A matter of facts

Why are the people of Britain suffering such severe punishment? Answer: because of the credit crunch and recession. So what is a credit crunch and why are we in the midst of one in Britain? Best to start by asking, what is a bank?
Basically, it is an institution which borrows money from some people and lends it to others. This is risky because much of the money is borrowed from people, such as depositors, who expect to get their money back whenever they want and is lent to people, such as mortgage holders, who expect to retain their loans for long periods of time.
So how do the banks deal with this problem? They check on their borrowers, they encourage them to provide security and they keep a supply of reserve capital which can always be called upon in emergencies. How much do they need? Prudence suggests some percentage of their total liabilities (borrowings), say 10 per cent. So a typical bank might have £100bn of assets (loans), £100bn of liabilities and £10bn of reserves. A key feature of this picture is that the reserves, looked after by the bank's treasury department, should be invested in very safe assets.
So what happened to British banks to get them into such a mess? It is thought that they lent their money unwisely, giving mortgages to people who were unable to pay or credit cards to reckless spenders. In fact, British bank lending was relatively prudent except perhaps with some of their corporate loans. The real mistake made by British banks was that their treasury departments took their reserves and invested them in assets which turned out to be unsafe, illiquid or even more or less worthless. Why? They were tempted by the high returns on these assets, the fact that rating agencies described them as safe, and the fact that high returns meant high bonuses. The consequence was that a lot of these reserves were lost. On top of this many domestic and foreign holders of capital, seeing this feckless behaviour, withdrew their deposits. With a lower level of reserves and lower deposits, the British banks had to cut their loans and continue to do so. This is a credit crunch and it is this which started the serious recession in Britain.
Stephen Nickell is Warden of Nuffield College, Oxford