Things can't get any better, right? Don't worry, say the Scots: they won't.

Trust the Scots to find the black cloud in any silver lining. Justto get worse, says Jules Stewart. But the lending criteria lessons learned in the last recession should help us get through the next one. when the banks thought it was safe to rejoice in their record profits and historically low level of bad debts, along comes Bank of Scotland’s chief executive Peter Burt with a dire warning of bad times lurking round the corner.

“I think this is going to be as good as it gets,” was Burt’s gleeful note at the bank’s year-end results presentation in April. “I don’t know whether it’s going to be the end of this year or next, but I am pretty certain there is going to be a deterioration.”

Of course, the Bank of Scotland has a hidden agenda. It is usually around this time of year that it talks down market expectations, only to reveal a year later that lending volumes have remained buoyant and margins have not fallen. The market expects Bank of Scotland’s bad and doubtful debts to inch up this year by perhaps one tenth of a percentage point to 0.6% of total loans, hardly a cause for alarm when compared with the 2.6% level reached in the late 1980s. So should Burt’s remarks be dismissed as simply a dour banker’s delight in spreading gloom?

“Burt’s assessment is correct inasmuch as there is a mild downturn coming and things are now about as good as they get in terms of asset quality,” says Hugh Pye, banking analyst at Robert Fleming Securities. The accent, according to Pye, is on the “mild”, given the absence of the basic ingredients needed to produce a full-blown recession. “For the moment companies are liquid and lowly geared,” he says. “It is also unlikely that we are in for any unpleasant interest rate surprises. So it looks as though we are looking at a mild cyclical downturn somewhere in the 1999 to 2000 period.”

What does seem likely is that, as in the past, British banks will lead their European counterparts into the downturn. Barclays, NatWest and the like recovered earlier from the last recession and, in terms of loan growth, profitability and asset quality, are set to peak sooner. Hence provisioning charges will rise faster in Britain than in Europe.

As Matthew Czepliewicz, managing director of equity research at Salomon Smith Barney, points out, the important factor is the year-on-year impact of provisions on bottom-line growth. “Let’s assume that in 1997 Bank X had a provisioning ratio of 10 basis points (bps) – 0.10% – as a percentage of its loan book, and that this was 20bp in 1996,” he says. “If the ratio remains stable at 10bp in 1998, the year-on-year impact would be negligible in terms of earnings growth. So even though asset quality didn’t weaken you don’t have a bottom-line boost to earnings per share.”

If this is combined with a lack of year-on-year growth from the bank’s trading book, the result is probably going to be slower earnings growth in 1998-99 than in the previous three boom years.

The big question is how high the provisioning charge will rise. Historically, over the course of a bad debt cycle, the UK banks’ provisioning ratio was about 45bp to 50bp. When things were really tough in the early 1990s it skyrocketed in some cases to as high as 250bp. Under today’s more benign inflationary environment, the question is whether that average ratio will repeat past levels or will be more in the 30bp to 35bp range. After all, a jump from 10bp to 50bp is a sizeable hit for the banks.

“It’s probably not a compromise to split it down the middle,” says Czepliewicz.

“We tend to err on the side of caution, as the banks have had a pretty poor track record over the past 50 years. We might give them the benefit of the doubt on 5bp or so.”

One key lesson has been learnt from the last recession: there may be little the banks can do to influence the economic cycle, but there is a lot that can be done to limit its impact on the banks. In the US, the banks have been helped by the Fed, which has kept interest rates at the right level and the yield curve in the right shape. In Britain, and to a lesser extent in Europe, the banks have tried to insulate themselves against market volatility by rebuilding their capital ratios – albeit more through cost control than improved margins and pricing – and developing sophisticated risk-management systems. The British banks are better placed in terms of Tier 1 capital and have no trouble maintaining at least a 6.5% ratio, while banks of core European countries such as France and Germany struggle to meet a 6% target. Net interest margins and asset-liability management are better and the British banks are also ahead on cost control.

In credit control, however, the Europeans traditionally lead as their economies tend to experience less of a boom-bust cycle.

Banks such as Barclays have begun putting into place stringent credit quality control systems, whereby as soon as a loan is extended a provision is made against it in the hope of smoothing the bad debt cycle. The problem is that the system has yet to be tested and nobody really knows what factors are going to touch off the next downturn. The spectre of inflation is always out there and this, coupled with margin wars usually drives banks into a scramble for market share. A sustained downturn in the securities market could force banks to fall back on their core credit business as a driver of earnings growth, and this always raises the temptation to allow lending criteria to slip.

In the end it comes down to management. A Jumbo jet doesn’t fall out of the sky without an element of human error somewhere in the equation, and banks don’t run into trouble unless somebody in the boardroom gets it wrong.

“A new lot will come on board in a few years who lack the experience of the last downturn,” says Pye. “The likelihood is that the recession after next will be the bad one. Bankers who have lived through tough times depart the scene and the historical trend has been that we get hit with a severe recession every second cycle.”

Jules Stewart is a freelance journalist.