Day:  Have we paid for the Battle of Waterloo? Cobbold:  I don’t think you can exactly say that. On this occasion, we should have little difficulty in evaluating when we have paid for the recapitalisation. There are, though, questions about the source of the funding and the level of borrowing by the country as a whole from overseas. For several years, the UK banking sector has been relying extensively on external capital flows, principally short-term wholesale funding, to finance its lending activities. Those external inflows have fallen sharply – a mild form of the reversal of capital inflows experienced by a number of emerging market economies in the 1990s. Unless they are replaced by other forms of external finance, the adjustments in the trade deficit and exchange rate will need to be larger and faster than would otherwise have occurred, implying a larger rise in domestic saving and weaker domestic spending in the short run. With the bank recapitalisation plan in place, we now face a long, slow haul to restore lending to the real economy, and hence growth of our economy, to more normal conditions. The past few weeks have been somewhat too exciting. The actions that were taken were not designed  4  BIS Review 128/2008  to save the banks as such, but to protect the rest of the economy from the banks.
Such lending can tide a bank over while it is taking steps to remove the cause of the concerns that generated a run or lack of confidence. But it can also serve to conceal the severity of the underlying problems, and put off the inevitable day of reckoning. I hope it is now understood that the provision of central bank liquidity, while essential to buy time, is not, and never could be, the solution to the banking crisis, nor to the problems of individual banks. Central bank liquidity is sticking plaster, useful and important, but not a substitute for proper treatment. Just as a fever is itself only a symptom of an underlying condition, so the freezing of interbank and money markets was the symptom of deeper structural problems in the banking sector. So let me explain why a major recapitalisation of the banking system was necessary, was the centrepiece of the UK plan (alongside a temporary guarantee of some wholesale funding instruments and provision of central bank liquidity), and was in turn followed by other European countries and the United States. Securitised mortgages – that is collections of mortgages bundled together and sold as securities, including the now infamous US sub-prime mortgages – had been marketed during a period of rising house prices and low interest rates which had masked the riskiness of the underlying loans. By securitising mortgages on such a scale, banks transformed the liquidity of their lending book. They also financed it by short-term wholesale borrowing.