Evercore Pan Asset

On Thursday the UK government gave banking chiefs a strong tongue lashing on the need to lend more money to small business on sensible terms. The government, however, says one thing and does another. The banking regulator has recently demanded that banks keep much more capital relative to the amount of lending they do. The two most obvious ways for banks to comply are to lend less, and to generate more profit from existing customers to retain more cash and profit to bolster the banks’ reserves.

It should therefore come as no surprise to the government that this is exactly what banks are now doing. Just as the regulator recently demanded, banks are now seeking to reduce their loans to a range of customers. They are looking for all sorts of ways to generate more profit and cash. They will charge more and higher fees for arranging and renewing loans and they will increase the interest rate they charge borrowers relative to the interest rate set by the Bank of England.

If the government wanted to maintain or increase the amount of lending to small business, mortgage holders or any other favoured group, it should have told the regulator that now is not a good time to demand bigger banking reserves and more banking capital relative to the volume of lending. If the government does want to continue with its programme of sharply reducing the excess credit in the system, as the Bank and the regulator have been trying to do since August 2007, it should honestly say so and admit this means a further squeeze on the mortgage and business loan customers of banks.

I had the impression from the actions of the authorities that they are trying to take a substantial sum out of the total credit advanced to businesses and individuals in the good times, as they clearly wish to reduce the credit bubble they allowed to build up. This is implied by the change of banking capital ratios and the high interest rates selected by the Bank. Their problem is that any withdrawal of credit causes problems for many borrowers, and helps trigger a recession. The recession then places more financial pressures on people and companies, who need more borrowing to tide them over difficult times.

It is never easy deflating a credit bubble. You can try to do it quickly and dramatically. That means a rush of property repossessions and company bankruptcies, a collapse of asset values as those inflated assets are put through a fire sale, and then recovery from a much lower base. You can try and do it at a much slower pace, seeking to avoid a collapse of asset values. You need to administer your interest rates and regulatory requirements for the longer haul, keeping borrowing growth down but allowing sensibly priced maintenance or refinancing of what has already been lent.

The authorities need to make up their minds which they are trying to do, make it clear to the rest of us, and then set interest rates and capital requirements at an appropriate level for their decision.

Urging the banks to lend more is no substitute for getting interest rates and regulatory requirements right for the outcome they desire in the real world. Pretending they are suddenly regulating a deregulated industry will not stand up to scrutiny. This has always been a highly regulated industry. It has also always had a form of price control dictated by government through the authority’s choice of interest rates, the main price a bank imposes on customers. The argument is not about whether it should be regulated or not, but about why the regulation of money markets and banks went so wrong in recent years.

Meanwhile, in global markets we are witnessing sharp falls in some Asian emerging equity markets and worries about how the weaker governments can carry on financing their activities without recourse to IMF loans. Currency movements have become more extreme. A few days ago we made the yen our preferred currency, when it was around 175 to the £1. It is now 153 to £1, providing most of the gain we hoped to make over a longer time period in the space of a couple of trading days. There is a general flight into what investors perceive to be the larger and more stable currencies, led by the dollar. We have remained cautious, recommending large cash holdings during this period of turbulence. We have also recommended avoiding UK assets completely. We continue to be more cautious about the UK, and think the interesting cheaper assets are emerging in Asia where the underlying economic position is still stronger than in the Western societies.