Bank of Mandelson and Cable

Politicians in the UK don't seem to be able to remember which banks they bailed out and which they didn't. Last week we had Lib Dem finance spokesman Vince Cable railing against Barclays for raising money from the Middle East, admittedly on generous terms, rather than signing on for (Mervyn) King's shilling of government aid. Now "Lord" Mandelson is leading a chorus of MPs warning banks that they must pass on future rate cuts to consumers, after HSBC (another non-bailee) hinted that it might not do that. No doubt the criticism will move on to Lloyds, which is planning to refinance its Government-injected pref capital early in 2009 so that it can start paying dividends again. The effrontery!

It may be hard to imagine why the banks don't want Mandelson, Cable and the rest of the finance whizzes in the House of Commons peering over their shoulders every time they meet a customer, but let's give it a try. Those banks that got into a mess did so by lending unwisely and too much, while raising too little in deposits. Let's start with the lending side. The HSBC exec who has attracted the wrath of Mandy said that credit had been systematically mispriced over the past few years, something which now needed to be corrected. The banks mainly have themselves to blame for the mispricing, though HSBC, which has a surprisingly small share of the UK mortgage market, was not one of the bigger offenders. Margins will have to reflect risk more accurately in the future if the financial system is not to veer straight back into the ditch.

The flood of lending that resulted from low underlying rates and mispricing of credit risk outpaced the ability of most banks to fund themselves through old-fashioned deposit taking, though again, HSBC is an exception in this regard. The majority of the UK's banks were only able to keep lending by funding themselves in the inter-bank or wholesale markets. When these started to dry up in mid-2007, these banks had nowhere else to turn.

Look back over the events of the past fifteen months and you can see how these problems on the asset and liability side of the banks balance sheets played out. The first victim, Northern Rock, was undone by its reliance on wholesale funding, despite having a relatively sound loan book. Bradford and Bingley was mainly done in by a dodgy loan book (too much buy-to-let and self-certification), though its reliance on wholesale funding didn't help. The other institutions that have tottered but appear to have been saved suffered from a combination of the two problems.

The government rescue has bought time for the banks to get their houses in order, i.e. deleverage. As well as more capital, the banks need a combination of much slower loan growth, reduced reliance on wholesale funding and improved deposit-gathering. How succesful they are with rebalancing their liabilities away from wholesale funding will determine how much money they can safely lend, which will in turn determine how severe the recession turns out to be. It's going to be difficult to get it right. But cutting rates too quickly will boost loan demand and curtail deposit growth, which is the exact opposite of what's needed. Mandelson et al must know this, mustn't they?