Jeremy Warner: Now we own the banks, what should we do with them?

Outlook: It's been on a slow burn, but that doesn't make the moment any less historic. On Monday, Her Majesty's Treasury becomes the proud owner of 58 per cent of Royal Bank of Scotland, ostensibly putting the Government in charge of £1.9 trillion of assets and liabilities, equal to one and a half times Britain's entire annual output. Add in the 43.5 per cent of the combined Lloyds TSB/HBOS that the Government is likely to end up with once the recapitalisation of the two banks has gone through, and the Treasury might be deemed to control assets valued at well over double GDP.

In the end, RBS shareholders subscribed for a miserably small 0.2 per cent of the new equity, which they can hardly be blamed for given that it is cheaper to buy the shares in the market than to subscribe to the rights, but does rather leave you wondering what the row about pre-emption rights at Barclays was all about.

With RBS, pre-emption rights were honoured but shareholders nonetheless chose not to take advantage of them. Barclays was lambasted for bypassing shareholders and instead raising the required new capital in the Middle East, but even if offered the new equity, would shareholders have been any keener than they have been with RBS to subscribe?

That's by the by now. The big question is how the Government will choose to use its newly acquired muscle power. Labour traditionalists have long dreamed of acquiring control of the commanding heights of the economy by nationalising the banks, and as recently as 1983, it was even a part of Labour's election manifesto. Michael Foot, the Labour leader at the time, would be forgiven a wry smile. Twenty five years later, the worst financial crisis since the First World War has finally driven the banks into the Government's arms.

Not that Mr Foot's successors regard this as a remotely desirable out-come. The present Labour hierarchy are only reluctant owners of the banks, or so they say, and want to divest themselves of the holdings as soon as they decently can. With this end in mind, a new organisation, UK Financial Investments, has been set up under the Treasury mandarin John Kingman to hold and manage the shareholdings, supposedly at arms length from the Government and free from ministerial interference.

The remit is to manage the stakes for value while ensuring that the commitments on pay and small business lending entered into as part of the recapitalisation are met. Despite the regulatory and market-driven pressures to deleverage, RBS and Lloyds TSB are confident they can manage for value without starving the country of credit. Having invested so much taxpayers' money in the banks, ministers find themselves in an extremely awkward position politically, which is partly why they are vesting the stakes in UKFI.

Already they are being blamed by backbench MPs for rising levels of home repossessions and the now all-too-apparent squeeze on small business lending. What's the point in part nationalisation of the banks, it is asked, if you cannot control credit allocation?

And there's the rub, for part of the problem of recapitalisation is that it provides banks with the capital cushion they need to start recognising bad debts and flogging them off. Managing for value may be incompatible with the credit expansion the Government wants to see to get the economy going again. As I say, both banks are confident they can do both.

Lloyds TSB and HBOS are almost exclusively UK banks, and it is therefore very much against their interests to damage the UK economy by going over the top with the deleveraging process. Nobody wants to see the banks return to the heady days of freely available 125 per cent mortgages, but nor is it in anyone's interests that the banks squeeze lending to a degree that it creates a vicious cycle of debt deflation.

Banks are ultimately in the business of taking deposits and lending them out, or maturity transformation to use the jargon. In the boom, they got carried away, geared up and lent recklessly. In the hunt for commissions and higher margins, they also pursued financial innovation. Now they are being forced to return to the plain vanilla banking of old, but once the debt overhang has been worked out of the system, there is no reason why this should be incompatible with a growing economy. The situation with Royal Bank of Scotland is a little bit different. During the boom, RBS became a massively over-leveraged bank whose balance sheet size outgrew even that of the mighty Citigroup. Capital efficiency was RBS's whole raison d'être. Running the show on the bare minimum of capital ensured one of the highest rates of return in the business and was worn as a badge of honour.

Yet most of this business was in capital markets and overseas. Little more than 10 per cent of RBS's balance sheet relates to UK lending. Stephen Hester, the new RBS chief executive, therefore has quite enough scope for "derisking" the balance sheet elsewhere without damaging lending to the UK economy. Indeed, he has already indicated that the focus of the deleveraging process will be in the capital markets business.

A further reason for the Government to keep its distance is that the last thing ministers want is for these massive banking liabilities to be counted as part of the national debt. The public finances already look bust enough, but they would take on the characteristics of a banana republic if the banks were brought directly on to the books. As long as the Government is deemed not to be actually managing the banks, there is a reas-onable chance the Office for National Statistics will take a relaxed view.

On the face of it, then, government control ought not to mean direct government intervention. There is no appetite among ministers to manage credit allocation, despite all the table thumping over small business lending. Yet this may not remain the case. What happens if the UK economy spirals out of control? Already it is embarrassing enough for ministers having government-controlled banks severely downsizing their workforces and adding to the ranks of the unemployed. Once they start to call in the administrators in the Labour heartlands, the "arms-length" value management of the UKFI will be sorely tested.

The disasters of the past year and a half have demonstrated that as the good times roll, supposedly trustworthy and conservatively run banks are transformed into inveterate gamblers and become completely reckless with our money. Yet nationalised banks hardly make for efficient and well-judged allocation of capital either. With the politicians fully in the driving seat, pork barrel projects and hair-brained lending become the order of the day.

Banks need to be much better regulated, but economic salvation is unlikely to come from directing them to lend to whatever fancy takes the minister's mind. All the same, for better or worse, we seem to be back in a new age of state interventionism. From banks to housebuilders, and from car companies to retailers and their suppliers, everyone seems to want government assistance. Market failure requires government therapy. Yet it's not going to help matters much if the Government starts to believe it can replace the market. Rather, the proper purpose of government intervention is to get the market going again.