Big bank profits – but problems remain on the horizon

Britain’s banks are back. Profit is pouring from atop towers in the City and Canary wharf.  In the Capital they even appear to be repaying our faith in them by doling out free bikes. Time to get the bunting out, surely?

Well, despite the red ink draining away from the big banks’ balance sheets, all is not perfect in the bankers’ garden. Three out of Britain’s top five bankers have told me that the government will have to prolong some parts of the bailout package.  As Peter Sands, the chief executive of Standard chartered told me in an interview: “It’s premature to say we are out of the woods… it’s clear that good progress is being made … but we shouldn’t underestimate the scale of the challenges”.

Mr Sands isn’t any old bank chief, though Standard chartered is making record profits in its key Asian markets. Alongside Mervyn King’s efforts, it was his emailed idea to Gordon Brown’s office in October 2008 that formed the basis of the bank bailout that prevented a collapse of the system. His views will be listened to at the top level of government.

After that original bailout in October 2008, the lending bailout of January 2009, and the further capital injection last November, you could call it Bailout 4.0. One senior banker told me that it would be a “renewal of part of the existing bailout”.

This is not an issue of solvency; the banks aren’t going to bust again. This is an issue of funding, and the ability of the banks to generate credit beyond next year. It is an issue of immense macroeconomic significance.

A decade ago Britain’s banks lent out only what was saved with them by depositors. There was no ‘funding gap’. The credit boom was fuelled by the banks using financial wizardry and foreign flows of hot cash to continually lend out more despite having fewer deposits.

The funding gap grew sharply reaching £305bn in 2003, and then it simply exploded, topping £840bn as the bubble burst in 2008.

At that point, lending should have collapsed, but that would have caused a depression, so the state, through the government and the Bank of England stepped in to ease the transition from a near trillion pound funding gap, back to one closer to zero. Right now the Bank of England calculates this year that the funding gap will be about £450bn.

Some of that is government support through the Bank of England’s Special Liquidity Scheme (SLS), and the Treasury’s Credit Guarantee Scheme (CGS) that will have to be repaid or refinanced within 18 months.

There are three ways out of this. 1. The banks raise far more deposits, and manage to restart the financial wizardry, the complicated bond markets that helped fund the gap in the first place. 2. The banks rapidly reduce the amount of credit in the economy leading to a renewed form of the credit crunch. 3. The government renews some of the funding and guarantee schemes (though the Bank of England has categorically ruled out doing so itself).

Option one is the benign route back to financial nirvana. And the tantalising reality is that it was looking a possibility, before the Greek crisis spooked markets around the world.

Option two looks likely, but could be disastrous to the economy if the recovery has not firmly taken hold, and if austerity and rising interest rates take their toll.

Option three would involve offering more support to profit-making banks at a time of multimillion bonuses, and austerity for everyone else. This type of conjunction led to the burning of bank chief effigies in Dublin.

“The biggest thing on the horizon, is the withdrawal of the Bank of England SLS and the CGS and what impact that will have because some of the banks in the UK, in Europe and in the States are still relatively dependent on central bank liquidity support, and that has to be pulled back and … if it doesn’t get replaced, it will require a contraction of credit,’ Sands told me.

‘I don’t think it’s likely that you will see the government putting its hand in its pocket again, the question is what the time frame is for when these liquidity schemes can be pulled back’.

Sands went public, but his bank needs no money (it lends out less than it takes in deposits) but another two bank chief executives have indicated to me some expectation that some new arrangement will follow the end of government guarantees in 18 months’ time.

A senior former Treasury minister has described this as “the most important decision” that will now need to be made by George Osborne. I get the sense that the banks may try to appeal over the head of the newly empowered governor of the Bank of England, in an echo of the liquidity dilemmas that followed Northern Rock’s problems.

For the Bank of England’s part, I detect frustration that many UK banks are not taking this fundraising challenge seriously enough, above all, when many banks are choosing to shell out more in bonuses and dividends (more on this in the coming days).

It would be only natural for the commercial banks to rely on political fears about credit availability to mount up over the next few months, leading to the pressure for the extension of emergency schemes. This has happened before.

The British banking system may be back on its feet, but as Peter Sands says: “We are not out of the woods yet”.