Surviving, not thriving

Written by The Economist | Updated: Jul 29 2010, 09:24am hrs
Britain's biggest banks may pass the common stress test for resilience that was applied recently to banks in the European Union. But that glosses over a long-term structural problem which makes them more of a burden than a benefit to the national economy. As banks struggle to deal with it, they may be smothering the chances of new entrants offering customers and small businesses a competitive alternative.

The problem is their addiction to government-supported funding: 165 billion of it through a Special Liquidity Scheme, which lets them refinance mortgage securities and other assets at a discount to market rates; and 120 billion more raised through bond issues bearing a government guarantee. These two schemes are due to come to an end in 2012, presenting the countrys big banks with a refinancing mountain. And other wholesale debt is also falling dueperhaps as much as 480 billion over the next three years. At the moment the banks are raising funds of around 12 billion a month, only half the rate they will need when the other bills are presented. Whether the Treasury will relent when the deadline arrives and keep some of its support in place is an open question.

The uncertainty means that big banks are hellbent on shoring up their balance-sheets by charging interest rates on loans that are much higher than the rates they themselves pay to borrow. This is not an outcome that pleases Vince Cable, the business secretary, who has been critical of bank behaviour since the onset of the credit crisis. But Cable is not likely to see banks lend moreor more affordablyto small firms, as some state-assisted ones have promised under supposedly binding agreements, until their balance-sheet restructuring is under control.

All these banks are trying to lower the ratio of loans to customer deposits; sounder banks will be rewarded when a new banking levy comes into force next year. Lloyds Banking Group, for example, has a loans-to-deposit ratio of 169%, according to research by Nomura Securities. Barclays and RBS are at 130% and 134%, respectively. But the banks may be wrong to think that squeezing loans will improve these ratios; the Bank of England warned in June that growth in lending is usually the main driver of higher deposits.

Banks are also competing for savings with the purveyors of other sorts of investments, such as unit trusts and tax-free National Savings & Investments (NSI) products. As the banking crisis struck in 2008, there was a flight to safety out of bank deposits which has recurred sporadically ever since (see chart). Prolonged low interest rates and the threat of an imminent rise in capital-gains tax (in the event the tax rose by less than people thought it would) lured savers away from banks after the general election in May. On July 19th NSI took unprecedented action to stem the flow into its tax-free and inflation-linked products, closing its Savings Certificates to new investors. It also lopped a quarter of a percentage point off the interest on two other products. Its declared aim is to reduce its net intake of funds this year to zero, balancing the interests of savers and taxpayers with those of the wider financial-services marketplace.

Consumer champions see this measure as more evidence that savers and taxpayers are bearing the burden of the banks excesses. The spread between the variable interest rate charged by banks for mortgages and the 0.5% base rate set by the Bank of England has increased dramatically since mid-2008, to around 4.5 percentage points for loans equal to 90% of a propertys value. Meanwhile the interest paid on deposits has dwindled. Most offers to entice new depositors with relatively high rates are closed to existing customers, and interest rates tend to fall sharply after the first year. So while banks are busy snatching each others depositors, few savers are benefiting from the exercise. Last month the Office of Fair Trading (OFT), a competition watchdog, responded to complaints about the way banks market individual savings accounts: there had been no deliberate strategy to confuse, it decided, and the remedy was more transparency.

As for the broader question of whether the big banks current position and refinancing mountain are distorting competition, shutting out new entrants and smaller rivals, the OFT is on the case. At the end of May it launched a review of barriers to entry, expansion and exit in retail banking. Expect a report, but no firm conclusion, by the autumn.

The Economist Newspaper Limited