Friday 29th June 2012 | 15:56

Liquidity announcements should improve prospect for lending to small businesses and sole traders

Commenting on the recommendations relating to liquidity contained within today's Financial Stability Report, and the FSA's reaction to these recommendations, the Chairman of the Treasury Select Committee, Andrew Tyrie MP, said:

"In October last year I wrote to the Governor of the Bank of England, Sir Mervyn King, and the Chief Executive of the FSA, Hector Sants, asking them to examine carefully how they could act in order to relieve the liquidity squeeze on banks that was being caused by some of the post-crisis regulatory action and the market responses to it.

"It has taken a while but this has now happened.

"Today's announcements should improve the prospect for lending to small businesses and sole traders who can't find loans at reasonable rates."

The British economy cannot fully recover until banks recover. The banking sector is crucial - and it is still dysfunctional. The evidence is everywhere, most visibly for small firms and small traders, who have great difficulty borrowing at reasonable rates.

There are many reasons for this. One is the actions of regulators, some of which are avoidable: in the UK, that means the Financial Services Authority and the Bank of England.

For more than a year I have been arguing that the higher liquidity requirements imposed on banks are inhibiting lending and that something needs to be done about it. It still does.

Bank credit has been contracting. Since the end of August 2008, just before Lehman Brothers' failure caused financial panic, private non-financial companies have repaid more than £80 billion net to the banks - 16 per cent of their outstanding sterling debt.

Meanwhile, the regulators, co-ordinated internationally by the Basel Committee on Banking Supervision, have been demanding that banks build up their liquid asset holdings to make them less vulnerable to a future crisis. Under their influence, since the onset of the crisis, leading UK banks' holdings of highly liquid assets have almost tripled.

That regulators think banks should hold more liquidity is understandable. A lack of liquidity made them fragile in 2007 and 2008. The Government and the Bank of England were obliged to provide them with massive emergency loans in the winter of 2008-09 to prevent an economic collapse. Taxpayers' money was on the line.

Nearly all of those loans have been repaid. The remainder soon will be. Several banks were also part-nationalised, at huge cost. We may never see some of that money again.

It was right to require that banks hold more capital and liquidity. But Britain now has the euro-area financial crisis to contend with, further hampering economic recovery.

The regulators' continued insistence that the banks make rebuilding liquidity their top priority has created additional risks for that recovery, on which the nation's future prosperity, the Government's fiscal plans and the banks' own fortunes all depend.

The recently accumulated extra liquidity and hence, resilience, is extremely valuable insurance against eurozone shocks. But there would be no point demanding ever-more liquid banks if recovery were the price. The eurozone crisis requires us to take stock of the speed at which we continue to demand that banks hold extra liquidity.

Regulators might reply that measures to strengthen liquidity don't need to be implemented for a few years yet. That's true in principle, but, in practice, the markets are pre-empting these requirements - the penalty on banks for not acting sooner is a higher cost of funding.

There is now a difficult regulatory, fiscal and monetary balance to be struck. Exactly how to strike that balance, and moderate the pressure on banks over their liquidity requirements, is a matter for the regulators, not me. The regulators could consider widening the range of eligible collateral beyond government securities to include high-quality commercial assets. Perhaps some other scheme could be devised to provide liquidity, without market stigma, against a broad range of eligible collateral. At the very least, we have to find ways to enable liquidity buffers to go in as well as out and avoid starving the economy of credit. The FSA, the Bank of England and the Treasury all need to play a role.

The Bank needs to do more to demonstrate that is providing liquidity insurance - even if this means accepting some risk on its balance sheet. The regulators need to reconsider how much liquidity the banks should be required to hold.

The Bank, together with the FSA, could demand so much strengthening of bank balance sheets that the risk of the Bank of England ever having to exercise its function as lender of last resort would be reduced to negligible proportions. But, particularly at the moment, there would be even less bank lending if they did this.

All this illustrates a wider point. Stimulating recovery without imperilling price stability in this crisis requires very close co-ordination of monetary, fiscal and regulatory policy, a reversal of the conventional wisdom that separation entrenches market confidence. Ultimately, the Chancellor may have to give a lead.

Unless action is taken, the road to recovery will just get steeper. And pressure from politicians to do something about it will grow. I hope that, behind the scenes, this point is already being made. There is no more important subject than this for the next bilateral meeting between the Governor and the Chancellor.

* Andrew Tyrie MP is chairman of the Treasury Select Committee and has been MP for Chichester since 1997. He writes in a personal capacity.