The next big crash is already in sight

The 2008-9 crisis highlighted two fundamental flaws in the UK banks. The first was illiquidity when their creditors and depositors withdrew their money at the first sign of serious trouble, but the banks couldn’t call in their loans in order to pay them, and the Bank of England had to intervene to provide them with emergency funding. The second problem was that some banks weren’t just illiquid, they were insolvent, i.e the loans weren’t going to meet the bank’s liabilities even when they became due, and the Treasury either had to nationalise failed banks or spend billions in buying the shares of others (£68bn in all).

Now the banks have been forced by the new Banking Reform Bill (inadequate though it is) to reliquify and recapitalise their balance sheets. As a result bank lending to UK industry has gone into reverse. In the 4.5 years leading up to the financial crisis, Britain’s banks raised loans of £260bn to UK companies, while in the 4.5 years after the crisis they have called back in from UK companies a net £110bn. So the way has been left open for a new intermediary, and that is very likely where the next crash will develop.

The gap has been closed by investment funds focusing on corporate bonds. Companies in desperate need of cash have issued bonds in huge quantities, and these have been taken up by investment funds. Thus in the 18 months to July 2013 bank lending to the corporate sector fell by £26bn, but this was more than made up by the issuing of £31bn of corporate bonds, in effect peer-to-peer lending on a massive scale. So what happens next time round when there’s an investors’ panic or when they decide en masse that there are prospects of bigger returns elsewhere and they all withdrew their money in short order? The answer is: a worse disaster even than that which befell in 2008-9. Why? Because corporate bond funds, unlike banks, don’t have access to BoE emergency lending facilities.

So the risk of a credit crisis reoccurring in the banks has been reduced (though far from eliminated), only for it to reappear in corporate bond markets. As so often, the government’s Banking Reform Bill has tried to solve yesterday’s problems, but is again behind the curve in responding to what are overwhelmingly today’s very different problems. If you think 2008-9 was unpleasant, just wait for the big hike in interest rates when it comes.