Since the banks were ‘bailed out’ with taxpayers money, a regular refrain from across the political divide has been that the banks are doing decisive harm to the country by refusing to lend to small businesses.
If this refrain were accurate, banks would be denying capital to the businesses that create the jobs to engender a sustainable recovery, instead choosing to deploy the capital in complicated financial instruments that create little value, or pumping up housing markets, or in paying enormous bonuses to bank employees.
This latter is an argument that Vince Cable in particular was vocal in espousing, and as soon as the real state of the bonus culture, now much more shares based than cash based, becomes apparent, he will doubtless claim the credit for that.
But when I met with Dr. Cable recently at a dinner, he was anxious to emphasise that the real reason that lending to small businesses has not taken off in the way that the sturdy economic recovery we have witnessed in the UK implies that it should, is because of the Basel III banking regulations.
Cable went so far as to say that, ‘we tried to fight on this, but they are international rules.’
The rule in question is that banks must retain five times more capital when they issue a loan to a business than they do when they issue a mortgage on a house. As the profits from any business derive from the return that can be achieved on capital, banks are put in a position where the incentive the regulator is insisting on, is for the banks to lend to the housing market, and not to businesses.
In addition, those same regulations already require banks to hold more capital than at any time in history; not a bad thing in itself, but it means that banks cannot deploy capital as freely now as they could in the past. So the regulator is restricting the amount of capital available in the market, and then incentivising the capital which is available to be deployed in the housing market. Such a policy threatens to ferment another credit bubble in the housing market.
The final point to make is that when the Basel III regulations require banks to hold capital, the capital must be held in cash, or other ‘liquid assets’, as defined by the regulators, and mortgage backed securities are counted as liquid. Those are bundles of mortgages traded on financial markets. Business loans are not counted as liquid by the regulator, further incentivising the banks to do exactly what policy makers post-credit crunch should be discouraging: the reliance of banking systems on the housing market.
Luckily, as often happens, when the regulation fails, the market steps in. Dr. Cable mentioned the increase in ‘crowdfunding’ and ‘business angel’ type finance for business and the bond market which offers a better deal for many businesses now than any bank ever could, but we need to do more to create the sort of economy that can sustain the Liberal Democrat party slogan, ‘opportunity for all.’
* David Thorpe was the Liberal Democrat Prospective Parliamentary Candidate for East Ham in the 2015 General Election
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20 Comments
David, is there any evidence that good business propositions are being turned down? Is it perhaps that the demand (from SME) is not present. Many small businesses have become adverse to bank lending following the sudden withdrawal of support during the crash, in other cases businesses have sufficient cash to fund themselves, and finally business confidence is falling. I’m not an economist, just a business owner, speaking from personal experience.
Stephen,
Those are allr elevant points, but business confidence is now much higher thant it was three years ago-but lending is below historcial levels-look at the bond markets-where lots of new issuance from companies, and increasingly from SMEs are happening, and crowd funding, lending to bsuinesses in a way that is totally new. Business confidence will be fine-it had a very rational pause due to short-term factors such as fears on an interest rate rise, and will suffer further as people realsie we could have a labour PM in six months, but in time the fundamentals will reassert themselves…
Nice point made by Will Hutton on the latest banking scandal involving the foreign exchange market.
http://www.theguardian.com/commentisfree/2014/nov/16/banking-changing-slowly-but-culture-still-corrupt
Barclays, a private bank under the leadership of the reformist Anthony Jenkins, appears to have done more than the banks majority owned by the UK taxpayer, RBS and Lloyds. It beggars belief. It may have something to do with the government’s narrow focus on the public finances and wanting to get the banks back into the private sector as soon as possible – by any means necessary.
actually Braclays is a case of the regulator getitng it right-those regulations means that barclays or other investment banks have to hold even more capital; for investment banking purposes than anyhting else-making it not economical to do so-so barclays have been cutting thousands of investment banking jobs and shrinking the bsuiness-Lloyds, which is partly governent owned-has never had an investment bank….see here for more info-although I did write the piece myself…http://www.whatinvestment.co.uk/financial-news/shares-and-trading/2473447/barclays-shares-and39have-plenty-of-capital-appreciation-to-comeand39-following-latest-results.thtml
also the Uk government could certainly have sold more lloyds shares a long time ago if it was detrmined to get it into the pricate scetor-=but no one would buy RBS-it is a basketcase….
