Banks slay the ghosts of '91

It all seems so familiar. The economy faltering after an extended boom. War against Iraq looming – sending oil prices soaring and shares into the dol- drums. And everyone is looking at the high-street banks to see how much pain they are going to have to shoulder.

But when Matt Barrett gets up on Thursday to kick off the big banks' reporting season, the Barclays chief executive will hope to still the gloom merchants. There won't be huge loan losses. There won't be gallons of red ink poured over the high-street lenders. 2003 is not a rerun of 1991.

So what has changed?

First, the economy is a bit different – or, more to the point, interest rates are a lot different. While in the teeth of the early-1990s recession the then Chancellor, Norman Lamont, pushed interest rates up to 15 per cent, last week the independent Bank of England cut rates to 3.75 per cent.

Second, the banks have got more canny about how they lend money. In the 1980s the game was all about not lending to problematic borrowers who wouldn't pay it back. Shipping had been a disaster in the early 1980s, so banks were avoiding anything on the high seas. They all, though, decided to lend to Third World countries in the belief that sovereign borrowers could not default. But they did, and the banks were left nursing billions of pounds of losses.

By the late 1980s the idea was that property companies had to be a safe bet. But when Canary Wharf's parent, Olympia & York, collapsed, and the infamous Imry Merchant keeled over, the likes of Lloyds, Barclays and NatWest were left with massive black holes in their loan books.

So the banks decided to try assessing how risky a borrower was and tailoring the loans accordingly. Instead of shunning some customers, the banks would either lend them less or on a higher interest rate or both. To analyse the risk, they shovelled mountains of data into their computers so that bank managers could have as much information as possible when deciding whether to make a loan.

As Banc of America analyst Jonathan Gollins says: "For the UK banks, it is a very different picture from 12 years ago. They have become much more scientific about risk and are twice as efficient at credit screening. The software they use is so much more objective than a manager sitting across from an applicant and making a judgement on his own. These credit-scoring products are things you can just buy off the shelves."

Third, the banks don't tend to hang on to the loans once they've handed out the money. Syndicated lending is nothing new: banks have parcelled out big loans to other banks for decades. But recently the market has exploded, with insurers, investors, even individuals, buying in. Banks not only sell the pure loans, they sell options to buy them. They purchase insurance on the loans and they create bonds secured on the repayments. Typically, a big bank like Barclays or Royal Bank of Scotland will hold on to less than 10 per cent of a large corporate loan.

This helps the banks in a number of ways. It diversifies their portfolios and so reduces exposure to particular sectors. It frees up capital for other opportunities and businesses – and with the likes of Lloyds TSB and Abbey National having to pump cash into their ailing life assurance operations, this boost is much needed. It also lets them earn money on the "intellectual" side of banking, assessing the risk and selling it on, which makes boring old commercial bankers feel like top City operators (and get paid accordingly).

Of course this isn't foolproof. One or two banks still appear to want to take a fair bit of risk on their balance sheet. In Europe this is more common, with German banks in particular becoming quite exposed to troubled borrowers like the Kirch media empire.

In the UK, many bankers are quite surprised at how much HBOS has lent to the retail sector. Senior banker Peter Cummings has led a £950m loan to Philip Green for the purchase of Arcadia, £840m to the Barclay brothers to buy Littlewoods, and £600m to Woolworths for a sale and leaseback. He is also said to be considering backing Mr Green's £3bn tilt at Safeway, though this could be too much for the board of HBOS.

Then there is the issue of mortgage lending. The Bank of England and the Financial Services Authority have both warned about the growth of consumer debt after £88bn was lent for house purchases in the UK during 2002.

Historically, house lending is one of the most secure parts of a bank's portfolio, but there is a feeling in the industry that this upsurge could hide a dirty secret. "I suspect a lot of small businesses are being funded from mortgages on their founders' homes," says one senior banker. If there is a sharp recession, this could bring spiralling loan losses.

Finally there is the fear of deflation, when economic growth and interest rates fall so much that the value of assets starts to decline. Deflation has blighted Japan, where banks are forced to pay people to borrow money from them.

There hasn't been deflation in the UK in living memory, and there certainly isn't anything in the data in the high- street banks' computers to show them how to deal with it.

Despite this, the banks are fairly confident that they are not heading for a 1991-style stumble. "Quite a number of people are around who do remember what went on before," says David Townsend, deputy group credit director at Barclays. "And we still carry the scars on our backs."

Smart weapons will savage bad debts

In the 12 years since we were last in recession, UK banks have built a big arsenal to defend themselves against any downturn. And in contrast with last time, the new weaponry makes the old stuff look like bows and arrows.

Two new financial products have transformed the way in which banks can spread their risks, making them much more efficient at using their capital. The first of these is the collateralised debt obligation (CDO) and the second is an offshoot of it, credit insurance.

The CDO – a product originally designed by the US investment bank JP Morgan in the late 1990s – is attractive to high-street banks as it draws on their primary strength. Banks are good accumulators of credit and risk because they lend, via mortgages and business loans, to so many people and companies.

A CDO takes all these loans, mixes them in a portfolio, sets it all on one side, and then uses it as the collateral behind a separate debt security. The effect of this for the banks is that the credit risk of one area of their business is thinned by putting it alongside others. If a recession caused widespread defaults in, say, personal loans, the CDO could absorb that through its exposure to other, less risky, debt.

As JP Morgan's director of credit derivatives, Oldrich Masek, explains: "Issuers accumulate collateral and repackage them in limited- purpose vehicles, which in many ways can be thought of as 'mini banks'."

Credit insurance offers the banks yet another way of spreading their risk, by selling it on to insurance companies. The strategy has been repeatedly referred to as "magic" by market commentators.

The banks also believe credit insurance will be much more robust than the mortgage indemnity insurance that characterised the last recession and left years of messy litigation in its wake. The product itself is a contract structured rather like a CDO: the insurance covers a portfolio of different types of credit – mortgages, credit cards, car loans – with the payout risk accordingly spread. Credit insurance has given banks the chance to ship large parts of their risk over to insurers, which are historically much better at absorbing it. However, insurers often make a fuss before paying up, as JP Morgan found when it had a battle over Enron loans.

A third new feature is also expected to protect the banks in the event of recession. What hit particularly hard in 1990 was the huge volume of business insolvencies, and the flood of loan defaults. But changes over the past decade mean that risk is considerably reduced. Where previously companies in trouble would have gone straight into administration, there is now an intermediate second stage where they can bring in insolvency experts to provide restructuring advice while the company is still technically solvent. This adds a new layer of padding for the banks, and is holding back the rise in insolvencies.