Credit Starvation Could Whack Britain

In a new report, the Bank of England warns that a growing number of firms may go broke because they can't get a loan

The prospect of large numbers of British companies failing after finding themselves starved of credit is moving closer, the Bank of England warned yesterday. Its latest Credit Conditions Survey, the best indicator of how banks and other financial institutions are behaving, revealed that there has been a sharp reduction in the availability of credit to companies over the past three months and that the decline is set to continue.

"Lenders reported that they had reduced overall corporate credit availability to mid-September and credit availability was tightened by more than had been expected in the second-quarter survey," the Bank said. "A further reduction in overall credit availability was expected over the next three months."

The Bank's warning is one of the starkest signs yet that the credit crisis is beginning to have a really serious impact on the real economy. The survey shows lenders are reducing the amounts they will lend to individual companies, increasing collateral requirements and imposing stricter loan covenants. Such tightening dramatically increases the risk of companies finding it impossible to renegotiate their debts, and subsequently going under.

Several British companies have already warned publicly that a lack of credit is causing them difficulties. Miss Sixty went to into administration earlier this week after finding it impossible to secure new credit lines.

However, economists believe a further deterioration of corporate credit is now inevitable. "It's only going to get worse from here," said Paul Dales of Capital Economics. "The worst aspect is that this survey excludes the dramatic events of the last few weeks – it was conducted from 26 August to 17 September – so credit conditions will probably tighten by even more than expected. Even if the problems in the financial markets were miraculously solved overnight, which is unlikely, the impact of the credit crisis on the real economy will be with us for some time."

Analysts are concerned that British companies could soon find the supply of credit as restricted as it has become in the US, where even blue-chip multi-national corporations are being forced to pay much more for borrowing than in the past. GE, the US conglomerate that has an AAA credit rating, the highest possible, said this week that the cost of its overnight borrowing – the debt known as commercial paper which helps companies fund day-to-day operations – had almost doubled in recent weeks.

Figures released by the US Federal Reserve yesterday showed that the size of the US commercial paper market has fallen by a quarter over the past year, with a shrinkage of close to 10 per cent in the past three weeks alone.

While lending to companies in the UK, either for short-term or long-term purposes, has not yet become so constrained, analysts are becoming increasingly concerned about the deterioration highlighted by the Bank of England.

Michael Saunders, an economist at Citibank, said: "The survey highlights the vicious circle that is now at work, with banks cutting back on lending to companies... The reduction in the supply of credit exacerbates the downturn – which will reinforce the reluctance of banks to lend in coming quarters."

The decline in lenders' willingness to lend to companies, particularly smaller and medium-sized enterprises and those in sectors considered more risky, such as property, reflects the acute nervousness in the UK's financial system. The interest rates banks charge each other for lending also continued to rise yesterday, with the three-month dollar Libor rate, a key indicator, rising to 4.21 per cent, the highest level since January.

Central banks have found it almost impossible to encourage banks to lend to each other, despite massive liquidity injections. In Europe, the ability of central bankers to cut interest rates has also been hampered by inflation fears.

The European Central Bank disappointed many analysts yesterday by refusing to cut the cost of borrowing in the eurozone, though Jean-Claude Trichet, its president, signalled that he was moving closer to accepting the case for lower rates.