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Expect the government to shrink the banks? Think again. But the markets….

The feebleness, impotence and tardiness of the Government in dealing with the banks could hardlybe more starkly highlighted.   Everyone (almost) agrees that the UK finance sector is far too big – its liabilities equal 5 times Britain’s GDP – and the economy urgently needs to be rebalanced away from the City towards a revival of manufacturing. So what happens? The Government sets up the Vickers Commission which takes a year to come up with the wrong policy and then the Government takes another 6 months to confirm the wrong Vickers conclusions. Vickers recommends:

  1. Chinese Walls ring-fencing retail from investment banking, which the City scam merchants will get round in no time.
  2. Raising capital adequacy ratios from Basel III’s 7% to 10%, which is the opposite of what is needed in recession when demand is low and credit hard to obtain.

On the crucial requirement of rebalancing the economy Vickers said nothing. But as so often the markets are well ahead of the Government.

The UK banks are under pressure partly to lend more to businesses and householders (which would require lower capital adequacy ratios, not higher) and partly because of the need to recapitalise against the risk of a failure of European banks, to which they may be exposed, or a collapse of the Eurozone as a whole. Eurozone banks are under a greater threat because of Merkel’s fixation with a pro-cyclical fiscal stability pact and because they do not have the advantage of a major quantitative easing programme as in the UK. To face these threats to their survival European banks have committed to reduce their assets by no less than €950bn in the next 2 years. That is approx. £791bn – a staggering amount of deleveraging.

Already French, Spanish and German banks are being forced to sell off major parts of their businesses to make sure they survive. Credit Agricole, Santander and Deutsche Bank have already started this process.   The UK banks, though less at risk, are not immune. It may even revive the debate as to whether Britain’s fractional reserve banking system, whereby banks create credit out of nothing whenever they lend to their customers, is a threat to financial stability. If the economic situation darkens in 2012, which is very likely, the UK banks will face 3 options to perform their proper role of lending to the private sector.

They could be granted another massive dose of quantitative easing on top of the £275bn already granted (in which case the Government should use the money directly itself to generate jobs and drive the economic revival, but it won’t because of its deep ideological prejudice against the public sector). Or capital requirements on UK banks could be loosened, but how will being soft on public enemy no.1 go down with the public, especially if the banks use the opportunity to pay out ever bigger bonuses? Or they have to tighten their own banks, like everyone else and like the European banks. No, I doubt it too. This Tory government, which gets half its party donations from the banks, will try to find any which way to let them off the hook. But it’s just possible that 2012 will be so bad they they can’t.

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