Friday, 20 April 2012

Circular easing

The Government has a new scheme. It's called Credit Easing and it's designed to improve the availability and lower the price of bank loans to small and medium-size businesses (SMEs).

There has been continual moaning from the SME sector about lack of finance. "Banks aren't lending", they moan. When the banks respond that SME's aren't borrowing, SME representatives bewail the cost of bank loans. Far too high, especially for risky enterprises.

Well, when I was doing corporate finance we regarded it as normal for banks to charge higher interest and fees on loans to higher-risk enterprises. And the SME sector generally is high-risk. They have few "hard" assets that can be used as collateral, and securing the loan by means of a charge over the company's assets is only as good as the value of those assets, which in the case of insolvency may be not very much. At a time when banks are supposed to be de-risking their own balance sheets and returning to more prudent forms of lending so as to reduce the risk of serious losses requiring taxpayer bailout, increasing high-risk lending to SME's doesn't look like a particularly intelligent strategy. The Government's Project Merlin has forced banks at least to offer finance to businesses that otherwise they might turn down, but it doesn't say they have to make it affordable. So bank finance is available, but often at a very high cost and with prohibitive conditions which many SMEs simply cannot or will not accept. The result is a near-freeze on SME lending.

So the Government is stepping in. It is making cheap funds available to banks to lend out under the credit easing scheme. The condition of accepting this funding is that SME loans must then be offered at a reduction of one percentage point on the rate that would otherwise have been offered. This assumes of course that the borrowing would be offered at all. Implicitly, the Treasury is assuming that banks are passive agents - that if they have more funding at lower rates, they will of course make more loans.

Frankly, this assumption displays a lamentable lack of understanding of how bank lending actually works, and has been shown to be false again and again over the last few years. The decision whether or not to lend is a commercial decision based upon the expected return versus the risk. I've explained in other posts how lending works in practice, but basically banks make lending decisions in the absence of funding and seek the funds to settle the loan when it is drawn. The Government providing funds to banks ahead of their lending may improve their liquidity but it won't necessarily make any difference at all to their decision whether or not to lend. If a bank regards some kinds of SMEs, such as startups, as unacceptably high risk, it will not lend to them however much money the Government throws at it. It will simply sit on the funds - park them at the Bank of England, or lend them to another creditworthy institution.

I can't see much point in this measure unless it is accompanied by other measures to reduce the perceived risk of SME lending. The most obvious would be a Treasury guarantee for SME loans. When the Government announced what it called the "National Loan Guarantee Scheme", I assumed that's what it meant.  I was wrong. What the Government means by this is guaranteed loans TO BANKS so they can lend to SMEs.  And I could forgive people for being confused by this. "Credit easing" and "National Loan Guarantee Scheme" seem to mean the same thing and could be more accurately termed "Bank funding easing" or "liquidity enhancement". How this is supposed to flow through to SMEs is a mystery to me.

Anyway, the provision of cheap guaranteed funds to banks is supposed to be the funding "push" that encourages banks to lend to SMEs. But at the other end, there is a proposal for a "pull" mechanism as well.  The idea is that the Government should create an agency to buy up SME loans from banks, package them into asset-backed securities and sell them on into the international capital markets. Once a capital market for securities backed by SME loans is established, the thinking goes, demand for these products would drive lending to SME's.

Demand for asset-backed securities in capital markets can indeed drive expansion of lending. Gillian Tett, in her book Fool's Gold, remarks that by the time of the financial crisis, there was so much demand for mortgage-backed securities in the capital markets that mortgage originators took higher and higher lending risks in order to meet the demand. I'm not sure such a demand-driven lending spree is entirely what we want - after all, we know what happened to the American mortgage market, don't we? But I'm not at all convinced that there would be such demand for SME loan-backed securities.