David Thorpe is the only Lib Dem economist I have seen stand up to QE and with news about Japan over night it seems those of us who were sceptical this would work have been proved right. People should read his article: “QE “benefits the better off” say Bank of England – so why are we still doing it?”.
This is another good article. I was not aware of how much Basel III regulations were encouraging mortgage over business lending.
I did a bit of my own economic analysis using IMF data last week and from what I can see Ireland (which David Thorpe has also said we can learn from in the past) is quite a lot richer than us. We should have a closer look at them.
David, what do you think about the Geni index? I am a fan of it as a way of measuring inequality, but hardly anyone seems to use it. I am not a fan of using baskets of goods in economic analysis, but that seems to be the favoured status quo.
Thanks for the interesting article. I’m only an amateur when it comes to economics, but a former independent financial adviser.
Good article David, is there any evidence of changes in mortgage lending to businesses? As I presume these aren’t including in the capital lending figures.
David, I am not sure I believe that business confidence had returned or that growth is a ‘fundemental’. I suspect that this is the new normal as our historical trading advantages are eroded, and after the credit bubble has exploded.
I have just recruited a keen as mustard, MBA/PhD candidate to run a business in India, on a lower salary than we pay junior technicians in the UK. In the long term, how is that difference sustainable?
Our staff in CHINA are amazed at the level of social security benefit, and at the ‘free at the point’of use’ NHS. I am not arguing against these policies, just wondering in a competitive world, how we can sustain them.
Seems to me, the fundamentals are not on our side, and no amount of macro economic tinkering will change that. I don’t think it is as simple as blaming the banks.
@Stephen Doinnely
We sustain them because they make use competitive
@David Thorpe
Do you happen to know why Basel III settled on that ratio of 5:1 for business:housing capital? I expect that a ratio greater than 1 would be appropriate simply because a house is collateral whereas a business isn’t, so a business is inherently more risky. However, I would not expect that the same ratio would apply for all countries of the world (and by the way, maybe you could remind Vince of the concept of risk when you next dine with him!).
Spot on. Too much QE funding simply sits in the banks to shore up these reserve ratios. It’s partly a theoretical failure to realise the virtual nature of money (although a 5% reserve does imply that 95% of the loan is virtual money). Sadly accountants rather than Keynesian economists are running our economy. We need to fund demand, restricting money supply only by output GDP, and not by a gold standard, government bond sales, or bank reserve ratios.
Banks are definitely more risk averse. I run an SME in Bristol. We are currently investing in a major growth project. The bank has funded BUT the conditionality has massively increased and requires total coverage by current assets and operating revenue. There is no way the bank would now fund the start up we were 20 years ago.
The only erroneous claim in the article is that business angels etc offer better terms than banks. Perhaps some do, but the established big bank venture funds I have talked to want to extract huge equity value in return for any funding they offer. If you can get it, bank lending is currently by far the cheapest option.
Stephen-you are hinting at what some economist call ‘secular stagnation’-which I dont believe will happen due to techno;ogical advances-business confidence is definitely higher-though its sliding due to a variety of factors not related to fundamentals-so for example, the Eurozone, the threat of eurozoen exit, russia, and other factors.
Geoff-Im an ardent Keynesian-as is vince Cable-he believes the current policy is completely keynesian-as he wrote in the new statesman, and I think so to-demand was increased byfgovewrnment internevention but he last government-and now that the proavte sector is expanding (and expanding it must be as the state sector is contracting yet the economy is growing all of that is Keynesian-the biggest problem Krynes ever endured was people missapropriating what he thought-he was also committed to balanced budgets over the medium term.
Geoff-I wasnt claiming that angel funders offer better terms, certainly I didnt mean to imply that-what I was saying was that angels are offering funding-banks arent-but the bond markets are offering better terms-but only to businesses which can offer them..
