Conjuring a recovery in lending

The Bank of England has become more optimistic about both recovery prospects and inflation in its last set of quarterly forecasts. The report, published on May 15,  shows inflation falling to 2 percent by mid 2015, on the basis that the main bank interest rate remains at its current rock bottom of 0.5 percent into 2016. In the medium term, “external price pressures fade and a gradual revival in productivity growth curbs increases in domestic costs,” the BoE believes.

But on the lending side, the picture looks as grim as ever. The Bank’s Monetary Policy Committee (MPC) said net lending has “remained weak, particularly for businesses”.

The MPC warned that some banks would need to improve their capital positions in order to ensure sufficient capacity to absorb losses and sustain lending. For these banks, meeting the target capital ratio set by the committee in 2013 would involve making up an aggregate capital shortfall of about £25 billion.

One lever the BoE has been pulling in a bid to increase lending is the Funding for Lending Scheme (FLS). The scheme gives British banks access to cheaper funding in direct proportion to the loans they advance in the economy. Yet observers are united in their scepticism about the scheme’s efficacy.

Dr Philip Booth, professor of insurance and risk management at Cass Business School, believes the ineptitude of government schemes like the FLS is directly to blame for the lack of lending to risky SMEs.

“We have on the one hand a government which is binding banks up in red tape, demonising the banking sector and imposing unreasonable capital requirements on banks so that they never again become a burden on the tax payer,” Booth argues. “On the other hand we have a government that is scratching its head, wondering why there are no new entrants into the market and why the banks will not lend.”

At a recent conference based around the FLS in Westminster, representatives of the Bank of England included Rohum Churm, a senior manager in charge of its Monetary Transmission Mechanism unit. He told delegates that the FLS had been launched as a short-term measure to alleviate tight credit conditions caused by elevated funding costs.

Churm admitted that there had been considerable delays in implementing the scheme and then seeing it bear fruit. “The FLS is not a panacea for weak lending growth,” he said.

In other words, the Bank of England can’t force banks to actually lend. “FLS is not a magic wand,” warned BoE chief economist Spencer Dale at the same conference. “At the margin, it is a useful thing which will push us in the right direction, but it has to be used alongside a wide range of other factors which are going on.”

Irene Graham, managing director at the British Bankers’ Association, argued that in order for the scheme to work, it must be for the long-term. “It is a price mechanism; it does not address matters such as affordability or security – those are different types of interventions,” she added.

Shiona Davies, director at consultancy BDRC Continental, reckoned only 40 percent of UK SMEs use external finance. “72 percent of all SMEs say the funding for lending scheme makes no difference,” she revealed. Some market participants attribute the collapse of the bank lending market to a plunge in appetite for credit from SMEs.

“Larger companies are sitting with £700 billion of cash on their balance sheets, which they are not investing,” shadow business minister Lord Mitchell said. “There is inertia (whether you are an SME or a large company) because no one wants to invest – they simply don’t see growth and they haven’t got confidence in markets.”

Also, the FLS is not initially available to all banks.

“In order to participate, new banks need to build up an amount of lending, which is eligible to form the necessary collateral – further, bank first needs to gain access to the Bank of England’s discount window facility programme which does take time,” explains Gary Wilkinson, chief executive officer of Cambridge & Counties Bank (CCB).

CCB is currently undergoing that process. “Even if we are accepted, we will not be able to participate until later this year,” he says.

For banks like CCB who do not have access to wholesale funding, there are further complications when taking on board long-term implications of the scheme. “You have to be very careful that when you come to the end of the funding period, you don’t fall over a cliff,” Wilkinson warns.

He says there is no exemption from regulation for being a small bank. “You have to apply the same rules, and the same requirements as bigger banks, and that is a cost that should never be underestimated,” adds Wilkinson.

He notes that this has become a barrier to entry for “new banks” entering the market. “There are many cases in which people have looked into setting up a new bank but very few have got across the line.”

He argues that regulators are realising that the increase in scrutiny actually increases barriers to entry.

There are various factors which are going to lead to innovation transcending the existing banking sector, according to Cass Business School’s Booth.

It is unclear what exactly Booth is pointing to – but an unregulated banking stream can only mean one thing: alternative sources of funding. And therein lies the opportunity for debt fund managers.

“What the government seems to be saying with its current policies is, we never want a bank to fail and the taxpayer to bear the costs, but we are happy for the Government to take on these risks directly.”

 He argues that this is inherently incoherent.  “In ensuring that we have a banking system where there is never failure, we are essentially ensuring that we have a banking system which will remain obligopolised forever,” he added.

He believes that the first issue is the fact that the existing banking sector is ridden with cross subsidies that will always make an industry ripe for attach from innovation. Second, if the kind of service banks provide can be provided without all that regulation through innovation “Santander will look as redundant as my landline at home in 30 years time.”