The next credit crisis probably won’t come from the banks. The danger lies in the corporate bond markets

Are investors any less susceptible to panic than depositors? Unlikely.

New Statesman
Where will the next crisis originate? Image: Getty Images.

After three years, two commissions, and intense international negotiation, the government’s draft Banking Reform Bill is finally making its way through parliament. The public has been promised a fundamental restructuring of the banks and a new age of financial stability.

The British financial system has not waited for parliament, however. It has reformed itself already. And its stability is, at least in one respect, more precarious than ever.

The crisis exposed two fundamental flaws in the UK’s banks. The first was a problem of illiquidity. When their creditors and depositors took fright and withdrew their funding, the banks could not call in the loans they had made. There was a liquidity mismatch. The banks were, quite literally, “caught short” – and the Bank of England had to step in to provide them with emergency funding itself when the public started running for the hills.

The second flaw was that some UK banks were not just illiquid, but insolvent. The loans they had made were not going to pay even when they came due, and the banks did not have enough capital to absorb the consequent losses. As a result, the Treasury had to stump up the cash, nationalising one bank (Northern Rock) and spending tens of billions of pounds buying shares in several others.

Public anger after these events focused on the behaviour of bankers. To its credit, the coalition government elected in 2010 realised that the roots of the problem lay deeper than that. To minimise future crises – and above all to avoid their costs being borne by the Exchequer – they decided that the very structure of the banking system needs to change as well. The result of the government’s deliberations is the draft Banking Reform Bill. Its merits – or lack of them – have been the subject of much debate.

The most enthusiastic assessment I have heard is that the bill is fine as far as it goes. John Vickers, the head of the government’s Independent Commission on Banking, says that the new liquidity and capital requirements it imposes are too weak. Others complain that plans to “ring-fence” the utility parts of the banks that will continue to enjoy taxpayer support do not go far enough. The government says that the banks’ international partners would accept nothing more.

However, while the government has been planning its counteroffensive the forces of finance have been on the move. If economic history teaches one lesson, it is that finance never stands still.

According to orthodox theory (and conventional wisdom), the economic function of the banking sector is to make loans to companies for productive purposes. Yet since the crisis of 2008 there has been an astonishing transformation in the way that corporate Britain funds itself.

The banks have been in repair mode, trying to catch up with the new regulatory requirements to reliquify and recapitalise their balance sheets. As a result, their lending to UK companies has gone into reverse. In the four and a half years leading up to the financial crisis, Britain’s banks supplied a net total of nearly £260bn in loans to UK companies. In the four and a half years since, they have called a net £110bn back in.

The shrinkage of the banks has left the field open for a new breed of intermediary. The slack has been taken up by investment funds specialising in corporate bonds. Instead of taking loans, companies have issued bonds in unprecedented quantities – and these have been bought by investment funds.

Rather than wending their way through the banks, the UK’s savings now find their way to its companies through the bond markets. Between January 2012 and July 2013, bank lending to the corporate sector shrank by nearly £26bn. Yet every penny of that and more was refinanced by bond investors, with nearly £31bn of corporate bonds being issued. Forget Funding Circle; this is peer-to-peer lending on an industrial scale.

If that were all there was to it, all would be well: the heartening tale of a Great Escape from a credit crunch to make the City proud – refuting once and for all the naysayers who whine that the only useful financial innovation of the past 25 years is the ATM.

There is, however, a hitch. Corporate bond funds have replaced banks as the providers of credit to companies: and investors in those funds have therefore replaced depositors in those banks.

Do these investment funds suffer any less from a liquidity mismatch than the banks? Not really. Typically, their investors can withdraw their money at a day’s notice, while the markets for the corporate bonds they hold are notoriously illiquid. Are investors any less susceptible to panic than depositors? Unlikely. They are, after all, the same people.

In fact, on closer inspection, the new system of corporate finance looks awfully similar to the old one – but for one crucial difference. Corporate bond funds, unlike banks, do not enjoy access to the Bank of England’s emergency lending facilities. If there is a run on a fund, that fund is on its own. The risk of a credit crisis originating in the banks has much reduced, only for it to re-emerge in the corporate bond markets.

These developments may have passed the government by – but thankfully they have not escaped the people at the Bank of England. In a little-noticed footnote to his second big speech since taking office, the new governor, Mark Carney, indicated that the Bank is actively discussing how it might support the ersatz banking activities of the corporate bond markets in a crisis, in return for more draconian regulation.

If you want to know what our new financial system is going to look like – and whether it will be safe or not – look not to George Osborne and the government, but to Mr Carney and the Bank.