The unknown circle

If I could ask Mervyn King just one question, it would be this: "Why is commercial bank lending to OFCs grown so rapidly?"

OFCs are non deposit taking financial companies. Since they don't take deposits they are not regulated like regular high street banks. OFCs make up the famous shadow banking system that we hear about but never see. Credit to these companies has soared in recent months, particularly after the fall of Lehmans.

The question arises because supposedly the UK is suffering the worst credit crisis in almost a century. Presumably, a credit crisis means that banks have stopped issuing loans and that their balance sheets are contracting. Not so. UK bank balance sheets are still growing, and so is their lending activity.

It is true that companies and households are finding it increasingly difficult to find credit. The credit crunch is real. In contrast to the real economy, the shadow banking system - the OFCs - has been flooded with credit. Currently, bank lending to other financial institutions is up almost 50 percent year-on-year. Since March last year, this sector has received ₤217 billion in additional lending. Meanwhile, mortgage lending fell by ₤107 billion last year.

Why is this sector eating up some much credit? The reason is not immediately obvious, but there are a few clues. We know that banks are not lending to each other. The interbank market broke down in August 2007 and hasn't yet recovered. So if they aren't lending to each other, they must be lending to themselves.

I am going to take a wild guess and say that this credit growth is to off-balance sheet subsidiaries of commercial banks. Moreover, they are doing it to cover the collapse of funding sources that followed the breakdown of the mortgage backed securities market.

It all points to the terrible circle of problems besetting the banking system. During the boom years, UK banks used off-balance sheet vehicles that now make up the shadow banking sector to avoid regulatory capital requirements. These institutions were initially funded by non bank investors looking for higher yield and who willing bought up all those structured investment products like mortgage backed securities.

Now these investors have disappeared, and as these products mature, iinvestors want their cash back. These shadow banks are highly illiquid and have to make up interest and principle payments by taking out credits from their mother banks, who created them in the first place and who are mostly retail high street institutions.

As the shadow banking sector finance matures and is repaid, it sucks up potential credit sources for the rest of the economy. Moreover, the mother banks can not stop extending this new money because as soon as the credit flow to the shadow banks stops stops, they will go bust.

But it gets worse, the real economy is now starved of credit, economic growth is contracting, and asset values are collapsing, particularly for real estate. In turn, this undermines collateral values, increases default rates and threatens the very existence of the mother banks on the high street.

Is there a way out of this circle? If I was allowed to ask Mervyn two questions, that would be my second one.