Monday, 20 January 2014

How banks work

It seems like we're into silly season again and banks are taking a kicking. "Why aren't they lending to small businesses" is the line and lots of homeopathic nonsense spouted to explain the situation.

It's very simple. Banks aren't lending to small businesses because the small business either isn't creditworthy according to the current underwriting criteria of the bank, or they refuse to pay the rate required by the bank.

And that's it.

No amount of whining by small businesses will change that situation. Stop expecting banks to provide the leverage ratio needed to make your sums add up, and go get some equity from Crowdcube, etc.

Similarly it is not the job of banks to lend, just because the government of the day refuses to spend.

Unnecessary private debt is dangerous to the long term health of the economy. Government ministers moaning about bank lending levels should take a long hard look in the mirror.

Banking is really a very simple business once you understand how it works at a fundamental level.

Banks will lend to any creditworthy borrower at the current price of money. 

What is a creditworthy borrower?

In a nutshell one that will pay the money borrowed back on time along with the interest.

It's very important to note that a bad debt to a bank is very costly. It can wipe out the return on tens if not hundreds of sound loans. That is why a good lender (i.e. one who intends to carry the loan on their books) is very careful to check out your credentials, and makes sure that you have good collateral for the loan.

Your collateral will be valued and subjected to what is known as a 'haircut' - the percentage ratio between the loan and the value of the collateral. The bigger the haircut, the more margin for error there is in the value of the collateral, the lower the loan cost will be and the more likely you are to be able to persuade the bank to lend.

Creditworthiness also changes over time depending upon the bank's current view on the economy. If the economy is stagnant, or the bank has got its fingers burned, then haircuts on collateral will be bigger and the income stream proposed to repay the loan will get greater scrutiny.

However if we're in boom times, then the bank may take the view that the collateral will be worth 20% more this time next year and therefore less of a haircut is required. The euphoria and desire to hit sales targets may mean that the income stream gets a cursory glance. The bank may have invented yet another way of getting the loan off its books and into the hands of some schmuck while banking a tidy commission.

So creditworthiness is a function of the state of affairs as well as the normal income and collateral assessment. And there isn't much you can do about that. The bank is, after all, trying to make a return on its capital in a world where the future is uncertain.

What is the current price of money?

This is the rate of interest that the bank will charge you for the proposed loan. There are lots of algorithms out there that banks use to calculate the rate to charge, and the loan sales team get an update of the latest loan criteria on a regular basis (usually via their computer systems these days).

The bank is, of course, trying to charge as much interest as it can get away with, to get the best net return for its employees and shareholders without killing the loan business stone dead. And it calculates this on the usual markup basis by estimating what the current costs are to keep its depositor base happy, to keep its capital bond investors happy as well as the regulators and the Group Risk Manager, then sticking a margin on top.

The loan types have various loadings that increase the price of the loan depending upon the nature of the loan - who it is being lent to, for how long and under what collateral arrangements. And that all depends how the Risk Managers see the different types of business. Is it seen as a better deal to lend on Bolivian Marching Powder Swaps, or shuttling Aluminium between warehouses, than to homeowners and small businesses?

What about those Capital and Reserve Ratios?

First point to note - they don't stop the banks lending. They may slow them down, or they may put the current price of money up, but that's about it. A hard constraint they are not.

To understand why you have to go back to the fundamentals. Loans create deposits. Deposits are used to buy capital in banks. Banks backfill any shortfalls in their ratios after the event.

A loan doesn't happen at an instant in time. It is a lengthy process (known as the 'sales pipeline'). When you get prospects in the door with a loan application, you can use statistics to estimate how many of those will actually end up drawing down a loan. That, along with lots of other data, is used by the Funding and Treasury departments in a bank to make sure all the numbers add up - and to constantly update the current price of money and feed it back to the sales teams.

So to get capital all a bank has to do is persuade enough depositors to swap some of their shiny new deposits for capital bonds and the regulator is a happy bunny again. The bank persuades people to buy capital bonds in the usual fashion - they pay a greater return on them. 

Similarly with the reserve ratio. The central bank has to make sure there are enough reserves in the system so that all the banks can hit their reserve ratios. If they don't then they lose control of their policy rate. The banks all then borrow and lend the reserves to each other until everybody conforms with what are arbitrary ratios. 

So what is the constraint on lending?

When the banks run out of creditworthy borrowers prepared to pay the current price of money.

What can be done then?

Make people more creditworthy or reduce the banks cost of money.

The UK help-to-buy scheme, for example, is essentially state provided mortgage indemnity insurance (due to - yes you guessed it - a market failure in the private insurance system), that reduces the lending risk of a section of the borrowing public. 

Funding for Lending is essentially a discount-window-you-aren't-embarrassed-to-use, that reduces the backfill costs for a bank - again for certain sections of the borrowing public.

You can try to attack the profit in banks, but that is more likely to affect what they consider creditworthy or just increase the cost of money. Real competition would likely require a state subsidised business development bank that had a near zero cost of capital.

Loans to the real economy are a really lousy way to make money when you have an in-house investment bank playing casino games every day. So all these schemes are really tinkering around the edges.  Better would be to ban lending for Bolivian Marching Powder Swaps and shuffling Aluminium between warehouses, and get the banks back to their basic functions. In other words, just make banks work properly.