Why a new government may extend support to banks
There is a much bigger story in the Financial Service Authority’s Financial Risk Outlook than the new stress test which I wrote about yesterday.
It is that the UK’s banks have to find £440bn of loans and finance between now and 2012 to replace maturing debt.
There are only three places that money can come from.
The money could come from savers in the form of a growth in deposits.
And, as it happens, we have been saving a bit more in the UK.
But if the banks’ stock of lending stayed flat for the next couple of years (which looks plausible if unpleasant for our economy) and we saved at the rate of the last three months of 2009, the gap between banks’ loans and deposits would still be just under £400bn at the end of 2012.
According to the FSA, we would have to increase our saving in bank deposit accounts by 12% per annum to close the funding gap, which – in the FSA’s words – would “imply a savings rate far in excess of conceivable levels”.
Another possible funding source are markets for asset backed securities, which closed with such calamitous consequences for the global economy in the summer of 2007.
Now, banks have again started to be able to raise money by packaging up mortgages and selling them to investors in the form of bonds; these markets are back in business.
But in order to close that £440bn funding gap, our banks would have to issue new debt in the next couple of years on a scale equivalent to the boom years of 2004 to 2006.
There are two problems with this.
First, it may not be possible.
Second, it may be highly undesirable: separate research by the FSA shows that these asset-backed securities – or at least those retained on banks’ balance sheets – were the source of a staggering 70% of all losses on loans and investments incurred by 10 of the world’s biggest banks (including the UK’s) between the summer of 2007 and March 2009.
In other words, further instability and chronic weakness in the banking system could be the consequence of closing the funding gap by resorting to the securitisation market.
Where else could the money come from?
Well there is only one other place: taxpayers.
As it happens, over £300bn of the maturing debt that the banks have to replace is the finance provided by taxpayers to prevent them from collapsing in late 2008 and early 2009.
This taxpayer finance takes the form of £134bn of state guarantees for debt issued by banks under the Credit Guarantee Scheme and a further £178bn of Treasury bills provided by the Bank of England in exchange for banks’ securitised mortgages.
If this sounds complicated, just think of it as just over £300bn of loans by taxpayers to banks, which are scheduled to be repaid by 2012 or so.
Now the clear implication of the FSA’s analysis of banks’ £440bn financing requirement is that taxpayers would not be able to withdraw that £300bn of support in 2012 without precipitating another banking crisis, or an economic crisis, or both.
Which means that any new government has a very difficult decision to make more-or-less immediately after the general election: should that £300bn of taxpayer support be extended?
Failure to do so would have one immediate and dangerous effect: it would encourage banks to stop lending; since the less any bank lends, the less it has to borrow, the less finance it has to raise.
But if banks went on such a lending strike, the UK would inevitably be tipped back into recession.
However if a new government rolled over that £300bn of support, that £300bn borrowed by banks would increasingly look like a long-term liability of the state; and in those circumstances there would be a stronger argument that the £300bn should be added to an already-ballooning national debt.
Which could be painful.
Finally it is probably worth pointing out that one bank, Lloyds, is much more exposed to this problem than others.
It has received £157bn of taxpayer finance via the Special Liquidity Scheme and the Credit Guarantee Scheme.
Quite how it would reduce this to nil by 2012 without closing its door to new lending is somewhat intriguing.
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