October 2013 newsletter – Restoring the bank lending channel of monetary transmission

This paper reports on a 'round table' panel discussion that that took place at the 30th International Symposium on Money, Banking and Finance, at the University of Nantes, 27-8 June 2013. The conference was organised by the European Research Group GdRE (Groupement de Récherche European) on Money, Banking and Finance which is part of the CNRS (Centre Nationale de la Récherche Scientific) in France. The round table discussion was organised by the UKs ESRC (European and Social Research Council) and Bank of England sponsored MMFRG (Money, Macro, Finance Research Group).1 This article is based on a longer report by Andy Mullineux.2

The conditions underlying the credit crunch of the last five years are now well-known. So too are the measures taken by central banks to mitigate the effects. These include holding short-term interest rates at unprecedentedly low levels; introducing unconventional measures such as ‘quantitative-’ and ‘credit-easing’ in order to increase liquidity and hold down longer-term interest rates.

However, these central bank initiatives have sometimes the appearance of ‘pushing on a string’. To bring about a significant stimulus to the economy, banks must start lending the idle cash and firms hoarding cash must start investing it. Improved ‘animal spirits’ will eventually, it is hoped, bring this about, and then the central banks will face the problem of extracting excess liquidity before asset bubbles and price inflation accelerate. The observation that, despite the best efforts of the national central banks (including the European Central Bank, ECB) to hold down interest rates and pump liquidity into their economies, bank lending remains restrained, prompted the choice of the title for Panel discussion. Essentially, the question was: under what conditions will the banking system resume ‘normal' lending, particularly to SMEs?

The panel discussion
Leonardo Gambacorta pointed out that the bank lending channel had changed a great deal over the last 20 or 30 years (see also: Gambacorta and Marques, 2011) and also emphasised how the crisis had reminded us of the importance of liquidity, a theme picked up by Douglas Diamond in his keynote lecture at the conference.

Leonardo highlighted the major differences between cycles with and without financial crises and illustrated how monetary policy is less effective in a financial crisis. This explains the deployment of unconventional monetary policies, such as quantitative easing, in response to the globeal financial crisis (GFC).

Whilst deleveraging in a ‘normal’ downturn is of little importance, a financial crisis is preceded by over-leveraging, and thus substantial deleveraging is required after the crisis (Bech, Gambacorta and Kharroubi, 2012). In this situation over indebted economic agents may not consume more in response to lower interest payments, but rather seek to repay debt. Moreover a struggling banking system may be not to pass on lower rates to the rest of the economy because of the need to restore appropriate risk margins and recapitalise from earnings retained from interest margins. Leonardo argued that deleveraging achieved during a downturn following a financial crisis is ultimately beneficial for the subsequent recovery. Whilst in normal business cycles, in which debt levels are not excessive, any increase in leverage would help to finance profitable investment projects and consumption; during a financial crisis, in contrast, such benefits are more than offset by the costs of failing to repair balance sheets. In this case, he postulates, sectoral credit policies that aim to reallocate resources towards sectors that are most productive, and have not been drugged by the crisis, could be very helpful.

Leonardo observed that, both as a legacy of the pre-crisis financial boom, and as a result of accommodative monetary policies in response to the crisis, the level of private non-financial sector debt is historically high globally . Despite some progress in reducing private sector debt, particularly in advanced economies that experienced a significant accumulation of debt during the boom, balance sheet repair remains incomplete and is acting as a drag on economic growth. Meanwhile, increased leverage in other advanced economies and in emerging market economies (EMEs), suggests the potential build-up of vulnerabilities in some regions. Debt levels in ‘Emerging Asia’ are, for example, trending toward the peak reached before the Asian financial crisis of the late 1990s. Moreover, while debt levels are serviceable at current very low interest rates, what will happen when interest rates rise to positive real rates? To service the debt at such levels, Leonardo concluded, faster GDP growth are required to reduce debt to GDP ratios.

