The words “credit crunch” contain the seeds of an explanation. In Latin, credit means trust. So credit crunch is, in essence, a breakdown in trust. Between different parties at different times, that loss of trust has been the root cause of the devastating impact felt globally since the credit crunch began. It also explains why the road to recovery in credit, and thus in the real economy, may be long and winding. In essence, events of the past two years can be re-told as a story of the progressive breakdown in trust.
....What explained this wholesale loss of trust? In the run-up to the crisis, banks’ business models were increasingly predicated on making loans for onward sale. Loans became tradable securities and long-term relationships gave way to short-term transactions. The perils of this practice were well understood by Michael Marks, founder of Marks and Spencer and of course one of the region’s greatest-ever entrepreneurs: “You either make things or you sell them. Don’t try both”.
Banks tried both, making loans with an eye to subsequently selling them. This had unintended, but in fact entirely predictable, consequences. Without skin in the game, banks’ due diligence became slipshod. The quality of tradable loans fell as their quantity rose.
Investors in these securities were not as canny as the landlady of the Esk Inn: they purchased them in size even though “they knew nought about them”. By the time the penny had dropped for these investors, the pounds had not taken care of themselves. Global losses on these securitised assets are now believed to lie anywhere up to £3 trillion.6 As losses accumulated, trust in these securities was undermined and with it trust in the banks issuing them.
..........Rising confidence among firms and consumers is a necessary condition for recovery. But it is questionable whether it is sufficient. That is because confidence and trust are subtly different concepts.9 Confidence derives from observable, authoritative proof. At the time of the failure of Lehman Brothers, people struggled to make sense of the state of the economy and financial system. Without a compass, they lost their financial bearings. Lacking authoritative proof, confidence collapsed. As the banking system has since stabilised, people’s bearings have returned and with them confidence.
Trust is an altogether different animal. It is based on beliefs, not observable proofs. It is grounded in perceptions rather than evidence. It is as much a psychological state as a financial one.10 A clean balance sheet might instil confidence, but it need not repair trust. Because it is a moral judgement, repairing trust can be a slow and painstaking business. Moral compasses take rather longer to self-correct than magnetic ones. This has implications for the path of recovery in the period ahead.
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