There comes a time when all kids have to leave home, and learn how to stand on their own two feet. If you are a parent, you can cosset them and protect them from the harshness of reality, but by doing this are you really doing them a favour?

It is like that with banks, too. Sure, they have been lucky with their guardians. There’s kind old Mervyn and the equally kind Uncle Alistair.

But behind the wide smiles, the two uncles are worried. Banks have got to learn to look after themselves, but how will they cope then?

Yesterday the Bank of England released its latest financial stability report, and there were some real gems in it. Even so, concerns remain that the real problem with risk has been missed altogether.

Mervyn King interrupted playing coo-coo with the banks yesterday, and put on his grave face.

Actually, he did have some good news. As you probably know, one of the big controversies over the way banks quantify their results lies with whether they should use the system known as mark to market accounting. As asset prices valued by the markets fall in price, under the mark for market rules, this means bank assets have lost value, and so their losses mount.

Well, the good news is that since March, banks have seen around £8bn in mark to market losses clawed back.

All of a sudden banks don’t look quite so vulnerable.

The snag of course is that asset prices go up and down. Will the recent good run on the stock markets, and hints of good news in the property market, continue? No one really knows for sure.

And in this vein, the Bank of England produced a fascinating chart comparing stock market performance over the last three years with the performance following the dot com crash, the 1973 oil crisis and the 1929 crash.

Worryingly, it seems that despite the recent rally, the stock market performance so far is similar to that seen during the three-year period after 1929, and worse than the dot com and 1973 crises.

Maybe we make too much of historical comparisons. It is fun to see how performances compare, but it is far from clear whether such comparisons are meaningful. Each crisis has its own unique characteristics.

One of the more interesting aspects of the Bank of England report is the way it illustrates how banks were, in a way, architects of their own destruction.

In science there’s this idea known as the Uncertainty Principle. The idea suggests you can’t measuring anything with total accuracy, as the very act of measuring it changes the thing you are measuring.

It seems that the teaching of this principle should be made compulsory at bankers’ school. Maybe for that matter it should be made compulsory at all schools. We affect the environment around us. Banks and investors, and hedge funds, the most famous example being LTCM, may look at a market place and how it performs and create their model, but fail to factor in how their very own actions influence things.

The Bank of England report showed how the crash in asset prices seen last year, caused because of fears about the future, led to renewed concerns about future losses at banks. So banks responded by cutting back on lending even further, making the recession deeper, which in turn meant the very thing that investors were worried about started to occur.

In other words, investors’ fears, at least in part, caused the very things they feared to occur.

But, there is a bit more to it than that.

Sure, there was an element of self-fulfilling prophecy about it all, but we can not move away from the fact that banks became too leveraged. They just took on too much debt.

And this brings us back to the Bank of England’s big fear. Sure, banks have cut back on risk but they are still far too reliant on the money markets for their lending.

The Bank of England report said: “Given their leverage and funding positions, banks in the United Kingdom and internationally will remain sensitive to further shocks for some time.” The report continued: “While pressures on the major global banks have stabilized over the past few months, their balance sheets remain impaired. Rising household and corporate distress, and continuing falls in property prices, raise the possibility of further asset impairment.” And then most tellingly: “Future revenue generation will need to balance the desire to de-leverage with the need to generate new business at profitable spreads.”

The Bank of England reckons British banks are suffering from a funding gap of around £800bn. Somehow, the banks need to bridge this gap in the future, and they can’t rely on the government indefinitely. Indeed, for that matter, the central bank fears that as government debt rises, the banks may find it harder to raise the money they need.

Conclusion: it seems bank lending could be constrained for years.

But before this article closes, consider this point. Surely the real problem with the credit boom was not so much the scale of lending, and the perceived riskiness; it was that the lending itself wasn’t that productive.

It’s that Heisenberg principle again. Lending to an individual to buy a property that is worth more than the loan may not seem that risky. Lending to an entrepreneur trying to invent the next big thing may seem to be terribly risky. But, if all banks do is lend to property buyers, they are not contributing to an economy’s productivity, and therefore they increase the chances of a wider economic recession, causing the banks to really suffer. On the other hand, if they lend to the more risky entrepreneurial type activities, then the chances increase that each loan may fail. But the net result will be a more productive economy, which surely is a good thing.

Cracking that problem is the real challenge policy makers should be facing up to.

© Investment & Business News 2013