Will banks' pledge to lend £190bn be meaningful?

BBC business editor Robert Peston on loan promises

Is there a genuine middle position between allowing market forces to determine how much is lent to businesses - more-or-less the current position which is widely seen to be depriving small companies of vital finance - and nationalising the process of providing credit?

The government hopes and believes there is such a "third way", to use an arguably tarnished term beloved of a recent prime minister.

The search for this third way has been in progress for the 10 weeks or so of negotiations between the Treasury and the UK's four biggest banks, Barclays, RBS, HSBC and Lloyds.

Ministers want banks to commit to a "responsible" approach to bonuses (in the words of a banker - he was unable to tell me what "responsibility" as applied to bonuses might mean although it doesn't mean "small") and to increase the credit the banks make available to support economic recovery.

If the Tory and Lib Dem members of the government can reconcile their differences about what they want and expect from the banks, an announcement of what George Osborne calls a "settlement" with them - and which also goes by the nickname of Project Merlin - could come in the coming week.

What would it mean in practice for these banks to "promise" to lend £190bn odd to small and big companies in 2011 (which is broadly what I expect)?

Well there's a hard version of such a promise and soft version.

The hard version - which is that the banks would pledge to actually lend that sum - is not going to happen.

The reason is that the banks' independent shareholders would not tolerate the banks lending to businesses that could not afford to repay the money.

Even taxpayers - who own a huge slug of RBS and Lloyds shares - might feel queasy at the thought that the banks were lending merely in order to hit quantitative targets, rather than to generate profits.

To lend only because they've been told by ministers to do so, and irrespective of the risks, would be to throw money away - something the banks did all too brilliantly in the run up to the Great Crash of 2008, even when they weren't being urged by ministers to lend more.

So if the chancellor wanted the £190bn injected into businesses, regardless of any judgement of credit-worthiness, he would have to nationalise all of RBS, Lloyds, Barclays and HSBC - which is not going to happen.

The banks are therefore making a soft promise: they will lend the £190bn only if it makes commercial sense to do so, if there is demand for the money from businesses able to make a convincing case to the banks that they can pay the money back.

Banks will make the £190bn available, but actual lending will be subject to "commercial terms": banks will retain discretion to judge whether applicants for loans are a good or bad bet.

Now, it's not immediately clear how that is different, in a fundamental sense, from what the banks are doing right now.

Maybe this is a test of the behavioural economics favoured by the Tory part of the coalition, of the idea that somehow banks' behaviour will be different if they are told to stand at the front of the class, admit their sins and promise to do differently in the future.

However some critics of the banks will fear that actual lending to businesses, especially to smaller businesses, will continue to shrink, as it has done for the past couple of years - because banks have swung too far from recklessness in their lending decisions to cautiousness.

That fear will be reinforced by the fact that the £190bn of commitments will be a gross figure, not a figure for how much banks' balance sheets should actually expand.

Or to put it another way, if banks were to force repayment of loans from some businesses for whatever reason (good or bad), that contraction of the amount of credit provided to the economy would be ignored in assessing whether they had honoured their lending promises.

That said, ministers know that they can't coerce banks to lend. So they are engaging in a second bit of behavioural economics: they are trying to nudge them to lend more, by getting them to strengthen the link between future bonuses and the provision of credit.

But, again, this will be a soft link between pay and lending, whose impact may be limited - because a hard mechanistic link would be viewed by shareholders and old-school bankers as insane.

As it happens, Stephen Hester, chief executive of RBS, has always had in his contract that the bank has to demonstrate lending availability - which is a million miles from rewarding him for actually lending money. And Antonio Horta-Osorio has a similar provision in his contract as new chief executive of Lloyds.

What ministers hope is that if RBS or Lloyds, for example, were to renew and perhaps strengthen the promise to make a specified volume of credit available and then failed to provide loans of that magnitude, the relevant chief executive would have to explain why the loans had not gone out of the door to the bank's remuneration committee in order to avoid a pay sanction.

But just how likely is it that non-executives on the remuneration committee would contradict a chief executive's claim that credit-worthy borrowers could not be found? If the chief executive said that more lending would have generated more losses for the bank, would the non-executives really wish to punish that chief executive for displaying the great bankers' virtue of prudence?

Look at all this another way.

Paying Hester, Horta-Osoria and their other peers bigger bonuses for actually pumping out credit, as opposed to just making it available, would be a bit rum. Such a pay policy would look a lot like the madness of the bubble years - when too many bankers became multi-millionaires for lending without due regard to the risks, and the rest of us were handed the bill.

You can keep up with the latest from business editor Robert Peston by visiting his blog on the BBC News website.

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