English banks slow to provide business credit, warns King

The reluctance of English banks to resume lending is hampering the UK's recovery from recession, the Bank of England warned today.

The painful process of repairing the finances of the sector increased the chances of a "relatively slow and protracted" recovery, bank governor Mervyn King said.

"It is likely that the supply of credit will continue to be restricted for some while, with banks being risk averse and aiming to raise capital ratios," he said.

The warning came as the bank predicted a deeper recession than in its last report in February, due to the worse than expected 1.9% fall in output during the first quarter of 2009.

It now forecasts that the annual decline in UK output could hit 4.5% at the peak of the recession this summer.

The governor said the pound's weakness, the impact of record low interest rates, UK government spending, and firms working through stockpiles offered hopes of recovery.

However, he added that the timing and strength of a subsequent revival was "highly uncertain", particularly as bank lending would take longer to return to normal than assumed in February.

Mr King warned: "The economy will eventually heal, but the process may be slow."

He said banks - some of which have been propped up with billions from the taxpayer - were displaying an "extreme level of risk aversion" when lending to businesses and households.

They were likely to remain cautious in the short-term if they were "going to continue as a private sector entity", he added.

It was a "judgment for government" as to whether it would decide to pump extra funding into the banks to unstick lending, Mr King said.

Economists said the latest figures and cautious comments from Mr King signalled that interest rates could remain at the record low of 0.5% until at least next year.

Inflation - currently at 2.9% - is set to fall below the 2% target and "more likely than not" to remain below it in the medium term, the Bank added.

Jonathan Loynes, of Capital Economics, said the report injected a "sensible element of caution" after recent talk about green shoots of recovery.

He added: "Although the bank still predicts a reasonably solid recovery in GDP growth next year, it has pulled its forecasts down a bit from February and warned that a sustained recovery could take some time to arrive.

"This appears at least partly to reflect a gloomier view on the outlook for bank lending."

Howard Archer, economist at IHS Global Insight, said he expected interest rates to remain at 0.5% well into 2010.

He added: "We certainly suspect that, while latest data and survey evidence have been markedly improved and even hint that the economy could be close to stabilising, significant relapses remain highly likely and we could well be in for a very bumpy period for some considerable time to come."

The bank surprised markets last week by increasing the size of its quantitative easing scheme by £50bn (€55.6bn), but said it would take time to assess the extent to which its purchases of British government and corporate bonds with newly created money had helped the country's economy.

According to Mr Archer, the Bank's forecast suggested the economy would shrink by around 4% over the whole of 2009 - worse than the 3.5% decline forecast by Chancellor Alistair Darling in last month's budget.

Although the bank has forecast a relatively swift pull out of recession at the end of this year, the projections are weaker than February's report and laced with caution in the uncertain climate.

The governor said there was great uncertainty about the outlook and judging the balance of the various factors in play on the UK economy was "extraordinarily difficult".

He added: "Some of the surveys afford promising signs that the pace in decline in activity has moderated.

"But they do not tell us how strong and persistent any such recovery will prove to be, precisely because of the uncertainty surrounding the way in which balance sheets will evolve."

Corin Taylor, senior policy adviser at the Institute of Directors, said the Bank's forecasts were "more realistic" and showed that "talk of 'green shoots' is premature".

"Times will continue to be tough for businesses for quite a while yet," he said.

"The government's forecast of a rapid and sustained recovery by 2011 looks wildly optimistic."

The inflation report warned measures to help struggling banks - such as placing hundreds of billions in toxic assets into a taxpayer-backed insurance scheme - "may not increase lending sufficiently".

"For instance, banks might respond to recent strains by choosing to hold more capital against their loans than before, which would inhibit their lending," it said.

"An even slower recovery of credit growth would delay the recovery of nominal demand further," the report added.

Today's forecasts also suggested that the Bank could increase the scale of the QE programme again to hit the inflation target. Mr Darling has approved up to £150bn (€166.8bn) of spending under the scheme.

Mr King said the decision to boost the QE programme last week was "not because we were disappointed by the evidence of its effect", but because of figures earlier this year showing both demand and growth in the economy were worse than previously expected.

"No one can know much about the effects of this so far," he said.

"It is far too early to judge."