It is broadly accepted that we got ourselves into this mess by allowing the banks to lend too much, too cheaply to people who were not really able to pay back the loans they shouldered.  The way out (whilst avoiding a depression caused by deflation & debt-induced personal bankruptcies) involves making existing loans servicable whilst at the same time not allowing people to add to their current debt burdens.  Hence there is a delicate tightrope to be walked along by lowering interest rates for existing borrowers but simultaneously rationing the availability of credit at the same time so that we do not dig ourselves a deeper debt hole than the one we are already in.

Credit can be rationed in two ways, either by restricting the availability of credit (via very strict lending criteria) or by raising the cost of credit (only extending new loans at high spreads over Libor or Base Rates).  Banks are currently not lending freely for many reasons which include households & corporates being unwilling to borrow, the banks wanting to make profits to rebuild their balance sheets and the knowledge that UK banks are going to have to refinance most of the maturing sterling loans which were previously extended by foreign banks (who have now all but ceased lending in the UK), amounting to roughly £80 bln annually over the next few years.

If we are ever to escape consumers having too much debt then the cost of credit needs to be kept high otherwise very low borrowing rates will simply encourage more borrowing which will prove too expensive to service when base rates eventually normalise towards the 5% level (this prospect is at least two years away).

Consumers paying down debt, however slowly, will keep the Austrian School happy as they believe the economy will never recover properly until the high debt burden is worked off.  The Bank of England may well be trying to encourage the banks to move the money they have on deposit at the BoE and lend it into the real economy but it is in no-one’s interest for this to be achieved by the banks lending at very low margins to borrowers of poor credit quality.

The upshot is that any recovery is going to be slow and protracted and banks are going to be making a lot of money during the long, slow recovery as defaults and loan loss provisions will eventually subside but banking margins will remain high as consumers will continue to be charged high rates for borrowing (personal loans, credit cards & mortgages).

The good news for the Government is that UK banks making big profits imply lots of future corporation tax revenues from the banking sector.  However, if banks make hay for long enough then eventually there will be calls for a windfall tax to be imposed on the banks “excessive profits” but that prospect is many years away (although it is hard to envisage a cash-strapped Government resisting the temptation to levy a windfall profits tax - but surely only after they have sold the UK banking shares they currently hold (LLOY, Northern Rock & RBS) at a good profit for the taxpayer).

There has been much speculation about the prospect of Tesco competing strongly with the existing UK banks as it increases its finance footprint and starts to offer loans to its customers.  Tesco already has stores spread nationwide which could serve as a branch network to the millions of customers who already shop there each week. Last year Tesco also bought out RBS’ 50% stake in their Tesco Personal Finance joint venture which means TSCO now has roughly 6 million accounts and deposits of £4.5 bln.  Today Tesco announced a deal with Fortis whereby the latter will provide motor & household insurance underwriting and claims management with Tesco doing the retail pricing and marketing.

However if we follow the money then the prospect of Tesco crushing the existing UK banks by its entry into the banking market seems less fearsome.  The big question is where is Tesco going to get the money from which it would wish to lend out to its customers?  The Bank of England (which will once again resume its proper role as banking regulator if, as currently seems likely, the Conservatives win the next election) will not allow Tesco to fund its lending via the wholesale markets (this is the business model which got Northern Rock into trouble and the BoE will not allow it to happen again anytime soon), so TSCO is going to have to compete with the rest of the banks for its share of retail deposits.  These retail deposits are highly sought after at the moment as every bank (except HSBC with its loan-to-deposit ratio of 90%) is keenly trying to increase its retail deposits so as to shift their loan-to-deposit ratios down towards 100%.  This is the structural problem in the UK banking sector at the moment – there are not enough customer deposits to go around and so most banks will continue to shrink their loan books.

The implication is Tesco are going to struggle to quickly attract tens of billions of pounds sterling in retail deposits and therefore their capacity to extend loans to customers is going to be limited to how fast they can attract deposits.  As Tesco do not intend to run their banking subsidiary at a loss (and have little experience in assessing credit quality), they are going to grow their banking business relatively slowly.  Calm down dear, its only a supermarket trying its hand at banking.  This is nothing new as the Co-op has been in the banking business since 1872 and announced recently that its customer deposits increased 21% in the first half of 2009.

The other way for Tesco to fast-track its way into banking would be to buy Northern Rock off the UK Government.  However NRK holds deposits of £19.5 bln and has a mortgage book of £66.7 bln.  However although the TSCO-to-buy-NRK deal has been rumoured, Tesco would still face the same problem of how to attract sufficient deposits to pay off the billions which NRK still owes to the BoE.  Also NRK’s loan book is said to be of low quality and questions would arise as to whether Tesco is capable of assessing NRK’s outstanding loan book, as in order to get a deal done, a significant chunk of NRK’s mortgage book would remain with the Government.

The existing UK banks needn’t spend too much time worrying about serious competition from Tesco over the next decade.