The world has changed.
We’re no longer in a world where central banks can wave their magic wands and make all the bad financial bogeymen disappear. We’re no longer in a world where every bank is rolling out the red carpet for anyone with a pulse and a desire to borrow money.
Yet lots of people are desperate to return to that world – our leaders chief among them. So they are still trotting out the same old tired solutions as ways to tackle the financial crisis and “get the banks lending again”.
Cut interest rates, they say. Spending more government money to prop up the economy during the ‘downturn’ is responsible, they say.
Well, I’ve got some bad news. There isn’t enough money in the world to spend our way out of this one…
Banks need any profit they can get at the moment
“Banks ‘profiteering’ by not passing on rate cuts,” screamed a headline in The Telegraph at the weekend.
Researcher Moneyfacts reported that several banks had cut savings rates after the Bank of England cut interest rates recently, but that they hadn’t followed up by cutting their Standard Variable Rate for mortgages yet.
A spokesman for consumer group Which? said that consumers “deserve a break,” reported the newspaper. “Not enough lenders have passed on the benefits of the emergency rate cuts and those who have only cut some or all of their savings rates are trying to have it both ways.”
Stories like this demonstrate the real lack of understanding that we have as a society about the way banking works. Consumers may well deserve a break – but banks aren’t charities. They are run for a profit – and they need any profit they can get more than ever at the moment.
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Here’s roughly what banks do at their most basic level. They borrow money, then lend it at a profit. They borrow money from savers, by paying them a better rate than their rivals. They also borrow it from institutions in the wholesale markets (the “money markets”). Then they lend it out to other people. The gap between their borrowing costs, and their lending price, is their profit.
Like any company, they want to maximise their profits. If there was only one bank, then you’d get a terrible rate on your savings, and you’d pay a huge amount on your mortgage. But because there’s a lot of competition in the banking market, margins between borrowing and lending are actually pretty tight.
And in recent years, before the boom exploded, those margins were almost non-existent. Banks were so keen to get customers, and competition so intense, that they adopted the “pile it high, sell it cheap” model of writing lots of loans at low margins.
This is what happens during boom times. There’s high demand, your products are flying off the shelves. Suddenly the important thing is to attract customers with loss leaders, then hope to sell them up to more expensive goods while you have their attention.
But the boom times are over. Now banks are focusing on profits, not sales and market share. They have to – they need the money. If they were still in a position to write lots of business at cheap rates, then the taxpayer (not to mention their shareholders) wouldn’t have had to step in to prop them up.
So regardless of what the base interest rate is, banks will attempt to expand their margins as far as they can. That’s quite easy right now, because demand for loans has fallen, and the amount that banks are prepared to lend has also fallen. Less competition means higher charges. And the stronger banks can afford to cut the rates they offer to attract savers, because right now people are more interested in savings security than high interest rates.
Slashing interest rates won’t save the economy
Regardless of what the government does, or how far interest rates are cut, this situation won’t be reversed any time soon. House prices are going to keep falling. No one wants to buy property when the price is falling, so demand for loans will also remain low. Meanwhile, more and more people are defaulting on their loans, which means that banks are still facing rising bad debts and so have a huge incentive to remain cautious in their lending.
So cutting interest rates won’t make lending conditions much easier. And rising government spending – the ‘Keynesian stimulus’ everyone is talking about – will only store up problems for the future, as the government sucks up what little money is available and spends it in its usual inefficient manner.
What both of these things will do however, is hammer sterling harder. It’s tanking again this morning, and shows little sign of stopping. My colleague David Stevenson wrote about the prospects for sterling on Friday – read his piece here: Latest: FTSE in meltdown, and now the pound crashes.
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