Are UK banks killing the economic recovery?

Time for a spot more of Britain's favourite sport? Yes, indeed; next week brings first half results from virtually all the top UK banks, and therefore abundant opportunity for renewed banker bashing fun.

If it gets in the way of the economic recovery, does anyone really care? Bloody minded retribution is still preferred to constructive restoration. It may take further hardships for sense to prevail.
But lest it be forgotten, the taxpayer too, never mind the wider economy, has a rather large vested interest in the continued recovery of the stricken banking sector. Taxpayers have got £60bn invested in Royal Bank of Scotland (RBS) and Lloyds Banking Group (LBG) alone.

With Europe's sovereign debt crisis apparently abating, the stress tests over, and the removal of some at least of the regulatory uncertainties that have been hanging over the banking sector, both the RBS and LBG investments are again within a whisker of being back in the money.
This doesn't mean that UK Financial Investments, which holds the stakes on the taxpayers' behalf, can think about divestment. There's still a long way to go before we reach that point. The Banking Commission, which is examining whether the banks need to be further broken up, must report first, and that won't be for another year.
If root and branch structural reform is recommended and enacted, it could be years before the banks are in any fit state for re-privatisation. In seeking to appease uncle Vince, the Treasury has created a potentially uncontrollable rod for its own back and pushed payback time into the indefinite future.
The other big uncertainty is new capital adequacy rules from the Basel Committee on Banking Supervision. The Committee backed away from some of the severer aspects of these changes this week, but again, nothing can be done in terms of divestment until the new rules are set in stone, which won't be until November at the earliest.
By historic standards, UK banks remain hugely undervalued. They used to trade at several times book value; now the two part nationalised banks are at or below it. There's also a big discount relative to some European peers.
Given the recent, near death experience of the UK banks and the still significant risk of a double dip recession, this might not seem so odd. Even so, the pricing differential with comparable European lenders seems hard to reconcile with the fundamentals.
Last week's stress tests showed that even the two part nationalised banks were significantly better capitalised than most European counterparts, as well as a good deal further down the road to full bad debt recognition. So how come they trade at a discount?
To my mind, the main reason for this valuation anomaly is confusion at the heart of public policy. What does the Government want from Britain's banks? On the one hand, policymakers are reluctant to promote fundamental change, for this would interfere with the return to normality, both in terms of a functioning financial system capable of renewed credit creation, and the sort of valuations that would allow taxpayers a profitable exit.
But on the other, they demand root and branch reform, a banking system so hedged around with checks and balances that it would never again be able to damage the real economy on the scale seen in the past three years. The two goals are not easily reconciled. Vince Cable, the business secretary, demands that at one and the same time banks both lend more and further deleverage to restore balance sheet health. You cannot do both without oodles more capital, which for the moment markets are not prepared to provide.
As things stand, the pressures are still very much for further balance sheet shrinkage. Never mind the looming new capital requirements; provided the transition period is long enough, these can be managed. Much more worrying is the approaching funding gap, which threatens, if we are not careful, a whole new credit crunch.
According to the Bank of England's last Financial Stability Report, UK banks will need to replace between £750bn and £800bn of maturing term funding and liquid assets by the end of 2012. That's an awful lot of lending that needs to be refinanced. Many banks will choose to withdraw credit in preference to finding scarce and expensive funding alternatives.
In any case, after a period of recovery, the quantity of credit in the UK economy is again shrinking. Bankers blame absence of demand and refute charges of lack of availability. Both assertions are partly true. Demand has certainly shrunk. Many larger companies, having cut costs, reduced inventories and widened margins through the downturn, find themselves flush with cash. They've been paying down debt, or finding alternative sources of capital.
The problem is rather in small to medium sized enterprises, where the cost and terms of credit have in many cases been significantly tightened.
Yet far from amounting to an unjustified squeeze, this process is in fact just a return to reality. It was the easy money of the boom which was abnormal, not present, more straightened lending conditions.
The situation might be improved, as Mervyn King, Governor of the Bank of England, pointed out in evidence to the Commons Treasury Select Committee yesterday, simply by requiring banks to pay smaller bonuses and dividends. This ought in time help rebuild both capital and lending. New entrants without the legacy of balance sheet impairment might also help. And as Mr Cable has suggested, it might be possible to encourage alternative sources of finance outside the banking system through a revival of regional stock markets and the like.
All this is no doubt worthwhile thinking, but as it happens, credit expansion is by no means essential to economic recovery. The velocity of money, or the number of transactions taking place in the economy, is the more important ingredient.
As things stand, this is still exceptionally low. Once a strong cyclical recovery is established, the credit will follow naturally. What's more, we don't need more lending to underpin an investment led recovery. Bigger companies account for the bulk of investment and they have all the money they need.
Sorry to side with the bankers, but it is uncertainty and lack of demand, not of lending, which is the main issue here.

Jeremy Warner, The Telegraph 29-07-2010

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