Can we avoid Credit Crunch 2?

BBC business editor Robert Peston on the threat of a second credit crunch

The chief executives of Britain's biggest banks are trooping in to see the chancellor today, to discuss how a second credit crunch can be avoided.

There are two issues. First, why aren't banks lending more to businesses right now? Second, how can a sharp squeeze in their ability to lend during 2011 and 2012 be avoided?

The first credit crunch led to a reduction in the rate of growth of bank lending to businesses that started in the summer of 2007. Month after month of reductions in the flow of credit culminated in a contraction of business lending of more than 10% per annum a year ago.

The crunch is still showing its effects, with the take up of business loans from banks still shrinking at more than 3% a year, according to Bank of England figures.

What's going on?

Here is what Andrew Tyrie, the new chairman of the Treasury Select Committee, told the annual conference of the British Bankers Association:

"My fellow MPs are acutely aware that sound local businesses are unable to find banking support at sensible prices."

A rather different message was delivered by Stephen Hester, chief executive of the UK's largest business lender, Royal Bank of Scotland. He said:

"RBS alone extended over £40bn in new facilities to business in the UK last year, and £45bn in credit facilities are still available but remain unused. 85% of SME (small business) applications for lending are successful".

He made two further points. First, that banks make an unacceptably low return on their lending to small and medium size enterprises, that they "do not even recover their cost of capital from SME lending".

That rather implies that RBS and the other banks aren't desperately keen to lend to businesses. But Mr Hester insists that the supply of credit isn't constrained.

What's happening, he insists, is that "businesses, unconfident of demand for their own goods and services, and recognising that debt was perhaps too high in recent years, are often seeking to reduce financial risk".

Or to put it another way, Mr Hester argues that what's driving the statistics that show a decline in business lending is that businesses don't want to borrow: with the economic outlook somewhat opaque, businesses are nervous about increasing their debts to finance working capital and investment whose returns look uncertain.

The chancellor will, of course, be aware that this is the banks' position, because they've been banging on to this effect for the best part of 18 months. But he'll hear it again today, from John Varley, chief executive of Barclays, who is today acting as shop steward for the bankers in their meeting with him.

What's the truth of it all? Probably not that there's currently an acute shortage of business credit but that there's a chronic, longstanding problem of mismatch between the kind of finance that smaller businesses want and what banks are prepared to supply.

However, the bigger issue for today's meeting is that there could be an acute shortage of credit in less than a year.

You'll remember the Bank of England's recent warning that the banks need to find £800bn of funding over the coming 30 months to replace taxpayer support that has to be repaid and bonds that are maturing (see my post, The risks of forcing banks off welfare) - and that the banks are currently raising nowhere near enough new money to refinance all this.

Which presents a pressing problem for the chancellor. Does he roll over £285bn of taxpayer lending to the banks, with the risk that this becomes perceived as a semi-permanent liability and is therefore added to official or unofficial calculations of a national debt that's famously rising too fast?

Or does he stick to the timetable for withdrawing financial support for banks, knowing that this could force banks to massively reduce the amount of credit they provide to businesses and households?

Nor is that the only potential obstacle to the flow of lending.

Again, you'll be aware from this blog that the banks are acutely concerned that if they are forced to strengthen themselves against future crises too rapidly - if they are obliged to raise a significant amount of new capital within the next couple of years or increase their stock of liquid assets or move quickly towards balance between loans and customer deposits - that again could spark something of a crunch to credit provision.

Probably the best way of seeing this is from the Bank of England's calculation that every 1% increase in British banks' ratio of equity capital to assets would require them to raise £30bn of new equity.

On the assumption they were able to raise this, it would force them to increase by 0.07% what they charge for their loans - in order to pay the dividends on the new equity that investors would demand. Which may not sound a huge increase in the cost of borrowing for businesses and households, but every little hurts, as they say.

But in practice, and in the short term, banks would endeavour in part to meet the new targets for capital ratios by shrinking their balance sheets. Or to put it another way, they would lend less.

How much less? Well if British banks endeavoured to increase their equity capital ratios by 1 percentage point exclusively by shrinking their balance sheets, that would see them lending a staggering £600bn less on a risk weighted basis (based on 2008 figures) and £1800bn less in respect of gross assets (equivalent to rather more than the output of the British economy).

Now the withdrawal of credit on that scale very quickly wouldn't lead to a return to recession - it would probably engender a full scale depression.

Which is why there is no serious argument against the phasing in of these new capital requirements - although there is still plenty of argument to come over the precise length of the timetable for implementing them.

The big point however is that one of the biggest threats to the UK's (and the world's) economic recovery is a possible second credit crunch. And for all the importance of George Osborne's recent budget, his soon-to-be published discussion paper on bank lending will also be of some economic significance.The chief executives of Britain's biggest banks are trooping in to see the chancellor today, to discuss how a second credit crunch can be avoided.

You can keep up with the latest from business editor Robert Peston by visiting his blog on the BBC News website.

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