Next, Paul Mizen illustrated the rationing of this supply of bank lending and the rise in the cost of bank lending in the UK. Because banks had increased their ‘risk spreads’ following the crisis, lending rates to SMEs remained significantly above zero. Supply and demand factors were at work and it was difficult to disentangle them. SMEs are the most ‘bank dependent’ firms in the UK and pose the highest credit risk for lenders as they have little equity to absorb losses and the value of their collateral (often the family home) has become less reliable.

As regards restoring bank lending, Paul asked, ‘to what?’; noting that banks over lent before the crisis. Relaxation of credit standards had led them to under-price credit risks. Nevertheless, there was an acute need to reduce the currently excessive credit rationing in the UK.

The UK government responded to the Credit Crunch by reviewing its Small Finance Loan Guarantee Scheme (Cowling, date) and replacing it with the Enterprise Guarantee Scheme. HM Treasury and the Bank of England also tried to stimulate bank lending to SMEs, first through ‘Project Merlin’ and subsequently via its current ‘Funding for Lending Scheme’ (FFLS); which provides cheap funding for banks engaging in mortgage and SME lending. The banks have shown much more interest in using the funding to advance mortgages, than SME loans.

Clas Wihlborg, the third speaker, emphasised that the Credit Crunch was particularly prevalent in the periphery countries of the Eurozone as a result of the ‘Doom Loop’ linking the sovereign debt crises to the banking crises; which had been the topic of the Panel session at the 2012 conference in Nantes.

The pre-crisis single Eurozone credit market had fragmented, so that German SMEs could borrow much more cheaply than Spanish SMEs. To get banks to lend more with lower risk premiums, it was first necessary to restore the health of banks. The long term solution might be a Banking Union, although Clas Wihlborg’s view, shared in particular by one of last year’s panellists, Jean-Paul Polin (University of Orleans), was that the Banking Union project was too grandiose and required progress towar@s fiscal and political unions that would take decades, rather than a few years, to achieve.

In the short term, the problem of the ‘Zombie banks’, that are technically insolvent, but propped up by governments, needed to be resolved; even if common bank regulation and supervision under the ECB can be operationalized. Loss recognition was essential and bad debt problems had to be resolved; echoing Charles Calomiris (Columbia University) comments at last year’s Panel (Mullineux, 2013a and 2013b). Bank losses should be written down whilst establishing ‘depositor preference’; assuring depositors have seniority as creditors. This must be agreed internationally.

Once the debts of bank creditors are written down in proportion to their seniority and residual bank losses have been realised, the banks would need to be recapitalised. Unfortunately, the banks most in need of recapitalisation often have the highest levels of their national government debt. Forced transfers between Eurozone creditor and debtor countries, and their banks, seem inevitable (after the September 2013 German elections!). Charles Calomiris also made this point last year.

Clas Wihlborg had some additional observations regarding the proposed Banking Union. Separate supervision of large and small banks might be sensible, but banking market competition distorting national supervisory favouritism and regulatory capture should be avoided. Regulatory capture of the ECB by big banks should also be guarded against.

Harmonising regulatory procedures might prove to be easier than supervisory practices and both needed to be embedded in legal systems. The logic of the EU’s Liikanen Report (EC, date) and the UK’s Independent Commission on Banking report (ICB, date) and recent US policy initiatives for the restructuring of banks into separately capitalised subsidiaries, at home and abroad, is that separately capitalised subsidiaries can be allowed to fail in a banking resolution process. Separation of deposit taking from investment banking and trading activity (the ‘Volcker Rule’ in the US and the ICB 'ring-fencing' and Liikanen proposals) helps safeguard deposit protection schemes, which even if funded and underpinned by depositor preference, are ultimately underwritten by taxpayers.

Under the proposed European Banking Union, there would be a pooling of national deposit insurance schemes, leading German taxpayers potentially to pay out to depositors of banks in other countries; a de facto fiscal transfer union. Strong prudential bank regulation and supervision is thus remains essential to protect depositors and taxpayers from abuse by risk prone banks (and their shareholders).

