Covered Bonds

QUESTION ONE: The government puts a lot of money into banks who over-lend funds. So why are the banks still lending out money for mortgages?

The term “over-lending” is not an official term used in finance. Therefore it can be seen in many different ways based on the behavior of banks in the recent global financial crisis. It can be said that banks do outstretch their lending activity, especially in a boom cycle. They reduce their credit quality when there is easy access to liquidity. However when they begin trying to sell pooled mortgages and other bad assets, the government is forced to buy them when they are not sellable, injecting an abundance of cash into the banks. There is an argument that governments are spending too much on bailouts while banks are still “over-lending”. However, this is not the case in the UK.

Governments resort to bailouts in fear of banks defaulting – because if this happens, contagion and other major problems will occur in the economy. There are therefore incentives for governments to bailout banks when they are in trouble. It can be said that it is a part of a government’s duty to ensure monetary stability in their economy, and in order to do so, they must keep banks running efficiently. During the global financial crisis, over-lending could not have been possible because there was absolutely no liquidity and no market for one. It was virtually impossible to borrow or lend. In conjunction, capital adequacy is claimed to be essential in finance theory. However it is useless when a bank’s assets cannot be sold. This was seen in the global financial crisis, and because of this, the governments had no choice but to take on the banks’ debt. They resorted to bailouts in order to rescue the banks.

There is evidence that shows that despite a major increase in UK bank lending in 1997 to 2007 from £32bn to £117bn (Pettinger, 2008), the banks were forced to drastically cut back on lending activity due to the credit crunch following the...