Geoff ‘s piece reminds me that not that long ago the government was strong on the third-sector and so we had CIC’s and other idea’s with the intent to create corporate vehicles more fitting to social enterprises and that capital (at favourable rates) would be made available to such enterprises – things have been very quiet for a long-time now and from Geoff’s comments concerning the options available to him, that not a lot has changed for the vast majority of businesses ie. the SME’s.
Good post David and thanks for highlighting this.
I think the problem goes even deeper than suggested. IIRC the draft Basel III regulations run to well over a thousand pages which alone guarantees that they will be too complex, too full of loopholes. And the theoretical basis is surely dodgy to say the least. So, for example banks must keep a certain amount of “risk- weighted assets” with the weights set by Basel III. But what is not at all risky today could be highly risky tomorrow – for instance sovereign risk – still deemed zero I believe – was indeed very low for most of Europe (Greece excepted) before the financial crisis. Well, there is no way it’s zero now; in Spain, Portugal and of course Greece it’s off scale and it’s rising fast in Italy and France. Yet Basel III encourages, virtually mandates, that banks load up with this toxic mess as well as housing loans even when there is clearly a bubble inflating. This cannot possibly end well. I guess it’s seen as the best way of kicking the financial crisis and Eurozone cans down the road.
When dealing with complex systems with many interacting parts (e.g. the finance system) the riskiest thing by far is to arrange that all the participants are ‘close coupled’ – all forced to follow the same impulses – so that they move as a herd rather than as random individuals following their own sense of what is right. The record shows that in the short run close coupling creates the appearance of stability because no participant fails but that the stability is always revealed to be an illusion in the longer run when the whole system collapses suddenly and catastrophically – the herd runs over a cliff together. That is what Basel II will deliver.
A better by far approach would be to limit the rules to a single side of A4 and just two rules, (a) banks should not normally have balance sheets exceeding £100 billion (i.e. they should be small enough to fail) and (b) if they do have a balance sheet exceeding £100 billion then, in the event that any external support is required, the directors are liable without limit for that shortfall. In my dreams!
David, herein lies the only place I diverge from Keynes, ie on the need to balance budgets in the mid term.
I argue that in an advanced technology economy, wages will inevitably be a smaller component of output, a citizen income will be an economic necessity, and deficit spending will also be inevitable and no problem. Current reality shows this in fact to be the case. We need a different theory of money, a theory of virtual money where money is constrained only by output GDP. It’s an argument I’ve sketched in previous LDV articles and where I have a longer paper available….
geoff-you appear to disagree with keynes on the fact that whne the private scetor is growing the public sector should be contracting-this government may be the most keynesian in history-mervyn king called it a textbook fiscal policy and je will have meant a keynesian textbook. Thats why I support the coaliton on the economy-and why I am a keynesian.
David, I agree in principle but not in extent. The coalition has failed to fully fund demand to match output GDP. Hence either unsustainable credit or recession. My earlier post at https://www.libdemvoice.org/opinion-51-32053.html sets the claim out although rather briefly.
Of course, regulators by allowing banks to hold much less capital, meaning equity, against assets considered safe than against assets seen as risky, leads banks to earn much higher risk-adjusted returns on equity when lending to the safe than when lending to the risky.
And that causes banks to lend too much (dangerously much) to those perceived as absolutely safe, and too little or at too high interest rates to those perceived as risky.
And since the “risky” always includes small businesses and entrepreneurs; those who with their dynamism help to seed the future of the economy, it is no wonder so many around the world are facing stagnation.
Per,
The point Im making is that if we accept that banks can;t lend as much to small businesses, then politicians shouldn’t used that as a political football, or try to force them to do so.
Geoff,
If demand wasnt funded relative to supply, then we wouldnt have asset price bubbles, as we do now, and net inflation, even if it is very low levels of inflation, the private sector funds demand at present, thats why unemployment is materially down, even as govt. are cutting jobs.
But real wages are flat-lining. Demand is only funded to match supply by credit and government deficit spending. We need a Citizen’s Income.