Wednesday, 26 September 2012

Vince's Folly

From the Oxford Dictionary: 
 folly : noun (plural follies)
1 [mass noun] lack of good sense; foolishness:an act of sheer folly[count noun] a foolish act, idea, or practice:the follies of youtha costly ornamental building with no practical purpose, especially a tower or mock-Gothic ruin built in a large garden or park.
Middle English: from Old French folie 'madness', in modern French also 'delight, favourite dwelling' (compare with folly (sense 2)), from fol 'fool, foolish'
The Business Secretary, Vince Cable, has outlined plans for what he calls a Business Bank, with the aim of improving the flow of credit to small & medium-size businesses.
"We need a new British Business Bank with a clean balance sheet and an ability to expand lending rapidly to the manufacturers"
said Cable to his fellow party members at the Liberal Democrat conference.

Wow, I thought. The Government has done another U-turn. It's going to create a State Investment Bank which will lend directly to businesses - even though not so long ago it refused categorically to create such a bank from the ashes of RBS. Since the main reason why businesses can't get credit is that banks are charging exorbitant rates for lending to anything that looks even slightly risky, providing a means of financing businesses that bypasses sclerotic banks seems rather a good idea.

But two things puzzled me. Firstly, the amount of money proposed as capital for this bank was tiny - £1bn. It was suggested that the private sector (presumably pension funds and insurance companies) would match this, but that is still peanuts, frankly. Compare this with the Bank of England's Funding for Lending scheme, which is providing up to £80bn of cheap money to banks ostensibly for lending to businesses and homebuyers.

And that's the second puzzle. If the Bank of England is providing all this money to banks for lending to businesses, where does this new "business bank" fit in? What would be its role?

No-one seems very clear, to be honest. Some reports suggested that the bank would provide a "one-shop stop" for the various Government and private financing initiatives for businesses, ending the current confusion and providing essential advice to business owner/managers. This would indeed be a good thing - but it isn't banking. Many people believe that this bank would actually lend directly to businesses itself, leveraging its equity by up to £10bn - i.e. traditional fractional reserve banking. But that would be direct competition with commercial banks claiming funding through the Funding for Lending scheme, which is most of them. People really should read what the BIS website says (my emphasis):
"The new institution will operate through the wholesale markets, it will not have any retail presence and will not displace or subsidise banks." 
No, this is not going to be a fractional reserve lending bank.

So what is this bank going to be, then? The BIS website directs us to the recommendations of the Breedon report. I have previously written about this report, so I won't say much about it here, but suffice it to say that it does not recommend creating a bank, as such. What it does recommend is creation of a State agency to buy up business loans from lenders (i.e. commercial banks), pool them and repackage them into securities for sale to investors in the capital markets. To people in the UK this isn't any sort of traditional banking: it is seriously spooky and definitely belongs in the catalogue of "evil investment banking" activities. As someone commented on twitter the other day, "isn't securitisation of loans what got us into this mess?" But American readers would be familiar with this. It is what the US Government-Sponsored Enterprises (GSEs) do.

The GSEs Ginnie Mae and Fannie Mae were created originally to improve access to mortgages so that a higher proportion of Americans could own their own home. Freddie Mac was later created to give Fannie Mae some competition, and since then other GSEs have been created, notably Sallie Mae for student loans. As far as I know, though, there is no American GSE for small & medium-size business loans. And the UK does not have GSEs at all.  Various UK banks, most notoriously Northern Rock and HBOS, experimented with the American originate-to-distribute banking model, but they used their own SPVs - and it has to be said that their experiment was far from successful. Most loans still remain on the lenders' books. This agency would not only be the first GSE in the UK, it would also as far as I can see be the first GSE for small business loans in the world.

This is not necessarily a problem. The fact that the UK is not used to originate-to-distribute banking may add risk to the scheme, though I don't think the US understands its originate-to-distribute model very well either. But the US's fragmented banking system and smorgasbord of competing regulators made it all too easy for loan originators to mislead GSEs and investors as to the scale of the risks they were taking on. Perhaps the UK, with its tradition of universal banking and its simpler regulatory system, may cope better: in particular, perhaps the "regulatory black hole" between originators and GSEs, which Congress still has done nothing to eliminate, will be covered by the Bank of England's conduct supervision.