One of the major reasons why mortgage-backed securities were so popular lies in the word "mortgage". Residential mortgages have traditionally been seen as "safe" investments because they are secured on property which generally is worth at least as much as the loan value and often much more, and because most homeowners will go to the ends of the earth to protect their homes from repossession, so default risk even on sub-prime mortgages in normal times is probably not that high. Compare this with SME finance: the MAJORITY of startups fail, and default risk can be fairly high even in established businesses. And as I noted above, available security can be pretty dodgy. Yet the market for mortgage-backed securities crashed in 2008 and now barely exists at all.  It is fair to say that markets for other asset-backed securities - including some for unsecured personal lending - have performed better. But at the moment you really wouldn't say that asset-backed finance was a growth industry. So why on earth would there be any appetite for new SME loan-backed securities?

There is a solution, of course, which was obliquely mentioned by the Chancellor in his speech to the Conservative Party Conference last Autumn. The Bank Of England purchases government securities (gilts) in return for new money under the Quantitative Easing programme. But it also has authority to purchase corporate bonds, though it has done very little of this. It has been suggested that the way to ensure that there is a market for SME loan-backed securities would be for the Bank of England to purchase them under its Asset Purchase Facility. There is a slight snag: the Bank of England cannot participate in a primary auction, so the SME loan-backed securities would have to be offered to private investors first, heavily underwritten by the issuing agency or some other tame institution. The Bank of England could then step in and buy any that remained unsold (which would probably be most of them).

Now, just to remind you - the Bank of England is wholly owned by the Treasury. So anything it purchases actually belongs to the Government. In effect, the Government would buy up SME loan-backed securities issued by a Government-sponsored agency that bought loans from banks that were funded by cheap loans from the Government.....

And so the circle is complete.

What I can't understand is why on earth we need to create a complex circular flow of funds from Government, through banks and capital markets and back to Government again, just to provide SMEs with the finance they need to expand. Wouldn't it be simpler for the Government to lend the money directly to SMEs?

Oh no, wait. Government isn't supposed to be in the business of banking, is it? So we need this ridiculous circularity just to avoid any suggestion that Government is lending to SMEs. And to think I have been castigating the idiotic complexity of Eurozone financing, which is entirely designed to avoid giving the impression that the ECB is funding Eurozone governments. It seems the UK can do its own version of fudge.

UPDATE - Following a Twitter discussion, another nasty possibility has emerged (thanks to Graeme Pietersz for raising this). The difference between cheap loans to banks ostensibly so they can lend more to SMEs at cheaper rates, and cheap loans to banks for any other purpose, is vanishingly small. The last time banks were offered cheap loans was in the ECB's LTRO operations in December 2011 and February 2012. These were thinly-disguised bailouts of weak illiquid (and possibly insolvent) banks and, indirectly, highly indebted sovereigns. Given that we KNOW that throwing cheap money at banks doesn't make them lend, maybe enhancing SME lending isn't the real intention. Maybe SME lending is just a smokescreen for the real objective, which is to provide more government support to weak UK banks. They certainly need it, but overt financial support is politically unacceptable at the moment. It is very telling that the strongest UK bank, HSBC, does not plan to participate in the National Loan Guarantee Scheme, and the bank that intends to use it the most is the UK's weakest bank, RBS.


  1. Why didnt we truly nationalise RBS and just borrow the monies to SME's? Initially because Gordon was afraid of Nationalisation and how this could be interpreted by the Tories. Now its not allowed, as Gideon adamantly refuses to scare the markets.

    We are between a brick & a wall and we need a great big JCB to knock the whole thing down and start again.

    I await with abated breathe.

    Good blog Mrs Coppola.

  2. Frances, I fully agree. There are two further arguments against encouraging an expansion on lending and borrowing. First, UK bank assets relative to GDP have expanded a whapping TENFOLD over the last forty years (that’s according to p.3 of a Bank of England publication, “Banking on the State”).

    Exactly what benefit this expansion has brought is a mystery. Economic growth is no better.

    Second, we’ve had a credit crunch caused by excessive and irresponsible borrowing and lending, and how do the plonkers in power try to get out of it? They cut interest rates to an all-time low so as to encourage more borrowing and lending. You just couldn’t make it up.

    If there is scope for stimulus, it should take the form of channelling money into household pockets and/or increasing public spending. That will expand firms’ order books, which will expand lending A BIT: there is nothing that bank managers like more than firms with full order books. But expanding lending more or less for the sake of it is bonkers.