HOW DOES ONE shore up the balance sheets of Britain’s banks while encouraging more lending to cash-starved SMEs? Not since the riddle of the chicken and the egg has a puzzle so confounded the business, financial and political communities in the UK.
Corporate lending is essential for the expansion plans that are so vital to the economic recovery and job creation the government craves. But banks are also being told to rebuild their capital base and tighten lending standards to avoid a repetition of the financial crisis that led to the recession.
Critics claim achieving both is impossible; advocates claim achieving both is essential and, moreover, Britain’s banks remain woefully undercapitalised. As if on cue, the Co-operative Bank was struck by series of disasters that neatly illustrated the point.
At the end of May, the banking division of the supermarkets-to-funerals Co-operative Group announced it had stopped lending to new business customers in a bid to quell concerns about its capital position. Weeks earlier, credit rating agency Moody’s slapped the bank’s debt rating with a six-notch downgrade – effectively reducing it to junk status – and warned that it could need taxpayers’ money to plug a capital hole that has been estimated at between £1.5bn and £2bn.
The problems at the Co-op bank are specific to the company, associated as they are with the bank’s decision to merge with Britannia Building Society in 2008, which brought with it hundreds of millions of pounds of bad debt. Nevertheless, it will reinforce the Bank of England’s calls for banks to find more capital. But whatever the precise cause and effect, there is no argument about the dire state of business lending. Bank lending to private companies has dropped by £57bn since 2008.
Figures from the Bank of England show the number of loans offered by banks has continued to fall despite the Funding for Lending Scheme (FLS), announced with great fanfare last summer. The stock of lending to businesses contracted by £5bn in the three months to February alone, while the annual growth rate of lending to both small and medium-sized enterprises (SMEs) and large businesses also fell.
This appears to be the picture across the corporate arena. Gross lending by banks and building societies in the second half of last year was lower than in the same period of 2011 in every major business sector. There are separate puzzles here: one is whether the lack of lending is down to banks’ unwillingness to lend or to a lack of demand among companies. If the cause is bank behaviour, what is the reason behind that?
It was the former issue that hit the political agenda after the Bank of England’s Financial Policy Committee (FPC), which since April has been tasked with reducing systemic risk in the financial system, called on banks to take on more capital.
According to the FPC, banks could face about £50bn in losses over the next three years – related to bad debts exposed to the eurozone and property markets, mis-selling claims and a more prudent approach to risk. It warned major banks and building societies would need to find £25bn by the end of the year to hit the target of holding reserves worth 7% of their risk-weighted assets.
The FPC, which is chaired by outgoing BoE governor Mervyn King, set out a number of ways this could be done, including selling off non-core assets and raising equity capital but did concede this needed to be done in a way “that did not hinder lending to households and businesses”.
“Any newly issued capital would need to be clearly capable of absorbing losses in a going concern to enable firms to continue lending,” it said after its most recent meeting.
According to the Bank’s critics, not only is this impossible but the negative impacts on lending can be seen already. Policy Exchange, a right-leaning think tank, says the “primary reason” for the lack of credit supply is the regulator’s desire to raise the capital requirements of UK banks.
In a recent report, Capital Requirements: Gold plate or lead weight?, it says that – with financial markets all but closed to banks and profits under pressure – they have been forced to cut back on lending.
“The drive to make the financial system safer through capital ratios is actually causing monetary policy to be less effective and hampering the recovery,” says James Barty, author of the report. “For our economy to recover, banks have to be able to lend. We need more flexibility in the regulatory system so that banks’ capital can support their lending and not just make sure they don’t go bust in a crisis.”
Colin Levins, CFO of Platform Black, an alternative finance provider that auctions companies’ invoices to a panel of investors, says capital requirement rules have stemmed lending to SMEs in particular.
“The capital requirement is related to the risk profile so banks are obviously reducing lending to unsecured loans which requires about twice the amount of capital as a well-capitalised security,” he says.
The message appears to be getting through. In May, chancellor George Osborne issued a thinly veiled warning to the FPC not to impose rules that would derail the recovery.
“It is particularly important, at this stage of the cycle, that the committee takes into account, and gives due weight to, the impact of its actions of the near-term economic recovery,” the chancellor said.
However, others warn against pinning the blame on regulation. “I would not jump on the bandwagon of saying the regulators are making things tougher,” says Gary Edwards, head of growth & acquisition finance at Investec Bank. “If you look back over history, there’s always been cyclical behaviour, with banks tightening in a recession, and then as the recession fades from memory, banks get aggressive again and overleverage. So it makes sense to put some regulation in.”
The BoE certainly disagrees that capital requirements should be lowered. In May, Andrew Bailey, head of its Prudential Regulation Committee, defended the FPC’s call for more capital, saying a “well-capitalised banking system was more likely to support credit creation in the economy” as higher levels of capital make it easier for banks to attract funding from other sources and thus lend more to small firms. The Bank recently published a working paper that said “requiring undercapitalised banks to raise their capital levels could … help underpin a sustained recovery of credit growth”.
More funding for lending
The government has also responded to calls for moves to stimulate more corporate lending. Osborne’s warning to the FPC came just a few days after the Treasury and BoE extended the Funding for Lending Scheme by expanding the way it can help access credit for SMEs.
