A Theory on UK Bank Lending

Fisher Investments  |

For the past few years, one question has puzzled UK economic policymakers: Why aren't banks lending more? Or specifically, why haven’t the Bank of England’s (BOE) Asset Purchase Programme (quantitative easing), Project Merlin or the National Loan Guarantee Scheme significantly increased the amount banks lend to households and small businesses?

I've long thought the primary culprit is regulatory uncertainty. Since the Independent Commission on Banking (ICB) was tasked with recommending how to overhaul UK banking regulations to (supposedly) prevent a repeat of 2007 and 2008’s troubles, it’s seemed likely banks would be forced to increase their capital buffers and alter their business models within the next few years. When banks see these risks on the horizon, but there’s no clarity on the actual policies, they tend to adopt a “wait and see” attitude. In the UK in recent years, this mentality likely drove banks' hesitance to lend—if banks expect to need to raise significant capital to offset their balance sheet risks in the future, they have incentive not to add risk in the present. Hence, banks have lent only to the most creditworthy borrowers.

As expected, the ICB ultimately recommended a strict regulatory scheme with capital requirements higher than the international standards included in the Basel III banking agreement. However, when Chancellor George Osborne outlined the legislation based on the ICB's recommendation, he loosened the capital requirements, which will be more or less in line with Basel III—a reprieve for the banks.

Around the same time, the Bank of England and Treasury partnered on the Funding for Lending and UK Guarantees programs, through which the Treasury will underwrite over £100 billion in lending to households, small businesses and private construction firms. With some of the regulatory clouds beginning to clear, it seemed possible these programs could impact lending more than the government’s previous attempts. So far, there’s been some success: Household lending has increased since Funding for Lending launched. (UK Guarantees, targeted at construction firms, has yet to kick in.)

Small business lending hasn't improved though, which prompted Business Secretary Vince Cable to announce the creation of a state-backed business (or development) bank this week. Similar to development banks in the US and Germany, this institution will act as a wholesale lender, providing loans either through “challenger banks” (the new, smaller High Street banks that aim to challenge the Big Five’s dominance) or directly to businesses through a sort of peer-to-peer financing model. The goal is to issue £10 billion in new loans to small businesses over the next few years—a 20% increase in current outstanding small-business loans.

While businesses should benefit from this new mechanism, it doesn't fix the underlying problem of regulatory uncertainty, which still appears to be stymieing lending. And after reading minutes from the recent meetings of the BOE’s Financial Policy Committee (FPC), I've developed a theory on what, specifically, is at play.

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The FPC, for those not familiar, is the body that will soon replace Financial Services Authority as the UK’s banking supervisor. The scope of its powers is still being debated by BOE and Treasury officials, but they’re considering granting the power to order banks to increase capital buffers above and beyond normal requirements. The FPC’s meeting minutes strongly hint at what actions the committee might demand once it’s in charge, and if the banks read this report the same way I do, they probably won’t turn on the lending spigots any time soon.

The FPC’s recommendations, as they put it, are essentially twofold: mark assets on balance sheets “more prudently” and raise capital “above that implied by the official transition path to Basel III standards.”

On its own, the capital raise would be burdensome enough. Though the FPC encouraged banks to do it in a manner that wouldn't constrain lending: issuing equity. But banks may not be keen on this since issuing new shares dilutes the value of existing shares, essentially penalizing current shareholders. Banks will issue new shares when they need to, but simply lending less is likely a more efficient way (as far as they’re concerned) to increase capital buffers—and since the BOE pays 0.5% on all reserves held there, banks have incentive to keep funds on the sidelines.

But balance sheet valuation compounds the problem. Here’s the bank’s full statement on the matter:

The Committee believed that capital needs could be better clarified, and the task of attracting fresh capital facilitated, if steps were taken to reduce uncertainty about valuations of on-balance sheet assets. One of the factors likely to be depressing price-to-book ratios was market doubts about current valuations of bank assets. The FSA was continuing to encourage banks to improve provisioning practices and to mark assets on their balance sheets more prudently, working within the constraints of existing accounting standards.

The FPC doesn't think markets doubt the valuations because they’re too low—rather, the FPC likely thinks banks have overvalued assets. Thus, we can translate “mark assets on their balance sheets more prudently” as “write down assets to market value.” Or, putting it another way, it seems the FPC would have banks adopt methods similar to mark-to-market accounting—a principle misapplied under FAS 157, the fair-value accounting rule at the heart of the US’s financial crisis in 2008.

Now, this doesn't mean UK regulators are inviting a financial panic. As long as they provide appropriate guidance, as US regulators eventually did when they adjusted how the rule should apply to illiquid, hard-to-value assets, there needn't be a vicious cycle of writedowns and forced capital raises. At the moment it’s not clear whether potential valuation rules would apply to illiquid as well as liquid balance sheet assets—added uncertainty that could further complicate matters.

And accounting uncertainty means UK banks currently have much more incentive to deleverage than they do to lend—getting balance sheets in order is clearly regulators’ first priority, despite the FPC minutes’ myriad references to supporting “additional lending.” As long as this mentality remains in place, it’s difficult to imagine credit picking up significantly. And without money flowing more quickly to the broader economy, it’s difficult to imagine UK growth rebounding robustly in the near future, no matter how strong other underlying fundamentals are.

Hence, in my view, the best economic stimulus for the UK right now would be for policymakers to ease banks’ regulatory burdens. Yes, some regulation is necessary, but not to the extent that it impedes banks’ normal functioning. Clarifying the FPC’s forthcoming powers, easing accounting and capital requirements and giving banks sufficient flexibility to structure their business in a profitable manner would enable banks to lend much more freely. Businesses and individuals would then benefit even more from Funding for Lending and UK Guarantees, and overall economic activity would get a huge boost from all the newly un-hoarded capital.

Will the Chancellor see this the same way?

*This article constitutes the views, opinions, analyses and commentary of the author as of October 2012 and should not be regarded as personal investment advice. No assurances are made the author will continue to hold these views, which may change at any time without notice. In addition, no assurances are made regarding the accuracy of any forecast made herein. Past performance is no guarantee of future results. A risk of loss is involved with investments in stock markets.

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