Economics: Bank on it – the worst of the economic crisis may well be over

In getting the economy moving to end recession, the focus of policymakers has been on stimulating spending. All-time low interest rates and massive fiscal easing are aimed at reducing debt burden and increasing the purchasing power of households and business.

Economists have always argued that it takes months, rather than weeks, for the full effects of such initiatives to feed through and so it is probably premature to make a judgement now on the effectiveness of the measures. But there are some early, encouraging signs (such as the Purchasing Managers Index surveys that are starting to edge up, de-stocking appearing to have run its course and house prices stabilising from a long period of nosediving) that the worst could well be over.

But there is an extra dimension to this recession. Even if company order books begin to fill, they cannot start producing without the working capital to buy raw materials, cover the rent and pay the workers, all before the goods are sold. This credit typically comes from the banking system. Similarly, house prices and interest rates are currently much lower than a couple of years ago, thus improving affordability substantially, but if purchasers cannot get mortgage finance, prices will continue falling. The credit crunch might not have caused the downturn, but it will have an impact on the pace and direction of recovery. The steps taken to boost economic activity will be blunted unless the banking system is restored to something like 'normal' health.

Irresponsible and reckless as some banks may have been in good years, the industry nevertheless still performs a vital service to businesses and individuals.

It is, in effect, the plumbing system that allows goods and services to move around the domestic and global economies, but the credit crunch means that system is blocked. The crisis is one of confidence and liquidity in the banking system and it is a crisis both about banks individually and their relationships with each other. The scale of the problem was unprecedented and the threat to the stability of the system was real. The authorities responded with a series of measures that were not only meant to end the turbulence in banking, but also to provide the platform to return the economy to growth.

Banks have been restructuring their balance sheets through injections of new capital, selling assets and scaling back lending. Though a natural reaction in a deteriorating credit environment, this last necessary adjustment obviously restricts the supply of credit thus making the recession worse. So the government and the Bank of England have introduced various schemes to underpin lending without compromising the banks' efforts to get back on an even keel, the most recent being quantitative easing (QE). Of the initial £150bn allocated for QE, all but £25bn has now been committed, with funding being injected into the banking system at the rate of about £6.5bn a week.

Having reduced the price of credit (Bank Rate), the MPC needed to ensure the necessary quantity of credit is available. There is no point cutting the price if people cannot get the funds – and QE is the chosen method to enable that. To monitor its progress, the Bank now publishes quarterly reports on credit conditions and monthly reports on bank lending. It is clear from the first survey results that something more was needed. In the first three months of 2009, credit availability to households and small business reduced, although there was a slight increase in the corporate sector. At the same time, demand fell and spreads widened, indicating a much tighter credit market.

Looking ahead, the initial nervousness about the impact on lending to SMEs, in particular of the withdrawal of some foreign institutions from the UK looks to be misplaced. Although foreign banks played a major part in the credit boom, much of it was concentrated in the property and retailing sectors, largely because they were London-based and lacked a national branch network. In both these industries, the credit appetite is constrained and any future credit limits will relate to perceptions of risk.

A second reason why the absence of foreign banks may not be an issue is that UK banks were previously expanding overseas, at about the same rate as foreign banks were growing in the UK. (In 2005-06, outstanding loans by foreign banks to UK residents increased by £83bn while UK banks' lending to foreign residents rose by £73bn.) This international expansion is being reversed by some UK institutions and the funds previously used overseas are now available for the home market. The increased spreads on domestic lending make this a financially attractive strategy, while QE implies there are more funds to lend.

It seems there are grounds for believing financial institutions will be in a position to supply the credit to support an increase in demand for facilities from households and businesses. Even though it might appear the banks now have renewed pricing power, the historically low interest rates mean the price is still relatively attractive for the borrower. Little by little, the conditions for a recovery seem to be falling into place.