Tim Kirk, Partner and Head of Financial Services, BDO LLP
Any calls to reduce the capital requirements so that banks can substantially increase lending to businesses must not risk undermining attempts to restore long-term stability to the banking sector.
In the fine balancing act to restore growth to the UK economy, banks have a key role to play. But regulators and the Government need to address both supply and demand issues for bank lending, including ensuring banks are financially sound going into turbulent economic times, encouraging new entrants – with scale – to the banking sector, and encouraging SMEs through business friendly tax and regulatory structures.
As the UK sits on the edge of a double dip recession and second credit crunch, Sir Mervyn King, Governor of the Bank of England has confessed that “no one can know what precisely the outcome will be. Who knows what’s going to happen tomorrow, let alone next month. ”
One thing becoming clear, though, is that the Chancellor, George Osbourne, has stopped talking about the “expansionary fiscal contraction” – growth being spurred due to the confidence generated by a fiscal tightening. Instead, confidence is decreasing. Goldman Sachs has estimated that growth will have been reduced by around 0.7% of GDP due to the fiscal tightening programme and the Bank of England is forecasting no growth until well into 2012, with the 2012 forecast downgraded from GDP growth of 2.2% to a miserly 0.9%.
What we now need most are steps that will restore confidence and promote growth. This this has prompted another senior Bank of England figure to call for a loosening of banks’ capital buffers to ease lending to small businesses.
With the volume of small business lending falling, Andrew Haldane, Executive Director of Financial Stability at the Bank of England, has suggested that rules should be relaxed so that banks can recalibrate their risk weightings – and how much capital is required to back a loan – to help boost economic growth. In Haldane’s view, greater account should be taken of the economic benefits that small businesses can provide in assessing risk and return. “At present, they are calibrated to the risk to a bank. In future, they need to reflect returns to society.”
There is much merit in the Haldane’s argument, especially his call for risk weightings to be dynamic to reflect the real economy and to provide more discretion to local regulators to fine-tune requirements within global parameters set by the Basel Committee on Financial Supervision. And the argument that there is no point building up capital buffers if you are not prepared to use them has an inherent logic.
But, given the current economic uncertainty and perceived weakness of the banking sector, it is taking a risk to suggest that the regulatory infrastructure around capital adequacy is eased at this juncture.
The European Banking Authority, which oversees regulation across the EU, recently identified a Euro106bn capital shortfall across 70 banks. And as we have seen before, even banks that are seen as secure by their regulator are not always quite so safe: 86 days after getting a clean bill of health as part of its stress tests, Belgium bank Dexia took a government bail-out to avoid collapse.
Nonetheless, even if capital requirements are higher than may ultimately be necessary, is this the time to start adjusting them and will that have a material impact on lending to small businesses?
Given we haven’t yet quantified the debt problems of the Eurozone, it is taking a substantial risk to suggest that this is the time to reduce banks’ capital requirements. The higher capital buffers banks are being asked to hold should be seen as protection against future debt default, made increasingly more likely as Europe drives towards economic turmoil. While UK banks have reduced their exposure to European sovereign debt, the contagion risk from further strife in Europe remains high.
It is also not clear that the solution put forward by Haldane addresses the root causes of a lack of growth in the UK. Our growth is poor by comparison to our European neighbours – the 17 members of the Eurozone, as a group, have grown by 1.4% in the past 12 months (even including the Club Med countries and Ireland) while in that period the UK has managed to grow by only 0.5% – but it is hard to build a case that this is attributable to a lack of bank lending available to SMEs when all countries are facing the same capital constraints and liquidity issues.
The British Bankers Association (BBA) shines some light in this debate with its independent research highlighting that the majority of businesses seeking loans or overdrafts had their applications approved and that:
- About 14% of SMEs sought new/renewed finance in the past twelve months.
- Only around 2% of all SMEs were turned down for an overdraft and even less (1%) for a loan.
- Those businesses which found difficulties in getting credit were newer, smaller businesses with higher external risk ratings or no track record of successful borrowing.
So, a key issue reducing the amount of lending seems to be a lack of demand for loans and more prudent lending policies. It would seem that most SMEs who ask are able to get the credit they need from their bank, but, given the current economic climate and risk of a double-dip recession, the majority are unwilling to take on additional risk and have preferred to operate without seeking external finance.
But, while the banks can point to evidence to vindicate their position, small business leaders clearly believe lack of credit – and its cost – is a major problem.
However, rather than current banks not being willing enough to lend, the real constraint on the supply side is in relation to competition. Rather than asking each bank to lend more, we need to consider how to have more banks lending. The banks from the US, Europe and the rest of the world that used to populate London have largely pulled out of the UK. It’s calculated that even if our banks returned to the levels of lending pre-crisis, there would still be a shortage of credit.
Unfortunately, the new entrants such as Metro Bank, while providing much welcome innovation in customer service, are small in relation to those who have withdrawn from the UK market. Even the enlarged Virgin Money, with Northern Rock now included, will make little impact against the banks that have left the UK and will be a minnow compared to the dominant Lloyds, Nat West/ RBS, Barclays, HSBC and Santander.
In the longer-term, Virgin Money, NBNK and Tesco Bank are the probably most likely to replace at least a significant part of the lending capacity withdrawn from the UK market. But this will take time and even then they will be constrained by tight capital requirements.
In the short-term at least, it’s unlikely that the FSA will be in a position to flex the relevant risk weightings that Haldane refers to. Any flexibility of the risk weightings could be seen to undermine the European Union’s approach to wider financial stability. The chairman of the Basel Committee on Banking Supervision, Stefan Ingves, warns that “the financial crisis resulted in a bold response by the committee. However, these efforts will have been wasted if they are not globally implemented on a consistent and timely basis.”
And while previous agreements have not always been honoured, the committee is promising that this time the focus will be on implementation, with ‘global review teams’ checking on regulators around the world to ensure that Basel III reforms are followed. This will include how banks measure asset risk, amid growing concern that banks are tinkering with their internal models to reduce perceived risk and the amount of capital they need to hold.
Banks can, and should, focus on both stability and economic growth, but it will take time. Only through strengthening their own capital positions, will they be more able to take the additional risks needed to support the small business sector and be in a stronger position in the event of future economic crises.
In the longer term, Haldane is right to consider how capital requirements can be flexible enough to meet macro-economic needs, and to allow local regulators to make adjustments within strict globally agreed parameters.
But, with the Eurozone crisis threatening economic stability and inter-bank lending dries up within Europe, the requirement to maintain a sound banking system means it is a risk too high in the short-term to suggest banks may reduce their capital. As Ingves warns, “the corrosive forces of short memories and supervisory complacency must be avoided.”
If the Government and Bank of England are really looking for a way to unlock growth across the economy, attention also needs to turn to the demand side of the equation and towards issues that may not be gaining sufficient speed of response from policymakers: the impact of tax and regulation on new and growing enterprises.
Figures from the World Economic Forum show that the UK now ranks 94th out of 142 countries for the damaging effects of tax and 83rd for competitiveness of government regulation. Neither Osbourne’s cuts to the spending by government departments – about 3%, versus the 2.2% they would have been under Gordon Brown – nor more pressure on banks to lend will have the same impact as freeing business, entrepreneurs and wealth creators from the regulation and high tax that can shackle enterprise.
By all means should the government and Bank of England find ways to ensure capital requirements don’t stifle growth, but first let’s create the right tax and regulatory frameworks to encourage business to take risk and allow growth to flourish.