UK suffers from banks’ Darwinian hibernation

By J Saft
January 7, 2009

James Saft Great Debate — James Saft is a Reuters columnist. The opinions expressed are his own —

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.


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.

— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click here.  —


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I have a novel idea. Why don’t the G8 countries and the European Union and the Commonwealth and any other multi-governmental economic groups that might be interested get together, and sign a multi-lateral forgiveness of debt treaty? Just reset the clock to zero, so to speak? So now everywhere in the world, no one or business or government owes money to anyone; then cancel all the internal debts as well. That way, we just start from there, and we can build from there. Even better, re-assess everything everywhere, so that there is a new equal base standard. Voila! Instantaneously we start fresh. To me that makes as much sense as anything else, since it is hard to know if the value of any commodity in the world right now has any long-term validity. Oh, and ban stock markets. Period. If it doesn’t exist in the physical world, why should we use it to make money? How can we call ourselves the smartest species on the planet when we are allowing computerized nonsense to control whether a country can feed itself or not? Come on. My grandfather lived through the Great Depression and thought then that all stock markets were ridiculous. Inventing financial instruments? What? If you told a child that you would buy his candy for 50 cents, then charge him a dollar to buy it right back, he would slug you.

Posted by erin van tassel | Report as abusive

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

There is an argument aginst state intervention and it is very strong. THE STATE INTERVENTION IS THE PROBLEM, so it cannot possibly be a solution. Let the brainless bureaucrats, pawns of the fianncial system puppeteers, get out of the business of managing anything. Cut down the government and disband all the useless agencies and departmens. Get off the backs of the middle class, the only productive people in the economy. Kick out all the parasites. But you would not suggest that, would you, it will mean the loss of power for those who got us into this mess in the first place.

Posted by Sam | Report as abusive

I would say that governments artificially inflated the economies of the G8 countries by borrowing money they never intended to pay back from their own citizens and foreign nations. I would say if they stop lending, we should stop paying.

Also the socialistic trend of forcing banks to lend to everyone and not discriminate based on ability to pay is well meaning but ultimately harmful to everyone because we all pay in the end through bankruptcies of the banks, bailouts and things that are starting to happen now (i.e. extreme inflation).

Posted by Marleen | Report as abusive

Gridlock in lending markets is also a question of skills. Most of the “bankers” who presided over the recent lending free for all are marketing gurus. They dished out all manner of loans with little regard for good lending practice.

To get good lending flowing the banking industry needs to replace these marketing types with real bankers who understand what lending is all about.

Unfortunately good lenders are in short supply and much sought after

Posted by anton kleinschmidt | Report as abusive

It seems to me that government, corporate and personal balance sheets are shot to pieces. We need to rebuild our capital fast. The quickest way to do this is to cut taxes substantially (along with highly inefficient central government spending). There is no point in governments trying to help businesses (selectively – and consequently distorting competition) if at the same time they are crucifying them with high taxes.

Cut taxes and radically restructure the role of central government to focus on the bare necessities that the market cannot provide efficiently or equitably: defence, basic health care focused on prevention, core infrastructure and law and order – (education can be subsidised through vouchers which would drive improvements in service through competition and increase social mobility).

When people and companies are financially secure and are not being bled dry by the tax system they will start to spend – and more efficiently than any bureaucrat. A smaller, less interventionist state is necessary to avoid the policy mistakes of the past, which stem from the over-zealous desire of politicians to command and control what they do not comprehend.

Posted by Father Ignatius Brown | Report as abusive

The comment by Erin brings to my mind the Jewish law that required forgiveness of all debts every seven years. If this was worldwide policy, this type of crisis probably could never happen.

Posted by A.Gabriel | Report as abusive

“The comment by Erin brings to my mind the Jewish law that required forgiveness of all debts every seven years. If this was worldwide policy, this type of crisis probably could never happen.”

Can we see the full text of the law. Does it mean only forgiveness of debts owed by jews to non-jews?

Posted by Zam | Report as abusive

Zam, the text you’re looking for can be found at rch=Leviticus+25
It appears that the debt forgiveness extends to all inhabitants of the territory controlled by the Israeli “state” (pre-modern).
However, some of the previous posters were slightly in error. The economic calendar established in Leviticus required a year of rest ever seven year, but debt forgiveness every 50. It should also be noted that the all land was to return to the original owners in the jubilee year.
While I suspect that a religious solution to the current economic crisis would be unpalatable in the current secular (letting alone some impracticabilities in the Levitican model) it would be interesting to consider the implications of adding checks and balances to the economic/social system that would reset conditions regularly. Sort of like having pre-planned “revolutions” to prevent real crises.

Posted by Loren | Report as abusive

The comment by Erin, whilst great for those with debt who have essentially obtained free money, so Erin if i was to borrow $500,000 from you, would you be willing to forgive that debt? Reset the clock as you say? That would be fair, lend me the money and I’ll sign up today.

Posted by markes | Report as abusive

Easier lending? ha ha that got us in this trouble to start with. Anyone who is having trouble getting money now should be saving more and buying less. To many want others to load up with debt to keep their own boats afloat, rather than producing something,(product, service or labor) that others with cash want to buy.

Posted by Ronald Checkel | Report as abusive

The year for canceling of debts is the seventh year, but it applies between Israelites, or “brothers.” My point was that if this ancient wisdom was followed, people would have a different approach to risk. There would be no debt bubbles when investors know all debts will be canceled every seven years, and no one would have to worry about being duped into long-term debts they can’t afford. Obviously, this would crash the economy if it was put into effect now; but when a giant Ponzi scheme collapses (not just Madoff–the whole system) there is a golden opportunity to go in the direction of serious solutions and preventive measures. Yet the systemic Ponzi scheme is increasing by multiples because nobody wants to lose money (understandable!) and are strategizing so that others, not them, will be the losers. rch=Deuteronomy%2015;&version=31;

Posted by A. Gabriel | Report as abusive