How the 'real' economy will pay for a month of mayhem in the markets

While dealings in this market tend to be undertaken at one remove from the retail banks, giants such as HBOS, Barclays and Royal Bank of Scotland are seen as the most exposed to this flight of confidence and for the debt as it ultimately falls due.

This is why the banking sector of the London stock market has been so badly affected by the turbulence of the past few weeks. There are now signs of some recovery but few are convinced that we have seen the end of this crisis.

These concerns are of particular interest to the financial sector in Scotland as it has come to be dominated by two large banks - Royal Bank of Scotland and HBOS. Shares in these companies are down by 20 per cent and 24 per cent respectively from their high points just a few months ago.

Now these are significant falls, particularly for shares that have long been underpinned by dividend yield attractions. And in both cases the falls have been worse than for the banking sector as a whole. Even allowing for the tendency of markets to overshoot in the moods of panic and euphoria, the scale of these falls, were they to be maintained, suggest consequences more far reaching than earnings ratios and future bad debt provisioning.

Even so, need the business community be that concerned, particularly if interest rates now look to have peaked, and action is being proposed in the US to cauterise the spreading defaults on mortgage loans?

There are three ways in which the liquidity crisis in the banking sector could transmit a slowdown in the wider economy.

The first and most immediate is through a sharp fall in corporate mergers and acquisitions. The turmoil in global markets is estimated to have caused a deal backlog of nearly 250 billion. Some 191bn of leveraged loans used to fund takeovers is stuck in the pipeline, as well as 40bn of potential equity deals such as flotations and rights issues.

Some major deals have already been postponed as tightening credit markets have pushed up the cost of debt. Confectionery giant Cadbury Schweppes has delayed plans to sell its US drinks business because private equity bidders struggled to raise enough in loans to meet the 8bn asking price. And among deals under pressure are the 11.1bn buy-out of giant Alliance Boots by private equity concern Kohlberg Kravis Roberts.

Volatile debt markets can also scupper fund raising and asset disposal plans. For example, pubs group Mitchells & Butlers was forced to delay a 4.5bn property deal last month.

The second conduit is through the adoption by the banks of tighter lending criteria, both for business borrowers and for households. Indeed, for many borrowers, mortgage rates are going up, either through the withdrawal of special offers or the conversion of fixed-rate loans taken out two years ago into variable rate mortgages at higher rates of interest. Thus a pegging of rates by the Bank of England this week does not mean that rates actually charged stay the same. In fact, as the graph shows, the three-month interbank rate has been pushed to some 90 points above the 5.75 per cent bank rate, the highest in the ten-year history of the MPC. Since market rates determine the cost of credit to borrowers, there has effectively been a substantial tightening in monetary conditions.

And the third transmission mechanism is the effect on business and household confidence. So far the effects on the UK wider economy of the turmoil in credit markets appears minimal. report that manufacturing companies are planning a surge in capital spending this autumn, and there appear to be few problems in raising finance. However, risks of a slowdown have grown, both in the US and the eurozone.

Financial sector retrenchment is likely to come in banking and corporate advisory work and to a lesser extent in fund management. And as this has been the fastest sector of the economy in Scotland, the repercussions could soon be felt. Markets will continue to be watched with apprehension.