Clas Wihlborg is an advocate of regulatory competition, believing it can lead to a ‘race to the top’ rather than a ‘race to the bottom’, if implicit taxpayer guarantees, especially of the larger (‘too big to fail’) banks, can be eliminated using credible resolution regimes incorporating ‘bail-ins’ of creditors and depositor preference.

Richard Werner, the last panellist to speak, argued that a separately identifiable bank lending channel of the monetary transmission mechanism, in response to a change in interest rates, was a misconception because monetary policy always works directly through the quantity of bank lending, there is no separate interest rate channel.

Banks are special because they create the vast bulk of the money supply (97 per cent) by advancing loans which create deposits. Hence regulatory liquidity requirements have an important role to play, as Leonardo Gambacortahad argued, and Bob Diamond had emphasised in his keynote speech. Richard also favoured the simpler and more direct ‘credit guidance’ procedures because they are, in his view, the only bank credit regulatory measures witha consistent track record of achieving the set objectives; such as avoiding asset price bubbles and financial crises.

Richard’s proposal for restoring bank lending is to clear non-performing loans from bank balance sheets, at zero cost to tax payers and society at large, through central bank purchases of impaired bank loans at face value. This would not amount to ‘printing money’, he argues, since through this book keeping exercise the central bank is not injecting any money into the economy (defined as the bulk of the economy that cannot create money). Major central banks have, in Japan for example, have successfully implemented this policy before (Werner, 2012). Banks should then be encouraged to lend their excess liquid reserves to the national government under an ‘Enhanced Debt Management Scheme’, whereby the government stops issuing bonds and instead covers its public sector borrowing requirements by entering into loan contracts with banks. This would increase bank credit creation and hence stimulate new economic transactions without crowding out others, adding to the money supply and boosting nominal growth, and hence employment. He believed that this was an attractive proposition for countries such as Spain and Ireland.

Richard's basic point is that bank lending is beneficial to growth as long as the borrowing is put to productive use; and as long as there are borrowers willing and able to do so, bank lending for GDP enhancing transactions should be maximised and the central banks should supply the necessary liquidity cheaply.

In such a world, the demand for credit, or rather the supply of potentially productive investment opportunities, is a potential constraint on the ability of banks to expand the credit supply productively. Nevertheless, there is a strong Keynesian case for the government acting as ‘borrower of last resort’ when bank credit is contracting, as in many Eurozone countries currently. Richard’s ‘Quantity Theory of Credit’ (Werner, 2013), however, envisages an endless stream of potentially productive investments as he argues that human ingenuity has always delivered new productivity-enhancing technologies and innovations.

Discussion and conclusions
The discussion following the presentations included responses by the presenters to the comments of the others and comments and questions from the audience.

Incentive compatible solutions, ideally in the form of contractual obligations, were necessary to stop ‘risk shifting’. ‘Market capital’ in form of the hybrid debt/equity instruments and contingent convertible (‘co-co’) bonds was advocated.

There was discussion of the advisability of the structural separation of retail, trading and investment banking activities, given that, if there were significant economies of scale and scope, it might introduce inefficiencies. It was observed that after all, the subprime crisis was a commercial banking problem aggravated by securitisation and derivatives, not a problem with investment banks per se.

There was agreement with Andrew Haldane’s view that Basel II and III relied on over complex risk weighting systems based on the big banks’ own models and that Basel III was already being ‘gamed’ by the banks. Leverage ratios are therefore needed as a backstop.

Concern was expressed that the addition of supervisory powers to monetary policy responsibility at the ECB will give it too much power. Similar concerns have been raised about the accumulation of power at the Bank of England. Against this, the US Federal Reserve has considerable powers, and the GFC had made clear that macro prudential policy involves interaction between prudential regulation and supervision and monetary policy.

