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.


Ralph Musgrave said...

The twits at the Harvard department of economics (Rogoff and Reinhart in particular) won’t like that article. No – on second thoughts, they won’t even understand it..:-)

jake said...

So the cost of credit is how much the banks think they can squeeze out of the real economy.

why not have a national bank which provides loans for small businesses with only a notional fee on top of a zero interest loans.Surely we should have a financial system that facilitates the market economy not extract from it.

Neil Wilson said...

The cost of anything is what people think they can squeeze out of others.

The whole point of competition and anti-trust/competition commission regulations is to bring that cost down by forcing entities to compete for business.

The charge a bank makes for lending is its charge for assessing whether a borrower is creditworthy. You would have the same charge whether there is a public or private system doing that work.

jake said...

a charge or fee to cover basic costs would be fine.But that is a one-off payment.
Onerous interest rates which drain Businesses and households by imposing on their cost structure seems like an uneccessarily expenisive way to underwrite the private sector.

A public bank could provide zero interest loans and even subsidise the cost of assesing whether a borrower is creditworthy.

That would make the cost of doing doing business lower and leave more income for profits and wages,or consumption for households.

A public service, part of the societal infrastucture which keeps costs down ,like roads and bridges.

Neil Wilson said...

Interest is the amortised cost of underwriting the loan over time. Back when I did loan underwriting we would front load the charge onto the loan and then work out the payment over the term. The result was an interest rate.

The client could have paid the charge up front, but generally preferred to have it smoothed over time to match cash flows.

There is no theoretical difference between doing that in the private sector or the public sector. The cost still has to be paid by somebody.

The circulation isn't quite as neat as you make out. If we're running at full capacity then the cost of paying the loan assessor has to be paid from taxes on somebody.

Interest can be seen as a tax on profits to pay for a loan assessor to assess whether the project is worth the money. It would be the same however you organised the tax.

jake said...

We've already established that the cost of Underwriting loans is how much the banks think that they can get out of the borrower.

Considering that banks are effectively accountants who keep digital ledgers whom are then granted the power to create loans by their banking license.

It is therefore clear that the real cost of underwriting loans is effectively zero.

The loan principal can be amortised over time, but interest charges can make the total cost run into the order of several times the magnitude of the initial loan. Take for example household mortgages.

'If we're running at full capacity then the cost of paying the loan assessor has to be paid from taxes on somebody. '

But we are not. Why do taxes to the loan assessor have to be paid? The interest ends up as the banks' profit and bankers bonuses. No money is leaving the circuit.If taxes are for limiting spending power, they cannot be used to describe interest charges which transfer money from the productive economy (businesses and households) to banks.

' a tax on profits to pay for a loan assessor to assess whether the project is worth the money'

What an odd system. So if the project is useful and profitable it needs to be taxed? Even though the interest charges imposes costs on its cash flow. Which increase the likelihood that it fails? Which can sometimes plays into their hands; RBS kills off firms and acquires their assets.

In which case,if an approved project does fail, does all the interest already paid out to the banks get returned as the assessor clearly was inaccurate in his/her assessment on whether the project was ‘worth the money’.

I don’t see how a public option which provides zero interest loans to small businesses , reflecting the true cost of money(zero) would not be viable or overwhelmingly preferable.

Private Banks already provide low cost mortgages to their staff when it suits them.

‘There is no theoretical difference between doing that in the private sector or the public sector’

The difference is that the public sector would not be profit orientated and therefore could advance zero-interest loans for the public good and ecconomic development.

‘The cost still has to be paid by somebody’

Considering that the real production cost for a bank to advance a loan is zero.It seems unreasonable that the costs has to be paid.

Neil Wilson said...

I see you have a hobby horse and are unable to see the issues with that concept.

I somewhat tired of those sort of discussions.

Jake said...

For the record: Banks have to charge interest in order to create profit but also to have retained earnings that will form part of its buffer equity to meet its capital requirements and enable on going lending.

This is especially important as even a 10% drop in a banks assets can cause insolvency. Some interest has to be charged to protect banks from the damage that even just 1 of 10 defaults will have on it's balance sheet.