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Rates of exchange

Accused of being behind the curve in countering the downside risk caused by the turmoil in the financial markets, the monetary policy committee took the bold decision to cut beyond expectations last week and invite speculation as to the true extent of the problems in the UK economy.

The overriding intention of the move, however, was clear – the economy had to be stimulated and the cost of borrowing had to come down to help with this.

For this to be successful, the rate cut must be passed through by the banks.

This message was made very clear by the Treasury in the immediate aftermath of the announcement and, by Friday evening, most of the major lenders had kowtowed to political pressure.

But, for the banks, while the base rate is clearly important, Libor – the rate at which banks lend to each other – is also crucial. A bank will not lend to customers at a rate higher than it can itself borrow at.

Three-month Libor has been trudging lower since the beginning of October but the gap between the base rate and Libor is still relatively wide – currently around 1.5 per cent. Historically, this has been around 0.25 per cent.

The MPC announcement caused the actual Libor rate to fall but it only did so by around 1 per cent to a level of 4.49 per cent. For the economy to feel the true impact of ongoing rate cuts, Libor still has a long way to fall relative to the base rate.

The reduction in the base rate was clearly designed to reduce the length and depth of any downturn in the economy. The effects of this move would normally be obvious – rate decreases in the loan market generally leading to increased borrowing and increased economic activity. Situation resolved, downturn averted.

However, at this time, is the pressure put on the banks to stimulate the economy through cheaper and more plentiful borrowing really a prudent course of action, given the health of these institutions?

Certainly, since the Government bailout, banks are in a better position to pass on rate cuts but one of the primary criticisms of the banks has been their imprudent lending over the previous cycle. The blame for the credit crunch was laid squarely at the door of lax financial institutions across the globe.

Should we really be surprised that the banks are less confident to commit a full 1.5 per cent point reduction in interest rates? Would any aggressive return to lending not be considered imprudent, the very issue that instigated this global turmoil to begin with?

Commercial viability for a financial institution during a recession would usually require prudent lending – normally at reduced volumes and more stringent criteria.

This requirement is necessary where banks are being required to strengthen balance sheets and rebuild their capital bases. There is a strong suggestion that encouraging banks to lend at this time is to forget the painful lessons of the past 12 months.

The theme of prudent and responsible banking will also not be lost on the financial regulator which is likely require tighter controls and more conservative lending practices. Ironically, while interest rates are taking a dramatic fall, tightened regulation may mean those allowed to reap the benefits and access cheaper credit are a limited few, primarily those consumers who do not require it. In the meantime, the political powers are appeased and the rate cut is comforting for borrowers.

Undeniably, cuts in base rate are essential in the downturn but so is a str-engthening of the position of financial institutions and a correction of lending practices to reflect the new economic reality.

These issues are not all necessarily addressed by this action. One size, it seems, does not fit all.

Colin Purdie is fixed income investment manager at Aegon Asset Manager

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