One member of the audience, Dominique Lacoue-Labarthe (University of Bordeaux IV), informed us that an EU agreement had been reached overnight on credit burden sharing using creditor ‘bail-ins’ in cases of insolvent banks; in light of the Cyprus experience and the preceding ‘bail-out’ (nationalisation) of the fourth largest Dutch bank, SNS Reaal, in February 2013, by the government of the Netherlands.

The question raised by the Panel was: what does 'restoring' the bank lending channel mean? It was clear that the panellists did not envisage restoring bank lending to pre-crisis levels, because the run up to the crisis had entailed relaxation of credit standards in pursuit of historically high returns on equity by banks, egged on by their shareholders. As the credit cycle had reached its peak, leveraging reached record levels and capital to asset ratios had declined. A tax system that allowed tax deductibility of interest payments on debt, especially by banks at the fulcrum of credit creation, had incentivised this.

The ‘new normal’, to which currently restrained lending should be raised, would be set in the context of risk based lending underpinned by adequate capital ratios. The debates about: how adequate is adequate, and what is the role of risk weighting based on banks own models are on-going. Banks should also make 'forward looking' provisions against bad and doubtful debts, accounting standards permitting.

It was also noted that loan guarantees are widely used to reduce credit rationing; particularly as regards SME lending; for which credit rationing is judged to be more acute due to greater information asymmetry, lack of collateral, and the fixed cost of lending problem.

A number of countries, including the USA, Switzerland and the Netherlands allow income tax deductibility of mortgage interest payments, and the US has made extensive use of mortgage (home loan) guarantees in the post war period.

The UK government revised its loan guarantee scheme in response to the Credit Crunch and has introduced a ‘Funding for Lending’ scheme to provide banks with access to cheap funding for SME and mortgage lending. It has proved successful in stimulating mortgage lending, but not SME lending and so a state backed Business Bank is being created. The UK government also introduced a ‘Help to Buy Scheme’ to help first time buyers with small deposits to buy new homes, and, in mid-2013, it extended the scheme to provide US-style guarantees for mortgage lending to people seeking to buy older properties, but who can only afford small deposits. The IMF has since warned that the UK government risks stoking up a new UK housing bubble by stimulating sub-prime lending!

The supply of funding for non-productive, speculative, asset price inflating and bubble creating 'investments', and purely financial trading, should however be curtailed; as part of macro-prudential policy, perhaps. A change in Keynesian ‘animal spirits’, combined with increased public sector led, perhaps via European Investment Bank, infrastructural project lending, can bring forth loans in response to a flow of good, productive, project proposals from SMEs. The on-going process of disintermediation will lead larger firms increasingly to fund themselves ‘directly’ via the capital markets, as in the US. Smaller firms will increasingly find alternative sources of funding from the true new challengers in banking, over the internet.

Notes and references:

1. Particular thanks are due to Christian Aubin of CRIEF (Centre de Récherche sur L'Integration Economique et Financière) who led the conference organising committee along with Raphaelle Bellando and Jean-Bernard Chatelain.. It has now become a tradition for the MMFRG to organise an event at the GdRE’s annual international conference, and vice versa.

2. University of Bournemouth. (amullineux@bournemouth.ac.uk)

Gambacorta, L. and Marques, D. (2011) 'The Bank Lending Channel: Lessons from the Crisis', Economic Policy, April 2011 (also published as BIS WP 345/2011, Bank of International Settlements, Basel).

Mullineux, A.W. (2013a), ‘Escaping the Eurozone's Doom Loop’. Revue Francaise d'Economie, January.

Mullineux, A.W. (2013b), The Eurozone Crisis: Lessons from Sub-Saharan Africa. Report for the African Development Bank, April 2013

Werner, R.A. (2012). 'Towards a New Research Programme on 'Banking and the Economy': Implications of the Quantity Theory of Credit for the Prevention and Resolution of Banking and Debt Crises', International Review of Financial Analysis, 25, 94-105.

Werner, R. (2013), 'Towards a More Stable and Sustainable Financial Architecture: A Discussion and Application of the Quantity Theory of Credit', Kredit and Kapital, 46(3), 353-389.