Give us the cash: what will it take to get credit flowing again?

Illustration: David Lyttleton

Of the many sins businesses can accuse the government of committing in its
response to the credit crisis, idleness is not one of them. Since last autumn,
ministers have announced a dozen initiatives to rescue Britain’s banks, to
encourage them to lend and bring relief to cash-strapped companies.

After the collapse of Lehman Brothers sent panic through the markets and
spooked lenders to hold on to their cash, the government knew it had to
intervene. Its £37bn recapitalisation of three of the UK’s largest banks ­
following the full or partial nationalisation of Bradford & Bingley and
Northern Rock ­ was the most dramatic state intervention in a generation.

That scheme was copied around the world and prime minister Gordon Brown was
even hailed as the saviour of the world’s financial system by Paul Krugman, the
current economics Nobel Laureate. As Michael Saunders, a senior economist at
investment bank Citi, says, “For last October’s package, the test of success was
relatively clear ­ would the banks close?”

By January this year, it was clear that, while the banks were still alive,
they were not lending to companies in anything like the volumes needed to revive
economic growth. Within five days, the government announced two fresh packages
of measures, one aimed at boosting lending to small- and medium-sized businesses
and the other effectively a second bailout of the banks.

Critical timing
For Alistair Darling, the banking package could not have come at a worse time.
Even as he was speaking in the House of Commons, bank shares were being
pulverised. Royal Bank of Scotland hit 10p a share, compared with a 2007 peak of
591p.

The Treasury package contained no fewer than seven key elements:
• A new government guarantee for new asset-backed securities to encourage banks
to re-enter the money markets and raise cash;
• A £50bn facility funded by the Treasury to enable the Bank of England to buy
corporate loans and bonds from the banks;
• Extending the Bank of England programme to swap illiquid assets for cash from
a month to a year;
• Extending a credit guarantee scheme aimed at guaranteeing up to £250bn of new
bank debt;
• A new scheme under which the Treasury will insure certain bank assets, for a
commercial fee, against losses on banks’ existing loans;
• A u-turn on the policy of shrinking Northern Rock’s loan book and a purchase
of £5bn of interest-bearing shares in RBS to cut its payments; and
• Clarification that banks need a capital-to-assets ratio of 4% ­ rather than 8%
­ to comply with Financial Services Authority (FSA) rules.

Removing barriers
The Chancellor said the aim was to remove the barriers to lending, adding that
the Treasury would demand “binding commitments” from banks to lend. There was a
similar message from business secretary Lord Mandelson when he unveiled a £12bn
package of loan guarantees aimed at the SME sector. “Some companies are
struggling to secure the finance they need due to tougher credit conditions,” he
said. “It is crucial that government acts now to provide real help to support
them through the downturn.”

The government is trying to do two things at once. The bailouts are aimed at
bringing down market interest rates and encouraging banks to pump money into the
system. At the same time, it is trying to kick-start banks at high street level
to lend to businesses and prevent a vicious cycle of a credit drought, business
failure, higher unemployment and falling demand.

John McFall, chairman of the Treasury Select Committee, admits banks are, in
fact, acting rationally by hoarding credit, but describes the result as the
“economics of the graveyard”. “As banks restrict their lending, they risk
dooming the economy to an even deeper recession ­ and further harming themselves
in
the process,” he says.

At wholesale level, conditions are still tight for companies looking to
raise money via securitisation or even plain-vanilla corporate bonds.

The clearest evidence comes from a survey carried out by the CBI, which says
that two-thirds of firms report the availability of credit has worsened
dramatically. Seven in 10 firms report a sharp increase in the price of credit.
Large firms are especially hard hit with all reporting a hike in costs, and a
third say interest rates have risen by at least a full percentage point.

One problem is that the London Interbank Offered Rate (Libor), the rate many
lenders use to price their loans, has not fallen in line with official rates.
Three-month Libor is currently around 2.1%, or 1.1 percentage points above Bank
Rate of 1.0%. The two are normally just a Rizla paper apart.

Corporate bond spreads ­ the extra price above government bonds that
investors demand to offset the risk ­ remain high. Companies with BBB-rated debt
are paying almost 12% to investors, compared with 6% at the start of 2008.

