Banks need to boost their profitability in order to generate additional capital to support higher lending. Yet a measure of the gap between their average lending and deposit rates is close to its lowest level for at least 10 years.

Recent government-sponsored capital injections were calibrated to provide banks with a buffer against coming loan losses rather than support an expansion of lending. With market capital available, if at all, only on penal terms, banks are reliant on retained earnings to build the additional cushion necessary to support lending growth.

Net interest income is the largest element of banks’ earnings. The chart below shows estimates of average interest rates on banks’ and building societies’ sterling lending to the private sector and their M4 deposit liabilities. The estimates are derived from Bank of England data on effective interest rates on different types of loan and the composition of balance sheets.

The gap between the average lending and deposit rates – the net interest margin – recently reached its lowest level in the history of the data since 1999.

This may understate current pressure on banks’ profitability for three reasons. First, a compression of the margin from 2003 was offset by rapid balance sheet expansion, which is now ending.

Secondly, sterling lending exceeds M4 deposits by £476 billion, with the resulting “funding gap” bridged mainly by wholesale market borrowing. The cost of such borrowing has risen significantly since the credit crisis erupted.

Thirdly, fee income has fallen in reflection of weakness in financial markets.

Cuts in Bank rate may not boost the net interest margin much, if at all. Suppose the average loan rate is linked to Bank rate while the deposit rate varies with interbank rates – this is a simplifying assumption but may contain an element of truth, given government pressure to “pass on” Bank rate cuts and competition for savings. Bank rate cuts that were not fully reflected in interbank rates would then reduce the margin.

The three-month overnight indexed swap (OIS) rate – which measures market expectations of Bank rate – is currently 280 bp below its average in September (the last date in the chart), while three-month LIBOR is only 170 bp lower (based on yesterday’s fixing). Actual and prospective cuts in Bank rate have therefore yet to be fully reflected in interbank rates.

The government is further contributing to earnings woes via the charges levied for its various support measures. The fees on the special liquidity and credit guarantee schemes are significantly higher than for their US equivalents, as is the coupon on government-purchased preference shares. Banks are also partially liable for the cost of recent payouts to depositors under the Financial Services Compensation Scheme.

The November Inflation Report published today is very dovish and will boost expectations of a fall in Bank rate to below 2% by early 2009. In his press conference comments, Mr. King also appeared to welcome substantial fiscal loosening while playing down concerns about the plunge in the exchange rate. However, the commitment to maximum policy stimulus sits oddly with the Report’s forecast of a relatively shallow and short recession. Markets may begin to worry about a loss of financial discipline.

Key points:

• The mean CPI inflation forecast in two years’ time based on an unchanged 3% Bank rate is just 0.9%, by far the largest deviation from target in the MPC’s history – see chart. This compares with an above-target forecast of 2.2% in August.

• The associated fan chart implies a 20% plus chance of CPI inflation being below zero in two years’ time.

• While it is difficult to infer precise figures from the chart, the growth forecast based on unchanged rates is consistent with GDP declining by about 0.5% per quarter between Q4 2008 and Q2 2009, stabilising in Q3 and then recovering by 0.5% per quarter over the following year. This would imply a peak-to-trough decline in GDP of about 2%, with annual average changes of -1.3% in 2009 and +1.7% in 2010.

• As discussed in a previous note, an average path derived from the last three recessions would entail a peak-to-trough fall in GDP of 2.3% with a recovery delayed until Q2 2010. This path would imply an annual fall of 1.7% in 2009 with growth of just 0.4% in 2010.

• Mr. King also stated that an updated growth projection would be less gloomy because of prospective fiscal loosening and recent sterling weakness.

• The large and sustained inflation undershoot is questionable against the background of a moderate recession and a substantial fall in the exchange rate. Either the MPC’s GDP forecasts are insufficiently downbeat or inflation is likely to revive sooner than the Report projects.

The October Royal Institution of Chartered Surveyors (RICS) housing market survey suggests a recovery in turnover from current rock-bottom levels together with a slowdown in the rate of decline of prices. Smaller price falls would be consistent with the equivalent stage of past housing downturns – see previous post.

The survey confirms a recent slump in activity and prices. However, the new buyer enquiries index tends to lead turnover and price momentum and rose for the sixth consecutive month in October, though remains in negative territory – see charts below.

The earlier fall in the index was exacerbated by uncertainty about changes in stamp duty. The recent revival probably also reflects lower prices and expectations of interest rate cuts (the survey was conducted before last week’s MPC move).

The slowdown in negative momentum should not be mistaken for the approach of the end of the downturn. While turnover may be bottoming, the next stage of the price decline is likely to be driven by rising supply as unemployment climbs. As the earlier post showed, experience in the mid 1970s and early 1990s suggests a sustainable recovery in prices will be delayed until 2011 or beyond.

Three-month sterling LIBOR fixed today at 4.42%, down from 5.56% before the Bank rate cut and 6.28% as recently as 10 October.

LIBOR can be decomposed into the expected level of Bank rate – measured by the overnight indexed swap (OIS) rate – and the credit risk / liquidity premium banks need to pay to attract term funding.

Of the 186 bp decline in three-month LIBOR since 10 October, 163 bp reflects lower expectations of Bank rate with just 23 bp due to a narrowing of the bank premium, measured by the LIBOR / OIS spread – see chart. The spread is 190 bp today, down from a recent peak of over 230 bp but well above the 75-85 bp level prevailing before Lehman’s failure in September.

With banks’ lending rates mostly linked to either LIBOR or Bank rate, recent falls will bring significant relief to existing borrowers.

However, the high LIBOR / OIS spread suggests banks still face major difficulty raising funds to finance new lending. To the extent that banks are financing loans linked to Bank rate with borrowing linked to LIBOR, it also frustrates their efforts to widen net interest margins – necessary to rebuild capital in order to support additional lending.

The large fall in LIBOR is welcome but the LIBOR / OIS spread also needs to decline significantly to justify hopes that financial and economic risks are diminishing.