Can wounded banks be nursed back to health?

In September, after the collapse of the American investment bank Lehman Brothers, the financial crisis took on a new and, frankly, rather frightening dimension.

The Bank of England Governor Mervyn King said that the banking system had been closer to collapse than at any time since the outbreak of the First World War.

And so in the following weeks, there began a wave of banking rescues, first in the United States and then in Europe.

But have they worked?

Catastrophe averted?

In one sense, they clearly have.

The threatened collapse, which must have given Mr King some sleepless nights, did not happen.

The losses have continued but the banking system has not shut down.

Alex Pollock of the American Enterprise Institute, a Washington think tank, says you have to consider what would have happened without the government help for the banks.

It was clear, he says, that we were in a game of nine pins where one pin after another was falling.

Now they have stopped falling and in so far as the objective was to avert immediate financial catastrophe, the job has been done.

But that was not the sole objective. The banks are still alive, but wounded and limping, and not yet in a state to make much of a contribution to any hoped for recovery from the recession afflicting most developed economies.

The great concern is whether they will provide the credit that firms and households need.

Unwilling banks

Professor Charles Goodhart of the London School of Economics and formerly of the Bank of England’s Monetary Policy Committee says that in Britain the volume of credit is still rising.

But in the downturn many firms need more to get them through what he calls this very difficult patch.

What they are doing is making more use of existing credit arrangements they have with banks.

The trouble comes, he says, when they need more. Banks are very chary, unwilling and slow, he says, to increase credit facilities.

What makes this recession so difficult he adds, is that it is driven by the weakness of the banks.

Hoarding rationale

In the US, Alex Pollock says credit standards have tightened, which means that businesses are now finding it harder to get new loans.

Banks also have to borrow. That is how they get the money they lend. And much of it comes from depositors’ accounts.

But in the boom years, an increasing amount was borrowed in the financial markets, sometimes by selling financial securities.

Charles Goodhart says these wholesale money markets are still largely closed.

Under normal circumstances banks also lend to one another. At any time some have surplus funds which they like to put to profitable use by lending to others who are short of funds.

But now those that can are hoarding, for two reasons, according to Mr Goodhart.

They need all the funds they can get for their own purposes, he says.

And despite the extra capital that governments have put into the banks, they are still not entirely confident about the status of their fellow financial institutions – in other words whether they are solvent and can be absolutely relied upon to repay.

The interbank market is one where players don’t want to take risks. It is supposed to be a very safe market.

Alex Pollock says that this market has in effect been replaced to a large extent by the Federal Reserve.

Many banks are holding money in accounts of their own with the Fed and the amount, he says, is at an all time record.

The Fed in turn is lending money out to the banks and others in various ways, including through purchases of financial securities in the markets.

So the Fed, he says, has become the credit intermediary to replace the interbank market, which is not functioning normally.

More help needed?

So the bank rescues have kept the system afloat.

But in some countries, including the US, it is drifting with the Fed increasingly acting – to continue the maritime metaphor – as a kind of credit market tug.

It’s latest announcement, along with the near zero interest rate decision, heralds more purchases of debt-related assets, which in effect means an expansion of its role as the supplier of credit beyond its normal focus on the banking system.

A deep and long recession would mean more losses for the banks on problem loans.

So it is perfectly possible that they will need more help.

Credit: Andrew Walker

Source: BBC