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Patrick Nolan: Project Merlin – Have we forgotten what got us into this mess?

Patrick Nolan, Chief Economist, Reform.

Patrick-nolanThe government has announced an agreement (Project Merlin) with the largest UK banks on lending, bonuses and transparency. This agreement includes bank lending of around £190 billion to businesses. Of this £76 billion will go to small firms. The performance targets used to determine the bonuses of bank chief executives will include whether they are providing these loans to businesses. The Federation of Small Businesses has expressed concern that, in spite of this, the cost of borrowing will remain too high.

Yet, as Gillian Tett wrote in 2009, there is no such thing as a free financial lunch. It is not possible to have less tightly rationed mortgages or bank lending and simultaneously a less risky banking sector. As she wrote:

"The only way to make the system more stable is to slap on a new level of regulation, curb innovation and to force the banks to hold dramatically larger capital cushions than before. The net effect of that will inevitably be to make capital more expensive. Tighter controls, in other words, means that mortgages and business loans will be more rationed – either through price, or supply, or both."

Recent history should make us cautious when politicians argue that controls over bank lending should be relaxed. As Nicholas Boys Smith showed in 2009 government policy under Jimmy Carter, Bill Clinton and George W Bush played a central role in creating the subprime mortgage market:

"Minority home ownership increased by 3.1 million between 2002 and 2007. And subprime loans funded this. For instance, 55 percent of black and Latino home purchasers in Boston in 2005 were classed as subprime. And more than three quarters of black and Latino borrowers from Washington Mutual were given subprime mortgages. Subprime was a phenomenon that the US government desperately wanted to exist. Neither it, nor the phenomenon of securitisation would have existed in anything like the scale they did had the not the state so actively supported them."

This collapse in this subprime mortgage market was a major trigger of the global financial crisis and is one reason we are in the mess we are in. While there may be a case for improving UK bank’s lending processes, politically driven targets for bank lending should be resisted. Project Merlin risks repeating past mistakes.


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