The Bank of England’s latest Financial Stability Report (FSR) supports the widely held view here that the government’s recapitalisation of the banking system is unlikely to head off a sharp slowdown in bank lending growth and a deep economic recession.

The FSR points out that the capital raised by the major UK banks prior to the recapitalisation was broadly enough to cover reported write-downs up to that point. The key question now is therefore whether the £50 billion of additional capital raising that has been announced will be enough to cover future losses. (The government will inject £37 billion into Lloyds TSB, HBOS and RBS, while other banks such as Barclays have announced plans to raise just over £10 billion of private capital.)

The Bank of England suggests that this £50 billion will be enough – just. In a “worst case” scenario, involving mortgage arrears rising to a peak of 4.4 per cent, the Bank estimates that the maximum dent to capital would be £50 billion. However, 4.5 per cent was said to be broadly where mortgage arrears peaked in the early 1990s and therefore, the current downturn is increasingly looking like it could be worse.

Accordingly, there is a significant risk that the capital shortfall ends up greater than £50 billion, meaning that banks would still have to contract their lending in order to keep capital ratios at recent levels.

Even if banks do raise a sufficient buffer of capital to absorb future losses, there are other ways in which they are adjusting their balance sheets. In particular, the FSR talks about the need to reduce the customer funding gap (i.e. the difference between customer lending and deposits) in order to reduce reliance on wholesale funds. The bank estimates that to reduce the gap to 2003 levels over one year would require customer lending to contract by almost five per cent.

The FSR argues that the recapitalisation measures, by reducing wholesale funding pressures, should prevent the adjustment from having to happen this quickly. But confidence is seen to be returning only slowly to the wholesale lending markets and could easily be knocked for a six again. As the FSR concedes, the risks in the hedge fund and insurance sectors could easily trigger another round of the financial crisis.

Of course, the banks that have accepted capital from the government have made a vague commitment to increase the availability of credit over the next three years. But many economists are skeptical about how this will be ensured and whether the demand would be there to meet any increase in the supply of credit in any case.

Many economists, therefore, continue to expect a sharp slowdown in the growth of bank lending, if not an outright contraction in lending. This would clearly mark an abrupt change from the double digit rates of lending growth seen over the past few years and have significant adverse effects on economic activity.

Meanwhile, Vicky Redwood of Capital Economics Limited, a London based research firm quoting the September’s household borrowing figures said it provided further evidence that housing activity has found a floor – but at rock bottom levels.

The number of mortgage approvals rose marginally from 32,000 to 33,000. And at this level, they are consistent with annual house price inflation of between -20 and -25 per cent , compared to the current rate of -13 per cent or so. Admittedly, the recent pick-up in new buyer enquiries offers some hope of a recovery. But with credit still restricted, potential buyers will find it hard to get a mortgage.

On the other hand, lenders have not passed on October’s rate cut in full to new mortgage rates. So buyers would like to wait until house prices appear to be reaching a floor. It is believed that house prices have at least another 20-25 per cent to fall and the weak £0.3 billion rise in consumer credit in September suggested that tighter credit conditions and/or weaker consumer spending are finally weighing on unsecured borrowing.

In another related development, the CBI Distributive Trades Survey continued to paint a gloomier picture of high street demand than the official data, even after the recent slight weakening in the latter. The reported sales balance was unchanged at -27 in October and so continued to point to annual growth of official sales of around one per cent, compared to September’s rate of 1.8 per cent.

On the face of it, this suggests that another monthly fall in the official measure is on the cards for October. Meanwhile, the motor sales balance was right down at -87, suggesting that the recent plunge in car sales hasn’t let up.

Meanwhile, Tim Besley, the Bank of England’s Monetary Policy Committee member has acknowledged that the falls in food and energy prices had reduced the risks posed by inflation. Admitting that the bank had “learnt major lessons” about house prices, he implied that it may need to target asset prices more rigorously in the future to prevent further booms.

He was talking of a “rethinking of strategy of monetary policy”. We have learnt major lessons about what happens when household indebtedness and house price rises lead to an imbalance in the economy.” He however, has also warned that interest rates cuts alone would not prevent the economy slowing down sharply in the coming months.”A cut in bank rate, on its own, will not be a magic bullet,” he said. “No single instrument can work to achieve all goals.”

Prof Besley argued that the sharp fall in commodity prices and the consequently more benign prospects for food and services inflation, as well as the substantial weakening in demand, implied that the upside risks to inflation have diminished significantly.

The bank has already warned that the world economy is facing potential losses on stricken financial instruments of a combined $2.8 trillion as the crisis intensifies. With signs fast emerging that the economy is now in recession, Prof Besley has asked Britons not to expect a softer landing. In his opinion the rebalancing of the economy would entail a lot of harships.