Finance and economics: what we have learned, and what still needs to be done – part 2

This week Liberal Democrat Voice is running a series of articles from Tim Leunig about the economy – how we got here and what we should do next. Yesterday was bank bailouts, and today…

Bank lending

It is important not to resume borrowing levels of two years ago. Indeed, we can calculate the optimal level of mortgage lending. Net lending should equal the value of new houses built, minus deposits on those houses, plus the same for houses bought by newly-formed households, and those moving to larger houses, minus regular capital repayments on the existing mortgage stock. Housebuilding rates are low and the deposits are high (sensible from the bank’s point of view, in the context of falling prices), so net mortgage lending should be low.

MoneySupermarket.com reports first-time buyer five year fixes at 6.6%, 2 year remortgage fixes at 4.5%, and the usual standard variable rate is 5.5%. The mortgage market is working pretty well.

What is not working is interbank lending. On any given day some banks have spare money, and others are short. Banks can lend to and borrow from the Bank of England, but it pays little interest and demands good security. So instead they borrow and lend among themselves, at the “London interbank rate”. This is usually slightly higher than Bank rate, reflecting a higher level of risk. At the moment it is much higher, and the reasons that this are not well understood. We need to work out why this rate is so high.

It is not the market rate, being set each day by six people meeting together. The solution may be a proper market in which supply and demand interact to clear, minute by minute, day by day, rather like stock markets, and in which each bank borrows at a rate that reflects other bankers’ perception of the riskiness of their bank.

Interbank lending is needed for business lending to resume properly. Clearly banks should be cautious about lending in a downturn, but banks are not lending where it would be profitable. This has potentially serious problems for the wider economy, since cash flow problems can force good businesses to go bankrupt, and lack of finance prevents innovative firms from investing and expanding. Governments may need to push banks, or supplement them on a temporary basis. If they do that the loans should later be sold on to banks.

For example, the Bank of England could make loans related to base rate, but with the proviso that when the London interbank rate returns to a more normal margin over the bank rate the loan becomes a normal one based on the London interbank rate, and which would then be sold to a private bank.

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3 Comments

  • The Labour government is wrong in wanting Banks to resume lending at the levels pre crash. The economy had been allowed to reach ridiculous levels of unrepayable lending – returning to those levels will only result in more bad debt and an even bigger disaster.

    It is not possible to calculate the optimal level of mortgage lending as there is no agreed objective way to estimate the “value” of new houses built. However, house price inflation is as destructive as any other form of inflation and overall monetary and fiscal policy should be tailored to keep both in line with each other, while maintaining a stable exchange rate. Banks were too lax in their lending in the past and priced loans too cheaply. New lending rates need to be (and are) higher, but may need to be increased further yet.

    Indeed interbank lending is not working. We need to work out why the interbank rate is so high. The most reasonable assessment is that the directors of banks, having been paid large amounts of money for bad lending decisions in the past, have been bailed out by the government with no strings attached. This has largely covered the loss of the Bank’s capital, but, in these conditions, times are harder now and they have seen the opportunity to get more money out of government if they continue to fail to lend. In the meantime, the best way to keep their jobs is to sit on their hands. They are happy in playing the market this way.

    “Governments may need to push banks, or supplement them on a temporary basis. If they do that the loans should later be sold on to banks.” Yippee say bank’s directors, you take the initial risk and we will buy the really profitable stuff off you later.

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