Investors love the UK but not its banks
One of the hugely important questions about the proposal of the Independent Commission on Banking to put ring fences around retail banks, whose details will be announced on Monday, is what impact it will have on the price that banks have to pay for loans and finance.
Because that will have an impact on the price and availability of credit for the rest of us.
As I've mentioned before, there are two main reasons why banks might have to pay more for finance:
- that the thrust of all the Commissions' recommendations, including the ring fence, is to direct future losses in crises on lenders and investors, rather than taxpayers, which would increase the risk of lending to a bank
- that big universal banks, such as Barclays or Royal Bank of Scotland, would to an extent lose the benefits of diversification, such that when retail banking is having a wobble, it would not be able to call on the capital resources of investment banking - or vice versa - which means that in theory the risk of lending to either investment banking or to retail banking would rise.
There are solid long-term reasons why such an increase in the cost of finance for banks might be a good thing - such as that it would reduce the probability that they would go on the kind of lending and investing spree that caused both the financial debacle of 2008 and our current economic malaise.
It is also arguable that such a rise in the cost of finance would be a short-term phenomenon, if banks in their new ring-fenced structure were to manage themselves in a more prudent way.
But let us assume, for the sake of argument, that the ring fence and the rest of the commission's prescriptions would increase what banks pay to borrow and raise capital, at least in the short term. What impact would that have on the economy?
Well that is very difficult to assess, because British banks are already finding it relatively hard and expensive to raise finance. The best way of seeing these difficulties for banks is in the high prices that creditors pay in the credit derivatives market to insure loans to banks against the risk of loss.
So, for example, the price of insuring a five-year loan to Lloyds and Royal Bank of Scotland through a credit default swap (CDS) is around 330 basis points, or 3.3%. What that means is anyone lending those banks £10m would have to pay £330,000 per annum to protect the loan from default.
That £330,000 cost is a multiple of the prices paid for insuring their debt in the boom years before the credit crunch of 2007 and represents a significant rise over just the past few months.
There is a similar story at Barclays, where the CDS price has increased more than a third latterly to more than 240 basis points.
These CDS prices imply that big UK banks are deriving almost no benefit right now from the implicit protection they receive from taxpayers. The market appears to be saying that if any of these banks went down, the bulk of losses would fall already fall on creditors rather than taxpayers.
Another way of putting this is to say that the official credit ratings of these banks are close to irrelevant. The credit ratings implied by the CDS prices are significantly lower than the official credit ratings of Moodys and its peers.
So the high probability that credit-rating agencies will downgrade UK banks' debt, as and when the government accepts the recommendations of the Banking Commission, should in theory have no impact on the price banks pay to borrow.
Of course that is no great grounds for comfort, given that banks' ability to finance themselves is already constrained. And if banks are already paying over the odds for capital and debt, which they are, that must push up the cost and limit the availability of finance for households and businesses.
So what's going on? Well the eurozone mess is going on.
The ballooning in the CDS prices for Lloyds and RBS is pretty similar to the ballooning of the CDS prices for Spanish, French and Italian banks - except that in the case of the big Italian banks, Unicredit and Intesa, the cost of insuring debt is even higher.
That said, there is an important and interesting difference between what is going on in the eurozone and what is going on here.
In Italy and France, for example, the big rise in prices that creditors to their banks have to pay for default insurance has tracked a significant rise in the price that creditors to their respective governments pay for protection.
Thus the cost of insuring Italian five-year government bonds is currently 430-ish basis points, or 4.33%, which is very similar to the cost of insuring loans to Unicredit.
And there has been a lesser but still striking increase in the cost of insuring French government debt, which looks like a contributor to the big rise in the cost of insuring the debt of big French banks such as Societe Generale.
To put it another way, there is a horrific negative feedback loop between creditors' confidence in the ability of certain eurozone governments, such as Italy, to repay their debts, and confidence in the ability of their respective banks to honour their debts.
As I've pointed out, the logic is straightforward: creditors to banks typically believe that in extremity they are lending to governments, because governments typically rescue banks in a crisis; but if the relevant government is already financially overstretched, as is the case in Italy, that implicit protection provided by governments is no protection or comfort at all.
Here is the really striking thing. The cost of insuring UK government debt is staggeringly low. At around 77 basis points, the premium to insure UK five-year gilts is 55% less than the cost of insuring equivalent French government debt.
And for the first time that I can remember, the cost of insuring loans to the UK government is a tiny bit less than the cost of insuring loans to Germany.
Now there is a whole different debate about whether this remarkable show of faith by investors in the ability of Britain to repay its very big debts is the result of George Osborne's deficit reduction programme or whether it shows that he has more wriggle room than he believes to slow the pace of deficit reduction.
Either way, it should probably be a matter of national pride that investors now apparently have more confidence when lending to the UK as a sovereign than to Germany.
But if the balance sheet of the UK is perceived to be so strong, how can the respective balance sheets of Lloyds and Royal Bank of Scotland be perceived by creditors to be so weak?
It is difficult to avoid the conclusion that investors are convinced that taxpayer support for these banks is definitively on the way down. Which from a long-term perspective would be seen as a very good thing - if we want to minimise costs for taxpayers from future banking crises.
In the short term, however, there is grounds for concern. Both Royal Bank of Scotland and Lloyds need to raise substantial sums next year to refinance debts that come up for repayment. The market is saying that will not be either cheap or easy.
To repeat the important mantra, when it is hard and expensive for banks to raise finance, the flow of vital credit to the economy can be interrupted and the price of credit can rise - and a weak economic recovery, of the sort we are experiencing, can be snuffed out.