The Treasury’s new scheme won't end the credit squeeze

Last week the Chancellor, George Osborne, and the Bank of England governor, Mervyn King, outlined their strategy for coping with a worsening eurozone crisis.

Under a funding for lending' scheme, the Treasury will provide subsidised funding for bank loans to UK businesses of up to £140bn. In return, banks have to promise to expand, or at least sustain, lending to the non-financial sector. Anyone familiar with the plan's predecessor, Project Merlin, will know that banks are likely to aim for the lower hurdle and then fail even to reach that.

The Bank's side of the bargain will be to lend money over six-month periods against a range of lower-quality-than-usual collateral (a sort of shorter-term UK version of the European Central Bank's Longer-Term Refinancing Operations). King has also since stated that banks should be given a more forgiving timetable over Basel III liquidity rules, and that they should redirect their reserves towards bank lending.

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This is classic regulatory forbearance, and what you'd expect to be happening. But while I hate to say it, not one of these proposals will make a blind bit of difference to the level of lending in Britain. Regulatory forbearance is what the textbook advises central bankers and other regulators to employ during a post-crisis resolution.

Translated into English, what this means is that when banks with large capital buffers go into a crisis, they naturally lose money. So regulators should allow these banks to run their capital ratios down, since the whole point of a capital buffer is to absorb losses. Once the damage is done, banks can rebuild their capital buffers. That's the theory. Unfortunately, our banks didn't go into the crisis with large capital buffers.

They had very small ones. So instead of being allowed to let their capital absorb losses, the regulators forced the banks to increase capital at exactly the same time as the losses were coming at their thickest and fastest. These losses scared most private-sector investors away, so we poor (poorer now) taxpayers had to pick up the tab and effectively nationalise two of our four main banks.

The trouble is, we're not done yet. Investor consultancy PIRC reckons that hidden losses at British banks come to a total of £40bn. I wouldn't be surprised if losses were five times that size. Here's the rub. The big four British banks sport some £255bn in core tier 1 capital, so if hidden losses of £200bn were to be revealed, so would the fact that the sector is still practically insolvent. Banks have already realised £230bn of losses, but that has taken almost five years of earnings.

Another big problem is that half the sector's capital resides at just one bank: HSBC. But because HSBC has also done more loan loss realisation than any other bank, it's a really good bet that far less than half of the remaining losses will come from HSBC.

That leaves the other three banks, RBS, Barclays and Lloyds, in a tricky position. As hedge fund manager Chris Hohn pointed out in a letter to the Financial Services Authority this week, a £20bn post-tax loss would send Lloyds' capital ratio below 5%. The same would also be true for the other two banks.

That brings us to why this funding for lending' idea won't work. Our three problem banks still have a £250bn loan-to-deposit gap that's money they're having to raise from wholesale markets, rather than from savers' deposits. They would like to work this gap down to zero.

So while they'll love to have the Treasury fund some loans, these won't be new loans they'll just be the ones that they already have on their books and can't affordably fund elsewhere any longer. So banks will do their best to use this £140bn of Treasury funding for half the loan-to-deposit gap and continue to shrink the other half.

It might slow the rate at which lending is being reduced, but other than that, all Osborne's plan will achieve is to hand another £3bn-£4bn a year to the banks via a wider loan spread (the gap between what the money costs them and what they lend it out at). And what's the betting that most of this goes on bankers' bonuses to reward their unique talents'?

As for the liquidity measures, as King said only last month: "banks need(ed) not loans but injections of shareholders' capital to absorb losses". Making yet more lending available against even lower-quality collateral will prevent banks falling victim to a liquidity failure they won't run out of money. But it does little to solve the underlying problem of solvency: the banks don't have enough capital after deducting undeclared losses.

As for King's plea for banks to use reserves to make new loans, this is disingenuous in the extreme. Banks have built up these huge reserves because they're risk-free, for which read they're not loans'. Banks won't turn their reserves back into loans until their balance sheets are fixed and no hidden losses remain. One thing is for sure, we're a long way away from that day.

James Ferguson is chief strategist at Westhouse Securities.