Economic recovery? Don't bank on it...

Today it was announced that the unemployment queue lengthened in February by a greater number than in any previous month in history. Meanwhile, the IMF is saying the UK's recession is likely to be the worst of any major economy and the only one to continue into 2010. And I suspect there's more bad news to come.

Interestingly, while the Government remains in denial about the extent of the problem - only yesterday, for instance, Solicitor General Vera Baird claimed that the UK is having a much less severe recession than other G7 nations and that the infamous green shoots of recovery will soon be visible - other voices are beginning to voice the one proposal likely to solve the liquidity crisis undermining our economy: setting up 'good banks'.

In the past week, Sir Richard Branson has floated the idea of establishing his own clearing bank, while a coalition is proposing the formation of a 'post bank', which would use the post office counters network as its branches.

However, both bids concern me. Taking Branson's first, the man's historical modus operandi is a concern: he likes to deploy a minimal amount of his own capital, marrying his brand and PR chutzpah to someone else's cash, taking receiving 'sweat' equity and royalties in return for his contribution, often making a nuisance of himself to the joint venture partner until it resorts to buying him out. Were he prepared to sink much of his net worth into a good bank, it'd be a long way towards sufficient capitalisation to make a difference to the economy. But it's not going to happen. Worse, such is the scale of the challenge that even the bearded one admits that the timescale for achieving his ambition is a couple of years, minimum.

Compare this to the post bank proposal. Though nominally cross-party, the most senior Conservative they've been able to attract is Phillip Blond of Demos. And it's fronted by left-wing Labour MP Jon Cruddas and promoted by the old-school trades union the CWU. Its thoughts on funding are as yet ill-defined: 'the taxpayer' and something to do with bonds. Worse, its constituents talk about their pet project lending to individuals and small businesses that would otherwise not be able to borrow. If the only obstacle to them being able to access finance was the credit crunch, that would be legitimate; but they mutter about saving the vulnerable from the jaws of loan sharks, which speaks to their hidden agenda: lending on non-commercial terms.

In principle though, the Post Office could be a great vehicle for the launch of a new bank: the infrastructure already exists (indeed, it's under-utilised) and the brand is trusted. Given the demographic profile of its core users - the elderly - it would be an attractive deposit-taker. If there's a downside, it's that it might compete with National Savings, worsening the Government's balance sheet.

Considering that we got into this crisis through write-downs by lenders who've overreached themselves while setting out to lend to companies and individuals who stood a decent chance of meeting their repayments, the prospect of a nominally 'good' bank, set up in chastened times, deliberately lending to those who wouldn't normally qualify for such borrowing, sounds like history about to repeat itself.

What we have here are two extremes: an entrepreneur who's a popular hero, but also something of a chancer, floating the idea of forming a good bank in the hopes of attracting capital, somehow, to see it through, contrasted with a coalition of left-leaning dinosaurs hoping that Government and other public sector bodies will gift it cash which it will then lend to hopeless cases.

I'd like to think that organisations that are heavier in weight than Virgin but a lot more commercial than the post bank lobbyists are already working on plans to form good banks. The likes of Tesco, Sainsbury and Marks and Spencer have long offered financial services products. To date, they've been white-labelled offerings, operated by other financial institutions. Who's to say they can't go it alone? They already have branch networks, their brands are trusted, the cost of adding call centres, online banking and a back office needn't be prohibitive, especially if, as would surely be the case for a 21st century greenfield operation, thinking was unencumbered by history and thus the cost base much lower than is the case for legacy banks.

On a day when Lord Turner, for the FSA, floated proposals to avoid a recurrence of the banking crisis, it's apparent that those who currently work in the industry have no monopoly on how things should be done. Indeed, it could be that encouraging new players into the industry will prove to be the best way to bring about lasting reform: given a choice between regulation and competition, as a Conservative, it's my instinct to prefer the latter.

For instance, one idea floated by Turner that clearly demonstrates how little regulators have learned from recent experience is that mortgage lending could, in future, be restricted to three times borrowers' salaries or a maximum percentage of the property's purchase price. Such measures are deeply flawed: a person with heavy debts, liabilities such as maintenance and child support payments and an extravagent lifestyle may be unable to afford a loan of three times income, whereas someone on a higher salary who lives frugally may be able to afford five or six times their annual stipend, especially if they choose a fixed, rather than variable, mortgage rate, and are hence protected against increases in interest payments. Likewise, a loan of say 85 percent of the purchase price at the peak of the market could represent a heavier burden than 100 percent of a distressed buy when the market has cooled.

One solution might be to allow lenders wide discretion in their lending criteria but to have their loan books audited and given Standard and Poor-style risk ratings. A sub-prime lender might rate as a C-, whereas one specialising in low LTV mortgages for public sector workers might merit an A+. If a highly rated lender acquires a less well regarded one, or acquires liability for its loans, its own rating would be affected. And rather than requiring banks to keep more tier one capital, as Turner is suggesting, which could further ration access to borrowing, capital ratios could be determined in proportion to the risk profile of each bank's loan book: the higher the risk, the more cash it must keep in reserve.

The Government continues to increase the debt burden of taxpayers for a generation trying to stimulate the economy, but it will fail until the fundamental problem of the banking system's lack of liquidity, brought about by the uncertain solvency of current lenders, is resolved. We don't have the time to let their balance sheets become more transparent over time and we can't afford to pump in so much cash that it ceases to matter. So creating an environment in which new banks can spring up and flourish, and encouraging this to happen, is surely the one route by which the pain can be foreshortened.