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Nationalisation by stealth

• Robert Peston
• 2 Oct 08, 05:29 PM

The big vulnerability of British banks does not come from the danger that retail depositors, the likes of you and I, might shift our money around.

In the end, it's not practical for most of us to move our funds abroad - although we can and do move our money from banks we deem to be weak to those we see as strong, which obviously undermines the weak banks.

No, the big flaw in the British banking system is the way it became massively dependent on the money markets and wholesale funds.

Bank of England figures show that at the end of last year, there was a 拢625bn gap between the money lent by our banks and what they took in from conventional deposits.

That gap shows their dependence on wholesale markets - which have seized up and are very difficult for our banks to tap.

And, to be clear, this dependence on wholesale markets was a problem of the banks' recent making, because as recently as the beginning of 2001 the funding gap was zero.

Over the past few months, much of that gap has been filled by loans from the Bank of England.

In fact figures published just this afternoon showed that the Bank of England's direct loans to our banks jumped 拢49bn in just one week - and, including the special scheme that allows the banks to swap their mortgages for Government bonds, the authorities' financial help for the banks has grown more than 拢200bn in the past couple of years.

It's a sort of nationalisation of our banks by stealth.

However the banks told the Governor, Mervyn King, on Tuesday evening that they need even more cash from him, to avoid falling over.

Part of the problem is that as these wholesale loans become due for repayment, they're not being rolled over - which makes the banks ever more desperate for help from the Bank of England.

But King's not keen to forgive the banks for their past sins and bail them out even more than he has been doing. He views them rather as a parent sees a mischievous child, as needing to be taught a lesson.

And rather like upset sulky children, an extraordinary number of bankers have said plaintively to me over the past couple of days that "Mervyn really doesn't get it" - which is as much as to say that the mess they've made is far too big for them to clean up without his help.

The Chancellor rather agrees with the bankers. He is increasingly taking the view that although there may be a time for spanking the banks, this is probably not it - because the priority is to restore them to some semblance of health.

So there's a spot of tension between Chancellor and Governor, which is probably a bit more than then normal rivalry between Treasury and Bank of England - although officials close to them say that King seems to be less inflexible than he was.

As I pointed out this morning, at issue is the range of collateral the banks can provide in return for loans from the Bank of England.

King only wants the best quality assets as collateral - which is understandable, since he wants to protect his balance sheet and the interests of taxpayers.

But the banks are running out of the good stuff, and now want to swap commercial property loans, loans to companies and car loans for readies from the Bank of England.

This may sound tedious and technical.

But it really matters to all of us.

Because if the banks were to run out of collateral they can swap for Bank of England loans, well in the current inclement weather, that would be lethal.

Unconvinced?

Well, one of the reasons why the board of the Financial Services Authority deemed last weekend that Bradford & Bingley was no longer viable and fit to take deposits - which was the precursor to it being nationalised - was that it had almost run out of good quality assets that it could swap for loans from the Bank of England.

It wasn't the only reason why the City watchdog decided that B&B had reached the end of the line.

But B&B's inability to get much more out of the Bank was like the valve being closed on an intravenous drip.

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Smack smack - we're dead

• Robert Peston
• 2 Oct 08, 09:05 AM

If the patient is the financial economy, here's a smattering of the latest worrying symptoms.

1) National Savings has been overwhelmed by calls from anxious savers wanting to lend their money to HM Treasury rather than keep it in a high street bank. And there's also been such a rush to place deposits in taxpayer-owned Northern Rock that .

2) There's been a flight by some British savers to the safety of Irish banks, where . And here's an odd thing. Yesterday Ulster Bank, a subsidiary of Royal Bank of Scotland, was given 100% deposit protection by the Irish government, on the same basis as the independent Irish banks. So it's now safer for both wholesale and retail depositors to put their money into Ulster Bank than into RBS's NatWest subsidiary in the UK.

3) Austrian, South African and US mints are working 24/7 but still unable to press enough gold coins to meet soaring demand.

4) As I disclosed on the Ten O'Clock News last night, British banks urged the chancellor and the governor of the Bank of England at a hastily arranged meeting on Tuesday to please please let them swap their car loans, their loans to companies, their commercial property loans for cash from the Bank of England - because of their deep concern that wholesale funds are draining from the system. The banks felt they received a sympathetic hearing from the chancellor and a relatively hostile one from the governor. The banks fear, perhaps guiltily, that Mervyn King's understandable desire to see them spanked for their past sins and deterred from repeating their errors could turn out to be a capital punishment (smack! - no more banks).

5) Those same banks told the chancellor that their real vulnerability isn't the instability of retail savings, or the fear that the likes of you and me will move our modest amounts of cash. What really worries them is that huge wholesale deposits made by professional money managers are harder and harder to retain. And what the banks warned is that the Treasury may find itself having to follow the example of the Irish by guaranteeing retail and wholesale deposits (though the Treasury is reluctant to do this, because of how it would automatically lead to a ballooning of the national debt).

And now for the complicated and scary stuff. Today is the beginning of "auction season", when the starts a series of auctions to settle who pays what to whom on a plethora of credit derivative contracts relating to businesses that have gone into default.

It's settlement time on those humungous insurance policies for corporate debt, called credit default swaps, which I've mentioned to you as being another potentially lethal flaw in the financial economy.

In the coming three weeks, payouts of hundreds of billions of dollars may be made - or at least demanded - to cover losses arising from the defaults on the debt of Fannie Mae, Freddie Mac, Lehman and Washington Mutual.

Sandy Chen, the analyst at Panmure who's been a smart predictor of credit-crunch accidents, estimates that payments on Lehman's battered bonds could be as much as $350bn.

Now the problem here is that for every beneficiary of these payments, there's an underwriter - those who provided the CDS insurance - which has to find the cash. And, as I've pointed out, this was a largely unregulated market, so the great fear in markets is that some underwriters have insufficient capital and will simply collapse when the claims are made.

That in turn would hurt financial institutions expecting to be paid out on their CDS contracts and damage others with separate exposure to the collapsed businesses. The shock to the system could be very severe.

To compound the current anxiety about all this, the CDS market is so opaque that it's impossible to know right now who is holding the radioactive baby.

This gigantic CDS mess has contributed to the seizing up of money markets in recent weeks, the tendency of all banks and financial institutions to hoard cash - because no-one knows who or what may be vulnerable during the CDS auction season.

That, as if you needed telling, is just one more reason why the US $700bn bank bail-out is no panacea, even if we should be relieved that it has passed its first Congressional hurdle.

The financial weather ahead remains stormy and unpredictable.

PS. The most significant British corporate announcement today was that , It was planning to spend up to 拢900m this year on improving stores, its supply chain and computer systems. That's being reduced to 拢700m - and next year it'll be slashed to 拢400m.

In other words, M&S will be placing far fewer orders than planned with other businesses - which will have a damaging impact on their profits and on the prospects for their employees.

That's a graphic illustration of how the horrors of the financial economy are infecting the real economy.

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