The G20’s plans for banks would be a disaster for the real economy

In a classic case of stable-door bolting, the recent G20 meeting saw US Treasury Secretary Tim Geithner sign the world up to his vision for a stronger, more robust and less risky banking sector. Finance leaders agreed that banks, especially the big ones, will need better-quality capital, and more of it – especially in good times. They also agreed that they won’t be able to ignore assets by zero-risk weighting them (which is when banks pretend an investment can’t go wrong). Furthermore, banks will be restricted in terms of liquidity.

What this last bit means is that banks won’t be able to lend more than their deposits. What the rest means is that banks won’t be able to lend as big a multiple of their capital bases. And what the whole lot together means is that banks must cut lending on a structural basis – in other words, from now on they simply won’t be able to lend at the levels we once saw.

That might sound a good plan to some. But at a time when the private sector is paying down debt (where it can), banks are restricting new lending, and broad money-supply growth across the western world is either anaemic or negative, such ideas are dangerously ill-conceived. Forcing banks to boost capital now would actually increase the risk of a global double-dip recession. Here’s why.

Banks have already written down the value of their securities. Next, they will take provisions against losses on their loan books. Of the £110bn in losses reported by UK banks so far, just 30% (£33bn) is directly attributable to losses on loans they’ve written. That equates to just 1.3% of peak UK bank loans. Yet loan losses reached over 4% in the early 1990s recession and this recession is already cumulatively more than twice as deep as that one was.

Moody’s Investors Service estimates that British banks are less than half way through the whole loss recognition process – they’re £110bn ($182bn) down, but still have as much as £130bn ($215bn) to go. Yet even another £130bn would take this recession’s loan loss ratio up to just 6.6%. The 1990s experience might suggest that 8% is more realistic; in Japan, losses reached 15%.

Since summer 2007, British banks have topped up their capital bases with £125bn (much of which was our money). But they’ll need the same again if Moody’s is right. The good news for banks is that, unlike with securities, they don’t have to realise loan losses all at once. Instead, they can hang on to borrowers who are willing and able to keep paying the interest, by extending the maturity of the loan. But for the rest of us this policy is a disaster. Banks that are forced to keep rolling their existing loan book over will be in no mood to make new loans. This does two things. It stifles the next generation of would-be entrepreneurs, as they can’t get access to financing. And it also accelerates asset-price deflation – banks won’t lend to the bidders at foreclosure auctions, so prices offered for repossessed assets plunge.

As asset prices fall, borrowers’ loan-to-value ratios rise. So banks entrench themselves even deeper, while firms fret that they will become insolvent if their assets shrink below the level of their liabilities, so they pay down debt. Debt repayments, combined with shrinking bank lending, leads directly to broad money supply shrinking – and that’s the true definition of deflation. And the lower asset values fall, the less money the banks can recover if a borrower defaults. That means banks have less to lend out in future. So cap all this off with regulatory demands from the G20 for higher capital ratios, and you have three very powerful headwinds forcing bank lending growth into negative territory.

US quarterly bank lending (see chart) is falling at a more than 15% annualised rate, breaking all records in the process. That’s taken the last three months of broad money growth (M3) to -5% annualised. In Britain, broad money growth is only positive because of quantitative easing and public sector bank borrowing. UK bank lending to industry went negative in the second quarter, after lending to individuals started shrinking early in the fourth quarter of last year. We are in grave danger of following the Americans into a potential debt-deflation spiral. We aren’t past the worst – we are on the lip of the whirlpool. And the leaders of the G20 seem completely unaware.

In short, as noted above, banks trying to make their balance sheets stronger create deflationary forces. Firms trying to delever then make things worse. So G20 regulators demanding the banks shore up capital could easily force the economy back into recession. It’s crazy but true.

There is a tiny light at the end of this tunnel. This is the G20 we’re talking about. ‘Impact assessment’ won’t be completed until early next year, ‘calibration’ of the appropriate ratios not before end-2010. Then measures will only come in at a rate that “does not impede the recovery of the real economy”. Given this exercise can’t do anything but impede the economy, potentially fatally so, perhaps actual implementation will remain on the regulators’ ‘to do’ list for some years to come. Let’s hope so.

• James Ferguson is chief strategist at Pali International. He also writes the Model Investor newsletter.