Banks’ central role critical to growth

Many commentators blame \"\"greedy\"\" banks for the global financial crisis and argue that tighter controls are needed - but faith in their vital role in economic growth should be restored.

Rightly or wrongly the world is blaming “greedy” banks for causing the worst financial crisis this side of the second world war. But retribution and strangling regulation, however, are not necessary. The lessons of the 1930s Great Depression are that purging credit excess only deepens the downturn. There will be plenty of time to investigate what went wrong, but for now the most pressing task is to prevent the world from embarking on a vicious downward economic spiral.

The role banks perform is critical. They supply funding for everything from financing for plant and equipment to acting as a depositary for wealth. We may joke that this final role is called into question, as savers worry about how much they are covered by any compensation scheme. But who would truly feel their money was safer under the mattress given the risk of fire, flood or theft?It is perhaps the role of providing different terms of finance, however, that is so important. Banks are so valuable because they borrow short to lend long, enabling activities such as mortgage lending and car finance to exist. It is no coincidence that Roseby’s, a British furniture store, has gone into administration, while General Motors, a car giant, is slashing production across its European plants. More worrying still is that as businesses are denied access to credit by banks hoarding cash, the willingness and capability of companies to invest is diminished, with corresponding effects on economic growth.

The seizing up of the financial markets has been caused by banks preferring to hoard cash with the central banks, rather than risk lending it to a peer that might go insolvent. Trust has evaporated and this explains why interbank lending rates bear little resemblance to official rates.

Starved of finance and with real incomes falling, households in Britain spent their savings in the first quarter of 2008, and only saved 0.4% of their income in the second quarter. With falling asset prices and rising jobless figures the outlook for consumption looks bleak. It is small wonder, therefore, that the commodities market has belatedly woken up to the fact that the global economy is slowing fast.

The world’s central bankers and governments have finally realised this. Inflation has been downgraded as an enemy; recession takes on the role of chief villain. Earlier this month, several of the world’s central banks slashed interest rates in a co-ordinated response to deteriorating economic data and panicking markets. Britain even trumped America’s $700 billion (£400 billion) bail-out with a rescue package on a grander scale that would see the British government potentially taking stakes in the banks, and not just acquiring their bad assets.

Will lower interest rates help? At the margin they may contribute towards an upward sloping yield curve that would allow banks to buy government bonds that yield more than they borrow and so recapitalise themselves. The danger is that in doing this they may decide not to lend to the broader economy. Lower official rates may in time drag down the London Interbank Offered Rates (Libor) – the rates banks charge to lend to each other -but it is questionable that they will lower the spread between the interbank rates and official rates. These will only fall once banks regain confidence in each other. To that end, the moves by the British government as part of its grand rescue package to extend the Special Liquidity Scheme and guarantee maturing medium term wholesale funding are helpful, although the fee structure for participating somewhat dilutes its effectiveness.

The liquidity problem is, however, a symptom of theunderlying problem of solvency. While the rescue packages gradually being announced by governments may resolve some aspects of this, it is not a panacea. The global economic system is having to purge itself of excess and the gradual de-leveraging will be painful. Pensioners will find their retirement plans are reduced, while rising unemployment will lead to further deterioration in credit quality and loan defaults will rise. In extreme cases, whole countries – Iceland, for example – will face a period of austerity.

The speedier the decline, however, the quicker the recovery. For financial stocks and the wider market to enjoy a sustained rally, the American housing market needs to find a floor. Excessive borrowing on overpriced houses got us into this mess; signs that American house prices have stabilised will probably also mark the bottom. After two years of falls, there is evidence that American house prices as a proportion of wages are beginning to look affordable. A bottom may, therefore, be in sight in 2009 – an event that would augur well for banks. In the meantime, we should probably all stop blaming banks, since we are all likely to have a direct share in their future.

Guy de blonay Manager of the New Star Global Financials fundnigel Thomas Fund Manager “Banks are so valuable because they borrow short to lend long, enabling activities such as mortgage lending and car finance to exist”