Hamish McRae: Convalescence has begun but it will be a slow road back to normality

Are we through the acute phase of the financial crisis? Probably. Does that mean things will return to normal soon? Almost certainly not.

Those are the twin messages I get from the Bank of England's Financial Instability Report, out this morning. (Actually it is still called the Financial Stability Report – but the modified title would be more appropriate, for it is reporting on the worst period of financial instability in the UK since the fringe bank crisis of the 1970s.)

The first message is encouraging but unsurprising. There is a natural cycle to financial crises – indeed the very word implies a peak or turning point. Financial institutions cannot live with high levels of stress for long: things either resolve themselves or the institutions collapse. The central banks, with the Bank of England now fully on the case, are pumping liquidity into the system almost without limit. If they find they have not done enough they will do more. The commercial banks now know that; they were not too sure a few weeks ago. While this does not mean that money markets are functioning normally, this is a necessary precondition for them to function in a reasonably effective manner. Meanwhile banks are finding other ways of funding themselves so that they are not so reliant on the markets. This costs more and is less flexible, but it has to be done.

So over the next year or so the gap between the money market rates and the official exchange rate will narrow. Before the crisis it ran at about one tenth of a percentage point or less. Now it is three-quarters of a point, with a peak of more than one full percentage point. This has, by the way, been pretty much the same gap for the dollar, sterling and the euro. The Bank of England has taken stick for not being as effective as the Federal Reserve and the European Central Bank, but while that might have been true in the past at some periods, right now there is no significant difference. It does mean that official rates have to be lower than they otherwise would be to achieve any particular level of monetary ease or stringency. We now have a base rate of 5 per cent and money market rates of around 5.8 per cent. That would be equivalent to a base rate of some 5.75 per cent prior to the crisis. In other words, actual interest rates are higher than they look on the label. The hopes last autumn of a steady glide-path back to normality have been sorely dashed, so don't take too seriously their expectations now. It may happen, indeed it ought to happen, but we cannot be sure.

Given this, you can have a debate as to whether the central banks ought to take actual money market rates into account and cut official rates faster – my view would be yes – but obviously no one would want to see rates so low as to give new impetus to inflation. We have quite enough of that about. Meanwhile, though there has been a plunge in bank liquidity, that has happened before. Back in 2000 conditions were tight too. What has been unusual was the steady increase in liquidity between then and last summer. I think the banks have to accept that the conditions of the past five or six years are abnormal and the new normality will be different.

But let's assume that convalescence has begun. It will be a long drawn-out process, which I think is better to see as a return to sound banking practice rather than something radically different. It will have several elements. One will be more regulation. Quite what form that will take will take time to evolve because it has to be done on an international basis, but one interesting idea floated by the Bank is that capital requirements should alter with the economic cycle. In other words, in the early stages of an expansion banks could be allowed to have less capital relative to their loan books, while as the cycle matured they would have to set aside more. This was mentioned a couple of weeks ago by George Osborne, shadow Chancellor, who is clearly on side on this matter too.

The Bank of England is also clearly eager to nudge banks into more responsible lending practices, as well as less lavish pay scales, as he indicated to the Select Committee this week. For me, the most shocking graph in the Bank's report demonstrates how the bad debt rate on credit card lending has soared to 8 per cent. The good customers have to pay for the duds. It was not like that five years ago. Of course there will always be some credit-card users who do a runner, but it seems to me to be immoral, quite aside from being stupid, to make reliable honest customers pay for bad ones on this scale.

As far as mortgages are concerned, the new discipline has begun. This week we have had news that the level of mortgages being granted has fallen to close to half its level of a year ago, and we had bad house price data just yesterday. There is a possibility, and I don't think we should put it higher than that, that the housing market will get really nasty, as it has in the US. There house prices have been falling, over the past three months, at an annual rate of nearly 25 per cent. Were that to happen here and were people to start to lose their jobs, then the more gloomy predictions of a fall in prices of up to 20 per cent over the next two or three years begin to become credible. Lehman Brothers' latest comment on the housing market is headed: "Mounting signs of a downward spiral". Um.

The more encouraging thought is that there is still plenty of money around. So were house prices to fall really sharply there would be people able to take a long view and ready to come in and buy. There seems to be some evidence of such "bottom fishing" at a professional level in banking. It seems that there has been such a savage re-pricing of securities on the banks' books that the market price, insofar as there is one, seems to be lower than the likely value of these securities. So institutions with cash can snap up bargains by taking the securities off the banks at a discount and then holding them to maturity. Cash is king everywhere.

The wider issue here is the extent to which banking troubles lead to economic troubles. Of that, this latest report can give no guide. That is not its job. But what it can suggest, and I think credibly so, is that the path to more stable banking conditions is now clear. That was no evident three months ago.