The way we view banks is conditioned by their key role in keeping the economic wheels turning. The unwillingness of banks to lend seems to go against the natural order, as if teachers were to stay at home on a school day. Even if we understand that banks are businesses, the extent to which traditional banking has had to adjust in order to remain commercially viable has largely remained unacknowledged. At the same time, it could be argued that the erosion in the profitability of conventional lending is at the root of the changes that over time has led to the current financial crisis.
For a long time lending was a simple business in which it was easy to make a profit. What changed? Originally local businesses, banks started to cast their net further afield to garner the deposits needed to finance their loans. Many overlapping branch networks were created. Both depositors and borrowers found they had a choice. Banks had to compete for their custom and the erosion of loan spreads was inevitable.
Economies of scale and continuous striving for efficiency gains provided a counterbalance on the cost side. For a period of time, computerisation was helpful in shoring up what was an increasingly unsustainable business model. Computerisation also ushered in automated credit risk assessment. But the absence of judgement in the lending process can be taken too far as demonstrated by the experience of 'self-certified' loans, the ultimate in minimising the cost of due diligence.
Economies of scale did not ease the cost of capital adequacy requirements. The amount of capital that had to be set aside to support the loans in the banks' books was fixed by regulation. This is where the selling of loans and securitisation came in. By selling individual loans or loan portfolios to third-party investors, banks could generate income from their loan origination capacity without incurring the regulatory capital costs that carrying loans in their balance sheet entailed.
The development of securitisation techniques and the emergence of large investors as buyers of loan assets created a new market. It was now possible for non-bank entities to originate loans and sell them on to investors without the assets passing through the formal banking sector. The business of the loan originators was simply to generate loans for selling on, not to hold them in their own books. In addition to the originators having no regulatory capital cost they also had little incentive to invest in risk analysis. This contributed to the losses, which set off the current crisis.
For commercial banks the increasingly uncertain long-term prospects of on-balance sheet lending translated into the need to shift focus to less capital-intensive activities. The expansion into investment banking that followed helped create the networks for the contagion from the US sub-prime market to spread across the continents.
By the time the Basel II accord on capital adequacy came into force at the beginning of 2007, corporate lending, as a freestanding business, had been insufficiently profitable for some two decades. The previous flat-rate capital requirement was replaced by a system, which distinguished between borrower categories according to their forecast loss rates. It could be argued that the new rules removed a cross-subsidy that had benefited smaller corporate borrowers at the expense of larger, better-established ones. In the present situation where the capital base of banks is under pressure, the proportionately high capital cost of lending to other than the most highly rated borrowers helps explain why small and medium sized companies are particularly badly affected by the unwillingness of banks to make loans.
Enormous amounts of public money have been committed to strengthening banks, but neither fresh capital nor the absorption of bad risks by governments has resulted in a return to normal business. It would have been reasonable to expect that having been helped back on their feet banks would resume usual day-to-day lending. The absence of a recovery is an indication of a more complex problem.
The emergency resources received by banks were undoubtedly critical in preventing the seizing up of the banking system, but they did not address the central question of the unsustainable business model of bank lending. Using subordinated loans at high interest rates as a means of providing public support gave taxpayers a stake in the revenues of the rescued businesses. The downside was that the cost of lending was probably increased.
More surprising is how ineffective the removal of risks from bank balance sheet has proved. That the freed up capital has not been allocated for new lending suggests that the banks are unwilling, or even unable, to expend capital on an activity, which does not produce an adequate return at a time when they are struggling to rebuild their capital base.
Until now, banks have been supported through blanket actions aiming to ensure that their minimum capital levels are met. There would be other, more focused options that could be considered, options that would make the business case in favour of lending to smaller companies economically compelling. One such possibility would be to strengthen lending returns by making the loan margins earned from specific groups of corporate borrowers tax-deductible for a period of time.
The cost effectiveness of such a measure could be expected to be high. It can easily be targeted to support lending to those borrower categories that have been particularly badly hit by the credit crunch. Moreover, the cost to the public purse would be counterbalanced by an upward move in the taxable profits of banks as the ongoing de-leveraging of the industry results in interest expenses.
An immediate upward effect on new lending could be achieved by topping up margins on loans to certain borrower categories. State aid rules would obviously come into play for such a scheme. If structured as aid to companies having difficulty raising bank loans, the individual subsidies would remain below the EU de minimis rules.
Looking forward, beyond the current crisis, it is difficult to imagine that the recovery of financial markets would signify the automatic emergence of a sustainable business model for corporate lending. Loans to all borrower categories need to generate revenues that are in line with the corresponding costs, including capital adequacy costs. At the same time, there is a limit to the lending costs, which can be passed on to borrowers without damaging their business. There is no obvious recipe for creating the right conditions, but a successful solution needs to take account of the factors that caused traditional corporate lending to lose its economic underpinning.
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