The liquidity ratio of UK insurance companies and pension funds – their holdings of money and short-term paper expressed as a percentage of their total financial assets – is at its highest level since 1975, implying institutions have ample firepower to deploy in markets when confidence returns.

Liquidity stood at £182 billion at the end of the second quarter, £31 billion up on a year before and equivalent to 8.4% of assets, the highest since the bottom of the equity bear market in 1990 – see chart. With the subsequent fall in asset values, the ratio is now likely to be about 9.5%, above the 1990 peak and a level exceeded only in 1974-75, after a plunge in share prices of more than 70%.

The latest Merrill Lynch global fund manager survey confirms high sideline liquidity, with a net 49% of respondents overweight cash – the highest since this question began to be asked in 2001.

A key “monetarist” insight is that the supply of money can diverge from the money demand of households, corporations and financial institutions. “Excess” money will tend to flow into economies and markets, boosting activity and prices. Conversely, growth and asset values are at risk when money supply expansion falls short of demand.

Implementing the concept requires estimates of the growth rates of money supply and demand. The appropriate supply definition is a broad one, including currency, sight and time deposits, savings accounts and money market mutual funds. Money demand cannot be observed directly but under normal circumstances is likely to be related to the level of economic activity, which can be proxied by industrial production (available on a more frequent and timely basis than GDP).

As the chart shows, inflation-adjusted broad money growth in the Group of Seven (G7) major economies has been running well ahead of industrial output expansion in recent months but this has proved a poor guide to monetary conditions affecting economies and markets, for two reasons. First, the collapse of the “shadow” banking system has led to an enforced expansion of banks’ balance sheets, inflating published broad money numbers. (An adjusted measure – including US commercial paper – is shown in the chart but does not capture the full extent of such “reintermediation”.)

Secondly, money demand has probably been growing much faster than industrial production, as the financial crisis has prompted a flight into capital-certain liquid assets. Changes in the precautionary demand for cash are likely to be correlated with measures of investor risk aversion. These appeared to be moderating during the summer but have subsequently risen to new highs.

Given these uncertainties, narrow money M1 – comprising currency and instant-access deposits – is likely to be a better guide to monetary conditions currently than the broad money / output growth gap. Any “excess” money is likely to show up in M1 before being deployed in the economy or markets. As the chart shows, inflation-adjusted G7 M1 fell by 2% in the year to August – the largest annual contraction since 1981.

Empirical analysis indicates that changes in real M1 growth lead the economy by about six months and are roughly coincident with stock market movements. The recent slide therefore validates equity market weakness and signals a grim near-term economic outlook.

Data confirmation should be awaited but real M1 could be near a trough, reflecting three factors. First, US M1 has accelerated sharply in recent weeks. However, this appears to reflect a “safe-haven” shift out of money market mutual funds into demand deposits rather than a genuine improvement.

Secondly, M1 is inversely correlated with deposit interest rates so recent and prospective central bank easing will be supportive.

Thirdly, real trends will benefit from a big fall in headline inflation over coming months as energy and food price effects reverse dramatically.

Can you rescue and punish failing banks at the same time? I doubt it, which is why I am less optimistic about the success of the UK banking rescue plan than its US counterpart.

It may seem just for the rescuer to appropriate future profits due to ordinary shareholders but those earnings are required to attract new private sector capital and offset prospective uncovered losses.

Compare and contrast the details of the UK and US rescue plans:

• Bank recapitalisation: US - redeemable preference shares with 5% yield and attached common stock warrants, no requirement to stop paying ordinary share dividends; UK - 12% yield,  irredeemable for five years, no ordinary share dividends until repaid.

• Bank debt guarantees: US - free for first 30 days, subsequently charged at flat 75 basis points; UK - fee of 50 bp plus median five-year CDS spread in year to 7 October, implying range of 110-170 bp for major banks.

• Transfer of troubled assets from banks' balance sheets: US - remaining TARP funding of $450 billion available to purchase illiquid securities; UK - final Crosby report awaited but similar programme unlikely.

