Bank lending, FLS and SMEs: Harold Wilson is back
by George Hatjoullis
Central banks have flooded financial systems with ‘central bank’ money since the crisis of 2008. However, the growth of various measures of money supply, which include deposits at banks, have barely grown. The reason is partly to do with the need for broken banks to raise capital to permit balance sheet growth and a greater caution in bank lending owing to an uncertain economic outlook. The banks, having been badly beaten up by politicians, the media and the public, have not unnaturally become a little extra cautious.
The UK government tried to offset this natural reticence by introducing the Funding for Lending Scheme (FLS) via the Bank of England (http://bit.ly/12NL6en). The FLS liquefies bank balance sheets at low-cost and enables further lending at a lower cost than otherwise. This scheme makes sense only if the problem for banks was the availability and cost of funds. Given the unspectacular success of the scheme one must assume this was not the case. Indeed one suspects it merely raised bank profitability on lending they would have carried out in any event.
Banks lost a lot of capital in the financial crisis and raising new capital has been expensive and challenging for some. Lending standards have also been raised. This is the logical response to all the criticism. The best banking model bases lending on the likelihood of being repaid. Collateral is helpful to limit loses in default but recovering a defaulted loan is an expensive business however well secured and, of course, the value of the collateral is itself variable. If the problem is system-wide then recovery can be problematic indeed. For a case study of this see the PIMCO report on Cyprus banking which can be accessed via my blog PIMCO report on Cyprus banking system: obsolete. Cyprus banks habitually made loans with little regard to likelihood of repayment, it seems, and relied heavily on cross-collateral and co-guarantors. This did not end well.
Banks are now being criticised for not lending enough to small and medium enterprises or SMEs. Vince Cable is particularly vociferous in this respect. Indeed Mr Cable is now lending tax payer money directly to SMEs via a new government business bank (http://bit.ly/140iNfa). What is unclear is what criteria this business bank is using to make such loans as the motivation seems to have been the failure of banks to meet this demand. If banks felt SME lending was too risky and/or SMEs have been reluctant to borrow, why will this business bank change matters? The implication is of course that business bank loans are an implicit subsidy to the SME sector from the tax payer. The last time I recall this type of government polciy was under Harold Wilson. I do not think Margaret Thatcher would have approved. Who will take the blame for losses arising to the tax payer from business bank loans? One of the unfortunate side effects of the FLS and business bank initiatives has been to depress rates available to savers. Savers are also tax payers. So tax payer funds are being channelled to SMEs and depressing savings rates for these same tax payers.
I have some direct experience of the riskiness of lending to SMEs. I have loaned a small amount to SMEs via a peer-to-peer lender. The loans are typically secured or guaranteed. My income for the last tax year is £256.25. My loss from bad debt is £164.19. Judging by the high number of comments on outstanding loans, I will incur further loan losses in this tax year. Of course, there may be recoveries as well. However, these take time and are highly uncertain and expensive. I will of course be taxed on the income and cannot offset the losses against my income tax. My losses may reflect my investment choice of loans and diversification strategy. However, I doubt it. I have also loaned money to individuals via other peer-to-peer websites and have only had £10 written off since inception. Indeed young people under the age of 25 have impressed me as very reliable. However, this is all anecdotal and ony for illustration. The important point is that SMEs can and do default.
The business bank has also started to lend via this peer-to-peer lender. This has depressed interest rates further along with the general impact of FLS. The returns available from reinvestment are now much lower from my SME pool. Given the tax disadvantage, the lower rates and my experienced default rate, I am running my portfolio down and reinvesting in unsecured peer-to-peer personal loans. The net effect of the business bank has been to displace my small loan. Mine may not be the only loan displaced. Moreover, there is no reason to think the business bank will have a different bad debt experience. The money the business bank is lending is that of the tax payer and I am a tax payer. Nice job Vince.