At the small- and medium-sized business level, anecdotal evidence points to a
continuing drought in lending. “Money is beginning to trickle through, but we
still get businesses telling us that the branch manager is unaware of all these
schemes,” says Stephen Alambritis, chief spokesman for the Federation of Small
Businesses. “They need to release, relax and be more positive. Businesses are
out there clamouring for the money to tide them over because they’ve not been
paid on or because trade is down.”

The British Bankers’ Association says the scale of the credit crisis has
forced their member banks to look again at their business models. “The key is
that lending has to be for a business that has a sustainable business model,”
says Lesley McLeod, a BBA spokeswoman. “You don’t want people getting into
fresh lending that gets them into a worse mess. The question is whether you are
financing escalating debt.”

In February, RBS appeared to react to the government’s demands, making £3bn
available to SMEs, but this is just half the £6bn it announced in January. Peter
Ibbetson, chairman of small business banking at NatWest, says while businesses
wanted to extend their overdrafts they are less keen on taking out new loans. “A
lot of businesses are putting their plans for reinvestment and buying new assets
on the backburner,” he told the BBC. “If businesses show that the demand is
there we will have another look at it.”

Quite conversely, official figures from the Bank of England show the fall is,
in part, because of a decline in companies’ demand for new money. Its quarterly
credit conditions survey shows applications for new loans collapsed in the final
quarter of the year with more than four out of 10 banks reporting a drop. The
BBA says businesses are running down their cash balances rather than taking out
new loans in a hope of riding out the recession. “Loan demand is slowing and
small businesses are using their cash flows for working capital, rather than
seeking credit options,” says David Dooks, the BBA’s statistics director.

Separate Bank of England figures show companies ran down their bank deposits
at a record rate in the final months of last year. Deposits held by
manufacturing firms fell at an annual rate of 12.5%, while those held by
construction firms were down 9.2% and deposits of service sector firms down
6.9%. “For the real economy, the signs are that corporate liquidity is worsening
at an alarming pace,” says Citi’s Saunders. “The effects are evident in the
sharp rise in business failures, widespread job losses and a sharp downturn in
firms’ investment intentions. Further cutbacks probably lie ahead.”

The BBA insists lending volumes are rising, albeit not at the rate seen a
year ago. Their most recent figures show small businesses borrowed an extra
£154m in November, half the monthly rate from January to September, when Lehmans
collapsed.

The key to squaring the circle between the contrasting stories told by
lenders and borrowers is the withdrawal of foreign banks from the UK, the BBA
says. Lending by foreign banks and non-bank institutions accounted for almost
half of new corporate loans, the Chancellor told MPs in January. “A significant
amount of lending capacity has been withdrawn or has been returned to their home
markets, demonstrating the need for coordinated international action,” he said.

Foreign exodus
This will be an issue at April’s meeting of the heads of state of the G20
countries in London, although the rising tide of protectionism makes cooperation
less likely. The BBA says this creates an issue for UK banks.

“There is an issue over how UK banks would fill the gap left by, say, the
Icelandic banks getting hit and the Irish banks retrenching,” McLeod says. “They
would struggle.”

The CBI agrees, pointing to the collapse in growth in total lending from 20%
at the start of 2008 to zero at the end. “That illustrates the funding gap,”
says Ian McCafferty, the CBI’s chief economic adviser. “Even if UK banks are
continuing to grow lending it is not enough to cover the 30% or 40% of lending
that was coming from the foreign and non-bank sector.”

CBI director-general Richard Lambert says the government has taken the right
steps even if they were not well communicated. “Firms needed a clearer sense of
when they are going to kick in,” he says. “Companies are thinking about their
cash flow and if they know something is going to happen on 16 April at 5pm, say,
that would give them a degree of confidence they don’t have now.” Lambert
singles out the clearer guidance on banks’ capital ratios as a key move. “That
should give confidence to banks to lend without worrying about having their
collars felt by the FSA,” he says.

Ultimately, this is about the real economy, says McCafferty. “The stimulus
from a 1% base rate, the fiscal package and the fall in the pound are in the
pipeline, but they are being held up. “If we can get credit flowing again, then
the stimulus can start affecting the economy. At least we could see the cyclical
mechanics starting to work again.”