• Security swap facilities (private AAA for government): US - secondary to direct Fed lending, one-month term, fee determined by auction; UK (special liquidity scheme) - primary means of liquidity support, up to three-year term, fee set at opening three-month LIBOR / overnight index swap (OIS) rate.

• Central bank collateral requirements: US - wide range of assets eligible for discount window access, including performing subprime mortgages; UK - minimum requirement of AAA rating for all facilities.

• Direct central bank lending to corporate sector: US - Fed to buy three-month unsecured commercial paper at 200 bp spread over OIS rate; UK - over Mervyn King's dead body.
  

The penal conditions being imposed on British banks place them at a competitive disadvantage to their US counterparts, increasing the risk that they will require prolonged public support or even eventual full nationalisation.

Northern Rock remains on track to repay its borrowing from the Treasury / Bank of England by early next year, in line with the forecast made here. Net of deposits held at the Bank of England, the loan stood at £11.5 billion at end-September, down from £17.5 billion in June and £26.9 billion at end-2007. The £6.0 billion fall last quarter reflected ongoing mortgage redemptions together with retail inflows of £3.0 billion, with savers attracted by Rock's government guarantee and competitive savings rates (recently reduced).

The loan will be reduced by a further £3 billion when the Treasury converts part of the remaining debt into equity, as announced in August.

As argued previously, Northern Rock’s retreat from the mortgage market is exacerbating economic and financial stresses. Economy-wide net mortgage lending totalled £108 billion last year, of which Rock contributed £13 billion. This year net lending may fall to £40 billion, with Rock cutting outstanding loans by £20 billion. In other words, its U-turn accounts for about half of the fall in mortgage lending between 2007 and 2008.

The rapid liquidation of Northern Rock’s mortgage book, possibly to be followed by Bradford & Bingley’s, is clearly inconsistent with the government’s insistence that banks participating in its recapitalisation scheme maintain lending to homeowners and small businesses at 2007 levels.

Similarly, official exhortations to banks to increase their interbank lending sit uncomfortably with Rock’s hoarding of cash at the Bank of England. Deposits stood at £7.1 billion at the end of September, equivalent to 7-8% of assets. Other banks currently hold less than 2% of their assets in reserve balances with the Bank.

The UK's credit guarantee scheme is designed to unclog markets rather than offer banks cheap funding.

The Debt Management Office has announced that the guarantee fee will be 50 basis points per annum plus the median five-year credit default swap spread for the borrowing institution during the 12 months to 7 October. Averaged across banks, this spread is likely to be in the region of 100 bp (see Chart 1.3 in the August Inflation Report), implying a total fee of about 150 bp.

According to Bank of England, the one-year interest rate on unsecured commercial bank borrowing stood at 5.8% late last week, 240 bp above the rate on government borrowing. A fee of 150 bp would therefore allow a significant reduction in banks’ cost of funding compared with recent extreme levels.

Also welcome is that the fee will be not be linked to current CDS prices. As previously argued, the effectiveness of the special liquidity scheme (SLS) has been reduced because it becomes more expensive when LIBOR rates rise – the time banks most need to use it.

However, an all-in cost 150 bp above government borrowing rates still represents expensive funding by historical standards – the differential between one-year rates for unsecured bank and government borrowing averaged 30 bp in the 10 years to mid-2007, before the credit crisis erupted. This suggests the spreads of household and corporate borrowing rates above Bank rate will remain under upward pressure, while banks’ efforts to rebuild capital from retained earnings will be constrained.

The new scheme will be a big earner for the Treasury: 150 bp on an expected £250 billion take-up equates to £3.75 billion per annum. The SLS is likely to generate a further £1.5 billion (based on an assumed average 75 bp fee on take-up of £200 billion), suggesting a total payment from banks to the Treasury / Bank of England of about £5.25 billion pa.

The Treasury statement on recapitalisation plans states that the banks concerned have agreed to maintain lending to homeowners and small businesses at 2007 levels over the next three years. While helpful, this begs the question of why the government is allowing Northern Rock to shrink its mortgage book by £20 billion per annum in 2008 and 2009. Rock borrowers forced to refinance their loans are absorbing a significant portion of other banks’ lending capacity.