My bigger concerns about the scheme, though, are twofold: firstly, market access for the securities that the new agency (it is in my view misleading to call it a bank) would create; and secondly, the implications for commercial bank conduct of a Government agency buying risky loans from them.

The fact is that no market exists at present for securities backed with small business loans. The idea seems to be that pension funds and other investment funds would buy them, but it is unclear how they would achieve the credit ratings required to meet regulatory requirements for pension funds. Small business loans have high default rates: the securities would be tranched, of course, but with no market history even the senior tranches would struggle to achieve the high ratings that pension funds require. Unless, of course, the Government were to guarantee them - but it doesn't appear to have any plans to do so. Breedon has in my view created unrealistic expectations regarding the market for these securities, and unfortunately the Government seems to have believed him.

So what would happen if the securities failed to sell, or only sold at very high yields? It would, to say the least, be highly embarrassing for the Government. The agency would be left with unsold securities on its books, or would be forced to accept large losses. How long would it be before the Bank of England was pressured to accept these securities as collateral against bank funding, or - worse - buy them under its Quantitative Easing programme? Mervyn King said "absolutely not" when George Osborne suggested the BoE could buy corporate securities. But he is leaving office in 2013, and will his successor be quite so resistant? We shall see.

My other concern is about moral hazard. The failure of mortgage-backed securities in the 2007-8 financial crisis really arose because retail lenders took on unacceptable risks in mortgage lending, secure in the knowledge that they could unload those risks on to investment banks and Government agencies. The investment banks and Government agencies themselves were equally sure that they would be bailed out if it all went wrong, so did not exercise any sort of due diligence with regard to the investments they were taking on. No-one was managing risk, because in the end they all expected the Government to pick up the tab - which indeed is what happened. Now we have a proposal in the UK for a Government agency to buy up risky loans from commercial lenders. If the securities failed, would the Government bail out the agency? Yes, of course it would. So in that case, why would the lenders bother to assess and manage risk properly, if they knew they had a guaranteed buyer for the loans which itself would be implicitly guaranteed by Government? Why would they retain risky and non-performing loans on their balance sheets if they could unload them on to a Government-backed agency?

There is also a bit of a financial puzzle concerning the relationship of this scheme with Funding for Lending. Reports suggest that the total lending supported by this bank would be about £10bn. This apparently would be enough to meet the needs of business. But the Funding for Lending scheme is providing up to £80bn of cheap loans to banks. If business only needs £10bn of funding, what is the purpose of the rest of the money from the Funding for Lending scheme? There really can't be that many prospective home buyers in the UK. To me it looks very much like back-door recapitalisation of banks via the central bank.

The sheer complexity of this scheme makes me suspicious. If the primary purpose was to provide essential business finance, the simplest way would be via a State Investment Bank, capitalised by Government and lending directly to businesses as a fractional reserve bank in its own right. But that would bypass commercial banks - and once bypassed, what would be the justification for their continued existence? After all, a bank that won't lend except to people who don't need finance, and pays virtually nothing to savers, is an expensive waste of time - but that is how our banks are behaving at the moment.

I suspect that the primary purpose of both the "Business Bank" and the Funding for Lending scheme is not to provide finance for businesses. It is to recapitalise banks, clear out their balance sheets and get them working properly again. It is more Government money poured into an outdated and dysfunctional industry. It is yet another attempt to bring the dead back to life.

So this scheme is not what it may seem. A sensible solution to the shortage of business finance it is not. It is a folly, in the true sense of the word: a costly experiment in trying to control the uncontrollable: a monument to the foolishness of a Government that understands nothing of the machinations of the banking industry and the lengths to which they will go to preserve their hegemony.


