Rules to bank on

When should the central bank prop up, and why? Along with price stability, financial stability - the stability of the banking system - is one of the twin core aims of central bankers everywhere. They have learned, sometimes painfully, that the costs of allowing a run on the banks to develop is far greater than the cost of stepping in and bailing out the bank that has got itself into trouble.

This is a balancing act. Central banks have a general requirement on them to supply liquidity to the banking system and this extends periodically to a need to support a specific bank. Yet they have also to allow the occasional bank to fold, to make everyone realise that there is no inevitable guarantee and take advantage of this. Central banks have then to accept that depositors will feel sore.

One could build a pretty accurate picture by looking at how central banks in general and the Bank of England in particular handled potential bank failures. But up to now there has been no comprehensive statement of policy by the Bank on the issue. Last night, Eddie George, the new Governor, put that right in a lecture at the London School of Economics, where he set out the principles of last resort assistance - as reported on page 31.

This is helpful in two ways. First, it asserts the doctrine of moral hazard. If everyone involved in banking, as customers, employees, managers and shareholders, all know precisely where the Bank stands, there is less opportunity for misunderstandings.

TAKE THE RAP

But Mr George's speech makes the burden of responsibility very clear. Local authority treasurers who place their taxpayers' funds with dodgy banks must know that they have to take responsibility for their actions. Bankers who lend to countries they have never visited or property projects that rely on absurdly enthusiastic assumptions will know they have to take the rap when things go wrong.

But it is also helpful in a practical way in that it ought to improve the quality of decisions by bankers and depositors alike. One of the core functions of banking is pricing risk. Banks do that as part of their day-to-day business when pricing loans: that is why large companies can borrow at 6 or 7 per cent when rates of interest on credit cards are between 20 and 30 per cent. Yet on the deposit side the gap between the good and the less good risk is perhaps too narrow. Really sound banks ought to be able to obtain funds significantly more cheaply than somewhat less sound ones. By reminding everyone of the limits of central bank support, Mr George's speech should have the effect of rewarding the more prudent banks and punishing the less prudent.

If banks that made a mess of their lending found that quite aside from chalking up loan losses, they had also to pay significantly more for deposits, they would be less likely to make duff loans in the future. There is a gap, but it is small.

This is not just an issue for bank customers and shareholders: it is a matter of great importance for the whole Western economic system. Stripped to its essentials, the task of the financial system is to allocate capital in a way that maximises the return. Getting those financial decisions right helps to determine whether countries become richer or poorer. The equity and bond markets make many of the larger decisions, but the multitude of small ones are taken by the banks. They decide whether each small company gets an increase in its overdraft or not, and on what terms. If the duff companies get the loans and the good ones don't, then the economic performance of the whole country suffers.

This is a practical issue for Britain at the moment. It may only be anecdotal evidence, but many smaller companies do seem to find that the battering the banks have taken through the recession has made them extraordinarily loath to increase loan limits, or when they do, to increase their charges and interest rates. One of the results is that although interest rates have fallen sharply for depositors and for large borrowers, they have fallen very much less sharply for small companies.

Further falls in base rates may therefore have little net impact on the economy: any boost to demand from lower loan rates will tend to be offset by a cut in demand from people relying on income from their deposits.

Of course one speech by a central banker is not going to make a radical change in bankers' attitudes, still less in economic performance. What it will help do is to teach the next generation of bankers of both the extent of central bank support and the limits to that support. The experience of the 1980s, in particular the Latin American debt crisis, was quite destructive to sound banking practice. Banks, having made mistakes by lending to the uncreditworthy, were urged to compound these mistakes by lending yet more. Central bankers did the urging.

In the short term you can see why they did so: they had to prevent a systemic collapse of the world banking system. But now is the time to re-establish discipline and it is very helpful to have the rules so clearly established.