THE news that HBOS is likely to merge with Lloyds TSB is further evidence that the credit crunch will completely transform the UK banking sector. Effectively, this will be a takeover of HBOS by Lloyds TSB. The former bank has seen its share price dive in recent days, raising fears about its future.
Given the recent collapse of Lehman Brothers, creditors are understandably cautious about lending to other vulnerable institutions.
Assuming the merger goes ahead, it could be bad news for the employees of both banks, including those at the HBOS offices in Yorkshire. Significant job losses are inevitable as the new bank seeks productivity gains by purging the organisations of waste and duplication. Undoubtedly, a high proportion of branches will close.
Unfortunately, this comes at a time when unemployment has begun to rise sharply. It will not be easy for former bank employees in Yorkshire to find relatively well paid jobs that reflect their skills and abilities, particularly at a time when other financial institutions are shedding workers.
In the short term, the outlook is grim.
Yet such rationalisations will be necessary to help the banks rebuild their capital and restore profit levels. And the economy as a whole will gain from such consolidation in the long term as the efficiency of the banking sector increases. Such "creative destruction" is often painful for the individuals concerned, but it is essential for continued economic growth and higher living standards.
Another issue is the effect on customers. In 2001, the competition authorities prevented Lloyds TSB from taking over Abbey National. The merged entity would have accounted for a quarter of the retail banking market. HBOS and Lloyds TSB combined are likely to make up a similar share, and will control 28 per cent of mortgages. However, the Government is determined to avoid another Northern Rock style bailout, and under the circumstances competition concerns will be waived.
This is the right decision. The UK has a large number of banks, including several former building societies, that offer a wide range of services to customers. The sector is also open to competition from overseas banks, as demonstrated when Spanish group Banco Santander entered the market through the acquisition of Abbey National. Accordingly, there is little prospect that the merged bank will significantly affect the choices available to consumers. And, of course, the alternative option would be far worse.
In the event that HBOS faced collapse, it would almost certainly be bailed out by the Government, following the precedent set by Northern Rock. The effects would be disastrous.
Millions of small shareholders, many of them workers, or savers who were allocated shares when the Halifax converted from a building society into a bank, would get next to nothing. Their confidence in the Stock Market would be shattered. Investment in other banks, even by large financial institutions such as pension funds, would probably be negatively affected. Starved of capital, it would take the banking sector longer to recover.
Taxpayers would be faced with liabilities that dwarfed those of the much smaller Northern Rock, perhaps running into hundreds of billions of pounds. The budget deficit, which already breaches the so-called "golden rule", would be sent even further into the red.
At a time when the economy may be entering recession, this would severely limit the Treasury's room for manoeuvre. In the absence of politically difficult cuts in public spending, it would put upward pressure on both taxes and interest rates.
There are also longer term implications from governments bailing out banks. Such actions may encourage riskier behaviour among bankers by reducing the downsides associated with failure.
At the same time, bank customers, reassured by both bailouts and deposit protection schemes, have reduced incentives to deposit their savings with conservative, risk averse institutions.
Given that the Government has effectively guaranteed their money will be safe, they will tend to patronise whichever bank pays the highest interest rates, even if it engages in the kind of risky lending practices that brought down Northern Rock.
Another danger is that expensive bailouts will provoke calls to increase the level of financial regulation. These should be resisted.
The banking sector is already very heavily regulated. In the United States, strict rules that forced banks to lend to risky borrowers in the sub-prime market helped cause the current problems. And regulations also incentivised bankers to create the complex financial instruments that are now proving so difficult to unravel.
Perhaps most importantly, more red tape will raise costs and reduce the flexibility of banks to deal with the current crisis. In the longer term, it will also stifle competition by making it more difficult for new entrants to begin trading in the banking sector.
The UK is fortunate to possess well developed financial markets. Providing the Government can avoid the temptation to over-regulate, these markets will continue to provide the best solutions for the current banking crisis, whether through rights issues, acquisitions, or mergers such as HBOS and Lloyds TSB. Expensive government bailouts should be avoided at all costs.
Dr Richard Wellings is Deputy Editorial Director at the Institute of Economic Affairs