  1. Food for thought

  2. Obviously you know much more about banking that I do and equally I agree with much of what you write in this article. However, I think that possibly you are being a bit harsh by calling it Vince's folly.

    Vince Cable did actually propose using RBS as British investment bank in an open letter to the prime minister (see fifth paragraph from the end)

    It seems that this idea was killed. I can only assume that returning RBS to the private sector ownership was seen as a political imperative elsewhere in the government and hence Vince was overruled. Equally I cannot see a state owned bank lending to businesses being easy to sell to the various supply-siders, pseudo-Austrians and other cranks who been brought by vested interests that sit on the Tory backbenches. I therefore strongly suspect that the business bank in its current formation is probably a political compromise.

    Given that it is a compromise the question is does it do more harm than good! I actually agree that this will probably function as another bailout for bad banks and equally I suspect you are right about selling on the securitised loans (and the debt sitting on the government books).

    However unlike Fannie Mae and Freddy Mac the loans are at least going to a productive part of the economy (rather than just pumping up an asset price bubble). Hopefully, even if the government has to write down a lot of bad debt from failed companies, then at least it will have spurred on some economic activity and created some useful assets that can be resold to build new businesses that can successful!

    In otherwords it might fail as a bank however it might nevertheless make some in roads with stimulating the economy! It might not even been the best way of implement a state investment bank but at least its a start that can be built on by future governments.

    1. I did mention RBS.....

      The Breedon report (available from the BIS website) is driving this initiative. I suggest you have a look at the cast list. You may change your mind about the purpose of this scheme.

      I doubt if many Americans would agree with you that enabling ordinary American families to own their own home is "unproductive". Owning your own home is an important part of the American dream and enabling more people to do so was one of the main initiatives in FDR's New Deal. The US gives far higher priority to home ownership than it does to healthcare.

      Why do you think that all loans to small businesses would be "productive"? Given that these loans would be made by banks that would take no risk but stand to profit, I'd regard it as a racing certainty that a lot of them would be to no-hopers. And I have reason for saying this: I suggest you have a look at the primary causes of HBOS's collapse and the FSA's decision to strike off Peter Cummings.

    2. I agree Paul on the more productive use of credit point but I also agree with Ralph this will be forgotten in ten days.

    3. Perhaps I misused the word productive. I certainly think home ownership is a good thing. However the risk always was that it would create a speculative asset bubble!

      I appreciate that business loans are not always good! I can see the bank itself perhaps not being commercially that successful. However small businesses generally create employment, services and even assets that might help stimulate other parts of the economy.

      As an aside, I once did an investigation into biotech manufacturing capacity in the UK and US. It was interesting to note that UK biotech tended not to invest in manufacturing capacity whereas US firms did. As a result there was much more manufacturing capacity in the US. Although the both US and UK firms often failed, the US firms had created useful capacity that could then be inherited by the next generation of firms. Possibly an example of how "bad" investments can actually be good for the bigger economy!

  3. Francis,

    You’ve lost the plot. Haven’t you noticed that Westminster politicians produce two or three silly ideas a week, which everyone forgets about ten days later? They have to make it look as though they aren’t brain dead. Remember Cameron’s “house extensions without planning permission” idea? That’s rapidly fading into the distance.

    They should have had a Department of Silly Ideas in the Yes Minister series.

    1. Haha. Earlier this year I started to write a post called "The Ministry of Silly Schemes", which was about the budget, but I didn't finish it. Maybe I should.

      I'm not so sure that this one will disappear, though. It has a lot of support from business - and, of course, from banks.

  4. Some psychologists have even called it a 'defence mechanism'

    Intellectualization is a 'flight into reason', where the person avoids uncomfortable emotions by focusing on facts and logic. The situation is treated as an interesting problem that engages the person on a rational basis, whilst the emotional aspects are completely ignored as being irrelevant. Jargon is often used as a device of intellectualization. By using complex terminology, the focus becomes on the words and finer definitions rather than the human effects.

  5. We are privatizing Law & Order; Courts are needed but governments are bankrupt. Tax is over.