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Banks worries the crunch will eventually bite – Sunday Express

Ben Thomson, Sunday Express
23 March 2008

Until now the problems of the credit crunch have largely been contained to financial markets. The fear is that it will spill into our everyday lives causing UK house prices to fall, interest rates to go up, and our economy to start shrinking. This is why regulators round the world are acting so quickly to try to prevent this from happening and the economy falling into a worldwide recession. The trick is to keep the confidence in the banking system and to ensure there is enough liquidity, ie money in the system. A lack of confidence and liquidity are the most important factors that lead to events such as the run on Northern Rock, the collapse of Bear Stearns in the US or this week’s shenanigans with HBOS which in turn undermine the trust and confidence in the financial sector .

The problems really started about three years ago when banks round the world began competing more aggressively for providing debt. This ended up causing all sorts of new structures to be created to fund asset classes such as sub prime mortgages, leveraged buyout and hedge funds to name a few. The effect of this aggressive lending was to balloon underlying asset prices such as houses and companies with cheap borrowing. In August the balloon was pricked by the realisation that one of those assets, US sub prime mortgages was so over inflated that investors were very unlikely to get their investment back. Banks round the world started to stop their aggressive lending and reduce the amount they lent. This caused certain asset prices to fall and exposed those banks that had been lending most aggressively, particularly when they relied on other banks to provide them with their money. This was the problem for Northern Rock which had been offering very low cost mortgages and relied heavily on lending from other banks to fund itself. Suddenly it found difficulties in obtaining cash to fund its mortgages.

This all seems far removed from everyday life but the process of the banks reducing lending has some serious consequences. As asset prices start to fall, banks have to write off more loans and mortgages, this causes banks to be even more cautious and that causes assets to fall even further. The UK has yet to see the housing market fall significantly like it has in the US but there is a real danger that if this goes on much longer it will hit house prices in the UK and that would in turn hit consumer confidence and lead to a downturn in the economy. In addition the write offs in the banks also cause the net assets of the banks to fall and this undermines confidence in the banking sector causing their share prices to fall as we have seen in the last few months.

The regulators round the world have been trying to make sure that there is enough cash in the system so that banks will be able to fund themselves. At the same time governments have been looking to try to reduce interest rates and lower taxes to stave off a recession.

In the UK, the Bank of England is now reacting to make facilities available to banks to allow them to lend. This is starting to address the liquidity problem. However the UK has no cards up its sleeve to stave off a recession if we start going that way. Unlike the US, the UK cannot reduce taxation in the short term because we our right at the upper limits of our own spending deficit at £40billion per year. In addition the rising costs of resources such as food, petrol and wage increases have caused worries over rising inflation and the Bank of England is cautious on cutting rates. This all makes it even more important that the banking crisis is resolved.

So how does this effect Scotland? In two ways, first the financial sector is the largest sector in Scotland after the public sector. If there are problems in the financial sector it will hit Scotland disproportionately hard. The banking sector, with RBS and HBOS in particular, has been a huge generator of jobs and growth for the Scottish economy and we should be concerned about anything that undermines the performance of those banks. Second that a recession, even a short one, would impact on us all potentially hitting share prices, asset values and consumer spending.
What can we do about it? To some extent this is a worldwide problem and there is little we can do in Scotland except to encourage our politicians, the media and the financial community to support the liquidity measures to make sure that there is no further loss of confidence in our banking system