Since the FLS was set up in August 2012, net lending under the scheme has been broadly zero – even though banks had tapped the FLS for about £14bn and benefited from a significantly cheaper credit. The expansion followed concerted lobbying by Vince Cable, the business secretary, amid concern that cheaper funding was being funnelled into the mortgage market rather than SMEs.
Banks will now be able to tap the FLS for ten times the amount of any net lending to SMEs in 2013, and five times the amount of any net lending to SMEs in 2014. Previously, banks could only tap the FLS one-for-one with any increase in net lending.
Analysts are cautious about the potential impact, given its previous record. Nick Bate, UK economist at Bank of America Merrill Lynch, says that even nine months after the start of the scheme, its positive effects are “only percolating through the economy slowly”. He warns the same may be true of the new version: “Both the potential improvements in credit conditions for SMEs and the subsequent stimulus to the economy may take some time to come through.”
Richard Reid, honorary senior research fellow at the University of Dundee and former chief economist for the International Centre for Financial Regulation, agrees the impact of the FLS has been “very slow to feed through” to SMEs.
While the BoE is plainly keen to ensure the low interest rates it has put in place to stimulate growth have an impact before they lead to a rise in inflation, the banks can be forgiven for not going gung-ho. “The banks are recovering their capital positions so at the margins they will be a bit more relaxed about seeking new opportunities,” he says.
Levins at Platform Black is also sceptical. “It’s one thing getting credit but the banks are not going to expose themselves willy-nilly to default risk just because they have cheap money,” he says.
While banks should not be forced to lend to un-creditworthy businesses, the government could benefit from a tougher stance on banks that take FLS money.
“Where the government is guaranteeing a proportion of the loan, I think it is a bit cheeky when banks demand a personal guarantee for the whole of the loan. That’s frankly unpalatable,” says Nicola Horton, corporate finance partner at accountants Crowe Clark Whitehill.
Others want the government to help foster a more disparate portfolio of niche and specialist banks. New entrants would also have the advantage of not having the legacy of bad loans that many banks carried over from the pre-crash lending boom and which they need to pay down.
“That would be a more healthy banking environment because you would have people who were specialists in their chosen areas of banking,” says Edwards at Investec. “But it’s hard to see how we can get over that inertia so smaller UK banks can get a foothold.”
There have been calls to slow or reverse what the technocrats call macro-prudential regulation – the package of credit requirements, leverage limits and liquidity ratios imposed on banks. Two years ago, the Institute of International Finance warned that Basel III would leave global GDP 3.2% lower than it would otherwise have been and cost the creation of 7.5 million jobs.
Reid says it is hard to work out the exact impact of regulation on lending. “Part of the problem for the banks – although they would say this, wouldn’t they? – is they don’t know where it will end,” he says. “We now have Basel III but we still have to have discussions on leverage requirements and liquidity requirements. There may be an element of the banks saying – if they have to set aside another £5bn – that may tend to lean them towards the conservative side [on lending].”
He says it is tempting to adopt a “mechanistic approach” that calculates the volume of lending that is lost as a result of every extra pound of capital reserve.
“The problem – which every bank has – is an immediate management response to [higher reserves], whether it’s deferring earnings or spinning off other businesses. So it’s very difficult to know what the exact impact of any requirement is on the supply of credit or the demand for credit,” he explains.
Reid applauds the government for the effort it has put into making FLS work but says policymakers could do more to look for other ways to get credit into the economy: “A lot of attention has gone on the banks, but it would be a good idea if the authorities looked at the whole financial system and looked at other types of institutions that could help with the provision of credit.”
He plays down the idea of a nationalised business bank as he is wary of the role the public sector could play. He points to institutions such as insurance companies which he says are “probably better at assessing business risk and making commercial decisions about lending”.
Policymakers face an uphill battle to close the gap. A taskforce on non-bank lending chaired by Tim Breedon, chief executive of Legal & General, last year estimated the business finance gap over the next five years was between £84bn and £191bn.
In the meantime, FDs need to make their own life easier, according to Nicola Horton. “You have to prepare your business case way more than you would have done in the past,” she says, and adds that the days where loans could be finalised with a “friendly chat” with the bank manager are over: “That’s not how it works any more.”
Horton says her clients are increasingly looking to alternatives such as peer-to-peer lending and retail equity and bond markets.
Meanwhile, Reid says the current debate is hard for businesses to read: “On the one hand, you have all this discussion about punishing malpractices and looking for heads to roll but, on the other, there’s increasing evidence of forbearance by regulators.”
He cites the recent decision by European regulators to take a softer stance under the Capital Requirements Directive, known as CRDIV, on banks that lend to SMEs. “And the whole FLS scheme is an easing of credit conditions,” he says.
There is clearly a tension between the goals of making banks safer and ensuring they lend to growing companies. They are laudable but hard to achieve simultaneously.
“We are all working our way through this,” says Reid, adding that every cloud has a silver lining. “2013 will probably turn out to be the year in which the bulk of the burden of rebuilding banks’ capital will be done.” ?
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