London's lifelines lack coherence

The dangerously mixed messages underlying the British government's rescue attempts threaten to derail efforts to secure stability, argues Robert Pringle, the editor-in-chief of Central Banking journal.

We are told repeatedly that the government's policy is to restore the stability of the UK banking system. The policies adopted and the signals sent to markets by successive rescue packages have not been consistent with this objective.

The government's policy towards the banks has delayed rather than encouraged the recovery of confidence. This is because each stage of the rescue or bail-out packages has included features that are directly contrary to the government's overall stated objective.

In this frenetic climate, atmosphere and attitudes count. It is understandable that ministers are frustrated, furious and losing patience with the banks. But to make this clear so publicly, as Gordon Brown, the prime minister did on Monday, is to increase uncertainty about the government's long-term intentions and set back the recovery of stability. At the weekend we read, for example, that the prime minister was reported to be "incandescent" with Barclays, Britain's third-largest bank, and came close to accusing the bank of deliberately deceiving the government about the extent of its bad and doubtful assets. On Monday it was the turn of the Royal Bank of Scotland to be on the receiving end of prime ministerial anger. Then there is the drip, drip of off-the record ministerial briefings, all of which have been hostile to banks. Banks cannot answer back. Such leaks are no way to communicate a coherent banking policy.

As it is essential that banking stability is regained, that aim must take priority over everything else. But it plainly has not done so. The government has followed multiple objectives.

1. The much-trumpeted recapitalisation last October included government taking preference shares paying 12% in banks receiving the assistance. This was ostensibly to protect taxpayers' interests. It is a prime example of muddled thinking. Taxpayers, who are also employees, employers and pensioners, need above all a functioning and competitive banking system. But the terms of the assistance run directly contrary to the declared priority, making it more difficult for banks to stand on their own feet. The prime minister has been given much credit for giving an international lead in recapitalisation of banks. But assistance available from other governments, especially US, to their banks, has generally been given on more attractive terms. The British assistance was set up in such a way that it was obvious that the interests of government were not aligned with those of banks or their existing shareholders. Along with ministerial briefings hostile to the banks, it gave the impression that the government hated the banks and wanted to humiliate and penalise them.

2. The massive and growing pressure on the banks to lend more is equally misguided. This is the major flaw in the new package unveiled on Monday. To repeat, if the priority is to restore confidence in the banks, then they must be allowed and indeed encouraged to trade profitably and rebuild capital. That means, for example, letting them widen margins between deposit and lending rates, being highly selective about new loans and cutting credit lines where the credit of the borrower is doubtful. They need to preserve precious capital. It is understandable that the Confederation of British Industry, a trade body, should be lobbying for banks to loosen the purse strings, but government should not endorse such pleas. If it wants to support a particular firm or sector for political reasons, it should do so directly. Likewise if there is a deficiency of effective demand, fiscal and monetary policies should be used to remedy that - not the banking system.

One of the key factors that prolonged Japan's stagnation in the 1990s was political pressure on banks to maintain lending. They did so to a large extent by rolling over loans to firms that should have been forced into bankruptcy. It increased bad debts, and slowed the economy's recovery. It looks very much as if the UK is going the same way.

3. Credit guarantees of the kind Lord Mandelson, the business secretary, announced recently are political gimmicks that will do little for business or the banks, as academic research into how to provide finance for small and medium-sized enterprises has shown. In this context it is a pity that Ken Clarke, Lord Mandelson's opposite number, has taken over the task of shadowing the business secretary. To have two political heavyweights backing business will only increase the pressure on banks still further.

4. The prime minister has very publicly not ruled out nationalisation. What kind of signal does that send to markets? If the prime minister has such little confidence how can he expect anyone else to? Shareholders and pension funds should be supported - one day their goodwill will be needed to help re-capitalise the banks.

Nationalisation would be a disaster. It would result in a paralysis of bank decision-making and obedience to what bankers thought was politically correct credit allocation. The current proposal to guarantee bundles of securitised loans in an effort to get lending going carries the same dangers.

Britain has a long, proud history of sound banking. Banks went astray in the last ten years as they succumbed to a competitive drive to increase shareholder value, and financial rewards to bankers became divorced from the reality of risks and became frankly offensive. There will be plenty of time to reflect on the lessons of that episode, but the wholesale destruction of shareholder value which has resulted should not be aided and abetted by the government which has so much at stake.

None of this is to excuse the irresponsible behaviour of bankers. Yet again government has given wrong signals here - failing to remove poor management that got the system into this mess. Government should be much harsher on individuals and much more supportive of the institutions. Only if policy focuses on creating conditions for banks to trade profitably over a sustained period will the system return to viability.