In the 1960s, the Marquis of Salisbury once said of his Conservative cabinet
colleague Iain Macleod that he was ‘too clever by half’. Much the same might be
said of some of the modern banking fraternity. They found all sorts of
complicated new ways to lend money, especially to people who really could not
afford to borrow. It worked for a while, at least long enough for them to claim
hefty bonuses, but now it is starting to unravel and the casualties stretch far
wider than those originally involved.
When US interest rates were 1% for a year or more, imaginative new ways were
developed to lend to those in the US on low incomes with poor credit histories –
the ‘sub-prime’ market. When rates then rose to 5.25%, many of these
over-burdened households began to default. But those caught up in the storm
included German banks, French insurance companies, Japanese pension funds as
well as US lenders. This is because the risky mortgage loans were parcelled up
and sold off as attractive packages worth billions of dollars throughout a
highly globalised financial sector as though they were as safe as government
bonds. So, institutions with no involvement in the US suddenly became exposed to
the risks when the sub-prime market went south and the value of the debt-backed
tradable securities and derivatives plummeted.
And when things go wrong in financial markets, as they did in 1987, 1998 and
2001, the adjustment process is rarely orderly or measured. Markets have a
remarkable knack of going from boom to panic without the good sense to stop off
at the intermediate stage of normal and, in the ensuing chaos, many innocent
bystanders get hurt. The world economy is here again, and once more the
important questions are about the extent of the collateral damage. Is it likely
that the irresponsible lending to the sub-prime housing market in the US will
affect growth and interest rates in the UK?
Banks are in the firing line, although few will have sympathy for those
financiers who lose their jobs or bonuses, or for those institutions whose
profits get squeezed. No doubt there will be a widespread feeling that they will
be getting their comeuppance, but this schadenfreude is short-sighted. Financial
services account for around 9% of GDP and have made a major contribution to the
buoyant growth of the UK economy in recent years. Anything that dents activity
in the sector will impact on GDP, but current estimates suggest that the
immediate effect will be to knock only about 0.1% off growth, something an
economy currently growing above trend should be able to absorb without too much
Of more concern are the ideas of financial contagion or a widespread credit
crunch. If defaults by borrowers run to such an extent that a financial
institution topples over, it could lead to panic across the industry. Equally,
caution is becoming the dominant sentiment among lenders, whether they have been
bitten or not, which pushes up the price of borrowing. This is what was
happening to lending rates between financial institutions in the UK, as the gap
between base rate and Libor (London inter bank offered rate) jumped in early
Both of these fears seem to be exaggerated. Banks’ balance sheets are strong
enough to withstand the current losses and, assuming the worst of the news is
out and the extent of the damage is known, bad debts on the current scale are
part of the normal cost of doing business. Losses that would sink businesses in
many other industries merely dent banks’ capital and profits.
A credit crunch would arise if financial institutions collectively adopted a
safety-first approach to lending, re-priced risk and retreated to cash and
ultra-safe government bonds. This would pose a threat to corporate debt, private
equity and retail lending, and increases the risk of bad debts among existing
borrowers. This threat has been recognised by central banks which have acted in
a remarkably coordinated way to inject liquidity into the market. For once, a
global issue has elicited a global response, and very quickly.
This is not to take a complacent view. Some families in the US will lose
their homes, some bankers will lose their jobs, share prices will be hit, future
borrowing may be harder to obtain, and so on. But this is not a financial
meltdown, more a reality check for those who believed that real credit risks
could be buried in complicated instruments that even apparently sophisticated
banks could not identify.
The major fallout will be felt in the US where the turbulence will push the
economy further downwards. And it has already brought forward the date when
interest rates start to fall. The knock-on effects for the UK will be a
tightening of export opportunities to the US and a slowdown in merger activity.
But, since 60% of global growth last year came from emerging markets, the US is
no longer the primary driver of the world economy and UK companies could, and
should, be looking for export markets elsewhere.
As the Bank of England said recently, it is probably too soon to tell how
badly affected the real economy will be by the financial turbulence but, so far,
it looks to be manageable.