Author Mark Fairlie

The amount people borrowed on credit cards rose 9% in the year to June, while other consumer credit borrowing soared by 10.6% Is this something we should be worried about?

On the 9th August 2007, nearly ten years ago to the day, alarm bells started ringing at the Bank of England and at other central banks around the world. As analysts looked at their charts, they noticed something they hadn’t seen for twenty years – banks were very reluctant to lend each other money and a financial crisis was looming.

Why do banks lend money to each other?

Banks have to keep a certain amount of money and other things (called assets) aside to make their books balance.

So, if the Bank of England demands that high street banks like HSBC, Barclays, Lloyds and so on must keep 10% of their cash in hand (the so-called reserve ratio), a bank holding £1bn must keep £100m of that in cash at all times.

When banks have your money, they do a number of different things with it. The most obvious is that they’ll lend it out in the form of loans. Other uses include purchasing investments (like buildings) to try to make a profit on them over time and investing it in the stock market and on currency exchanges.

Their books must always balance. At any given time, some banks have more money than they need and some banks less. In situations like that, the banks with a surplus will lend the money at interest to those with a shortfall.

Why did banks stop lending to each other ten years ago?

For two reasons. The first reason is that the things they invested in were very complicated. Very few people understood what they were (and still do). Whenever a bank puts together an investment, they go to credit rating agencies. These credit rating agencies give the investments a score based on how safe they are.

Lots of these complicated investments came to the market with very good ratings from the agencies and banks invested heavily in them. But, on the 9th August 2007, investment bank BNP Paribas turned to its investors and said they could not take money out of two of their funds because they didn’t know how to value the asset. And if they did not know how to value the asset, they couldn’t put a cash value of what their shares in the asset were.

On top of that, a growing realisation started to spread among many banks that what they had invested in may have little or no value. As a result, banks didn’t want to lend money to each other because they were worried about other banks’ financial health. It wasn’t worries about a “return on investment” that stopped the lending, it was “return on investment” – would they get back anything at all?

Second, when banks stop lending to each other, they all hoard their cash. It’s not just other banks they don’t want to lend to, it’s people and businesses they don’t lend too either. A lot of growth in the economy comes from the creation of loans. For example, if a bank lends a business £100,000, that £100,000 can create new jobs, that then creates new profits, and then those new profits go back into creating, even more, new jobs. None of that growth and none of those new jobs would have happened if the £100,000 was not lent to the business in the first place.

In 2007, banks became very concerned that their worthless assets could become even more worthless because, as they stopped lending money, they knew the economy would slow down as well. When an economy slows, more often than not, things drop in price and become less valuable, thus leading to the financial crisis we saw.

Also, when economies slow down, people spend less money meaning that many extra businesses and the people they employ would also become bankrupt and that their debt may never be paid back in full.

Why are people worried about a financial crisis happening again?

The levels of debt that people, businesses, and governments are in never really went down a great deal. Central banks tried lots of different things (like printing new money) to make it easier for banks to lend out money with the hope that lending out money would create business growth.

That did happen but not at the speed that many central bankers and politicians hoped. Economies around the world have recovered a lot over the last 10 years but people’s wages did not grow at the same rate. For example, once you’ve taken into account inflation, UK employees now earn £15 a week less after tax and deductions than in March 2008.

How is the economy growing if wages aren’t growing?

Living costs have been rising rapidly (witness last week’s 12.5% hike in electricity prices from British Gas) meaning that many more individuals and families in the UK aren’t able to save up in case of emergencies. For example, a quarter of all UK families has less than £95 in savings, according to a report from insurer Aviva.

The amount of money that consumers have borrowed in the UK has topped £200bn for the first time since the eve of the financial crisis, reports the Daily Telegraph.

Much of the money that has helped the UK economy to grow in recent years has been from consumers putting themselves into more debt.

So, what’s next?

No one really knows but many economists and politicians expect the rate of growth to slow down in the next year or two.

At the moment, there are no predictions of a recession.

There’s also a big difference from ten years ago in that some of the really-difficult-to-value investments created by banks no longer exist. Arguably, banks know better than ever what the value of everything they have on their books are. A lot of what happened in 2007 was fear of the unknown – that’s not really the case this time around.

Central banks are also still helping where there are shortfalls in the amount of money available, particularly in the EU.

So, it doesn’t look like there’s going to be as something like the financial crisis that happened ten years ago with the credit crunch but keep an eye out on economic developments in the months and years ahead.