The government is still contradicting itself on bank lending

Allister Heath

ONE of the great but ultimately vacuous buzzwords of the Blair years was “joined-up government”; a fuzzy, heart-warming attempt at making sure that every part of the state machinery worked together, trying to achieve the same objectives. It failed pitifully.

But at least the Blairites tried. This coalition, by contrast, is becoming ever more contradictory and seemingly illogical. When it comes to financial policy and banking, it is passing laws to restrict credit and make it harder or costlier for banks to lend – and then passing other laws to subsidise credit or circumvent the original rules.

The coalition supports global financial and banking rules, including for capital and liquidity, and has done its best to gold-plate the regulations. The result, as Sir Andrew Large explains brilliantly in his report on RBS published on Monday, lending to small and medium sized enterprises (SMEs), which tends to generate a return on capital of between 3-7 per cent, comes with a cost of capital that is often around 11-13 per cent. Those statistics are among the most important yet released on UK banking policy and demonstrate how making the system safer has had significant side-effects. It is now extremely hard to make real money (when adjusted for opportunity cost) on average when lending to small firms, partly because business lending incurs a high probability of a loss – but primarily because the cost of capital has been increased so much.

There are three possible responses to this. The coalition could just shrug and accept it. It could try and reverse the rule changes. Or it could try and devise a way of subsidising credit to compensate for its higher, regulatory induced cost – in other words, introduce a policy that would directly contradict its earlier policy, while pretending that it hasn’t actually changed its mind. That was the whole purpose of Funding for Lending (FLS) and also the Help to Buy scheme: in the latter’s case, the coalition’s aim is to undo the effects of the rules it previously backed that make it costlier for banks to extend high loan to value mortgages. If you think it’s the economics and politics of the madhouse, you wouldn’t be wrong.

The Funding for Lending Scheme had been withering for several quarters, so Mark Carney’s announcement yesterday that it will be largely phased out – it will now just be available for business lending – is actually little more than a housekeeping exercise. The change is unlikely to have any impact on growth – investors were wrong to sell off housebuilders’ shares so heavily – and it would have made sense to ditch it completely. As Citigroup points out, usage of the FLS was £4.4bn in the third quarter of last year, £9.5bn in the fourth quarter of 2012, £2.6bn in the first quarter of 2013 and just £1.1bn in the second quarter of 2013. The 28 banks that signed up and borrowed under it saw their total outstanding loans to UK families and firms drop £1.2bn. The 14 banks that signed up but didn’t use it saw their total loans drop £1.1bn. Those banks that did not sign up saw lending shrink by £0.7bn.

The scheme was no longer making any real impact; retaining it just for businesses is also unlikely to make much of a difference. Credit conditions have improved for other reasons, including reduced risk as a result of the thawing of the Eurozone crisis, improved economic growth, increasingly bank balance sheets and Carney’s much more liberal liquidity system.

The real story is that the economy is recovering even though the business sector is still deleveraging – something that many economists thought impossible. A similar trend has been seen in other countries, and in fact it is also what we saw after the last UK recession.

It is certainly good news that Mark Carney is now taking the possibility of house price overvaluation seriously, even though he doesn’t think there is currently a problem – but this shift’s significance was much less about practicalities than it was about psychology.
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