The government attempts to revive lending within the UK economy are starting to seem futile. They have already put a number of measures in place to kick start bank lending, such as the £50 billion bail out deal and supported the Bank Of England historic interest rate cut to 1.5% today. These efforts are doing little to tempt financial institutions to reduce their own interest rates and pass them onto the consumer, and on the whole banks have made it much harder for businesses and consumers to borrow. But why are banks in this position?

One detrimental consequence of the credit crunch is that banks have generally stopped trusting each other causing the interbank lending rate (i.e. the rate of interest banks are willing to lend each other) to be way above the UK base rate.

Another reason why banks are reluctant to pass on the rate cuts is due to the state of their own balance sheets. Essentially financial institutions are required to have a certain amount of capital (or deposits) in order to be able to lend money out to customers. This is called a capital adequacy ratio; this is a calculation of the amount of deposits required against the amount of money that is being lent out. According to BASIL II the minimum deposit to lending ratio should be 8%. The credit crunch has literally torn through many institutions balance sheets making it extremely important for institutions to widen the margin between the interest rate they give depositors and borrowers in order to recover their losses. Under these circumstances it makes lending at the base rate for many institutions very unattractive.

Finally, banks are being extremely cautious in the way they lend money, as they do not want to repeat previous mistakes. Due to the state of the economy and housing market many institutions are wary about lending to businesses and consumers, as there is growing uncertainty over their ability to repay the money. This is particularly true in the housing market where there is a real threat of negative equity for many homeowners so if they were to default their home would not cover the outstanding debt.