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How much should banks cut rates?

• Robert Peston
• 7 Nov 08, 10:41 AM

Spare a thought for those poor misunderstood chaps who run our big banks.

They've been bashed and battered for causing our current mess, by lending far too much too cheaply in the years preceding the onset of the credit crunch in August 2007.

And now they're being duffed up for making a more realistic assessment of the true risks of lending, and therefore failing to pass on all of the 1.5% reduction in the Bank of England's policy rate to borrowers.

I'm not being flippant, by the way. There is a serious point here.

We can't have it both ways. If, which is the case, the cause of our woes is that lenders lost sight of the true risks of lending - and you'll also have heard that diagnosis from the Bank of England and the Financial Services Authority - we can't really react with total outrage when the banks attempt to set the interest rates they charge us at a level that captures the probability that some of us won't be able to repay.

And, to tell you what many of you know from painful personal experience, the risk of a borrower defaulting rises when the economy shrinks in just the painful way that it is doing right now.

But, you'll say, the economy would shrink less if only the banks would lend more to small businesses and homeowners and at cheaper rates.

The banks are surely shooting themselves in the foot by restricting the flow of credit and increasing its cost, because in doing so they are turning our troubling economic plight into something rather worse.

You'd be right.

Where as it's wholly rational for any individual bank to take a much more cautious and conservative approach to lending, it's wholly irrational for all of them to do so at precisely the same time, especially when the economy is so weak.

That's of course why the Bank of England has reduced what it calls its Bank Rate by far more, 1.5 percentage points, than it's ever cut before (or at least since taking control of setting rates in 1997).

The Bank of England knows it can't be certain that the Bank-Rate reduction will be passed on in full in lower mortgage rates or cheaper money for businesses.

It's slashed enough, however, to be confident that a useful proportion of the reduction - perhaps half - will be passed on.

Now the really important point to understand is that the Bank of England can influence the cost of money for the banks, which in turn determines the rates that they can afford to charge us, but it does not set the cost of money for them in a mechanistic and precise way.

If banks were able to borrow from the Bank of England all the money which they then lend to us, then of course the Bank of England could set the interest rate we all pay.

But most of banks' cash resources, what they need to provide loans, comes from elsewhere.

It comes from us, in the form of the balances in our current accounts and whatever savings we have in our deposit accounts.

It comes from managers of hundreds of billions of pounds, who lend to banks for short period and for longer periods.

And it comes from other banks, since banks also look to each other for funds, to smooth out the peaks and troughs in their cash needs - via the now famous interbank market.

To a great extent, what really matters for the banks, when setting the interest rates they charge us, is what all the money raised from all those many different sources actually costs them, when it's all lumped together and averaged out.

Some of that money still costs them nothing or almost nothing. I'm talking about the funds that some of us still keep in current accounts that pay zilch.

But, as I pointed out in my recent note ("Why interest rates aren't falling") the cost of obtaining any substantial funds - especially from those money managers that look after squillions - has been rising since the onset of the Credit Crunch. And the main reason is that money managers believe the risk of lending to banks has risen very sharply, and they therefore want to be compensated for that additional risk.

So what is the average cost of money for our banks?

Well, it's not the Bank of England's 3% Bank Rate. Apart from anything else, that's a rate for borrowing overnight - and it would be foolish even by their standards for banks to set interest rates on loans to us with maturities of three months, or two years or five years on the basis of what they have to pay to borrow for 24 hours.

A traditional proxy for their average cost of money has been the three-month LIBOR rate, which is what banks pay for unsecured loans from other banks of three-month duration.

However, there is controversy over whether that rate is quite as accurate a measure of the genuine cost of funds as it once was.

But, for what it's worth, those who operate in the market believe that three-month LIBOR will fix at just under 5% this morning.

Which would mean that the Bank of England's 1.5 percentage point cut had reduced the cost of money for banks by around 0.75 of a percentage point, perhaps a tiny bit more.

There is therefore an argument that mortgage rates and loans to businesses should be reduced by at least 0.75%.

And if banks fail to do this, well then the Chancellor - and the rest of us - are probably entitled to biff the banks.

That said, the Chancellor is not quite the innocent bystander in all of this.

As you'll recall, he recently rescued the banks with a 拢400bn taxpayer-funded package of capital injections, guarantees and loans.

A very important part of that was a commitment to provide taxpayer-backing for 拢250bn of tradable debt issued by banks with maturities of up to three years.

To translate, we - as taxpayers - will stand behind a bank when it borrows from financial institution. We're saying we'll repay the banks' debts if it can't do so.

The Chancellor understandably took the view that if taxpayers are in a sense insuring the money being borrowed by banks, we should be paid for that insurance.

But the cost of that insurance isn't cheap. It's working out at between 1.2% and 1.7% per annum of the amounts being borrowed for most banks.

That's 1.7% that has to be added to the 4 per cent or so interest-rate cost of the funds being raised.

In other, the price of money for banks under the government's own sponsored scheme is somewhere over 5%.

It's therefore very difficult to see how the banks can charge us less than the 5% that the Treasury is demanding they pay for the vital taxpayer-backed funds they need.

Unless, that is, the Chancellor were to decide that the banks should be transformed into loss-making public utilities.

UPDATE: 13:05

Three month sterling LIBOR has in fact fallen just over 1 percentage point to 4.49%. There will be intense pressure on the banks to pass this cut on in full, at the very least in the rates for new tracker mortgages.

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