The price of lending began to fall only a month later. There is a lesson to be learned here—but, incredibly, our central bank has failed to grasp it. The bank says it has no intention of buying government bonds at this stage. It may buy corporate bonds, but only "high quality assets," not those that have fallen farthest, and most need support.
With wholesale markets still in lockdown, every week sees weaker consumer confidence, falling house prices and more asset losses, deterring investors further. We may soon need to bypass markets entirely, and move to a state-managed financial system where no new lending occurs without state backing. If this happens, we will enter terrain where even the great depression has no lessons to teach us.
