Thursday, 13 September 2012

Credit Drives Growth (Not Interest Rates)

Thanks to IPPR and The Finance Innovation Lab for an invigorating seminar on bank reform this morning. I've noted some of the highlights below, but in summary: Chris Hewett gave a great overview of the range of proposals; Richard Werner debunked the myth that interest rates drive economic growth and explained why the Bank of England must guide bank credit away from speculation and into productive firms; and Baroness Susan Kramer explained the work being done in Parliament.

Chris's 'policy map' in particular is worth studying in particular (zoom out of his presentation to find it). It reveals the ideas that are merely 'a glint in the eye', those that are attracting support and those that are being fought over by stakeholders in a way that is likely to produce change in the near term. 

Richard showed that interest rates do not drive economic growth. Rather, they lag changes in economic growth by as much as a year. So it's a myth that lowering interest rates will increase economic growth, or that raising them will slow growth. Instead, the evidence proves that those in charge of monetary policy merely react to a slowing economy by lowering interest rates, and react to a growing economy by raising them. In other words, economic growth drives the setting of interest rates not the other way around (so GDP growth and interest rates are positively correlated, not negatively correlated as many people suggest).

So the current low Bank of England base rate merely reflects the current economic malaise, and changing it one way or the other won't drive economic growth (GDP). Mortgage rates are already much higher, anyway, and it may be doubted whether banks would pass on any rise to savers.

In fact, Richard observed that the only driver of growth in GDP is bank credit that is used for productive investment. Credit used for consumption merely raises inflation, and credit used to buy financial assets (which don't count towards GDP) merely drives up non-GDP asset prices.

Richard explained the importance of recognising that we derive 97% of our money supply from banks extending credit. They 'create' money every time they make a loan. But here's the killer: only about 10% of credit created by UK banks actually goes to productive firms. The rest of the credit created is used by investment banks, hedge funds, private equity and so on to speculate on non-GDP assets.

In addition, the risk-weightings under bank capital rules discourage banks from lending to small firms (as I've also mentioned before), effectively encouraging lending to fund speculative property deals - even though the overall risk profile of loans to small businesses is lower than lending for speculative purposes, and in spite of the fact that small firms represent 99.9% of all enterprises and are responsible for 60% of private sector employment).

Richard explained that Project Merlin and the more recent efforts by the Treasury to shame banks into lending to productive firms all fail because the banks can afford to ignore the Treasury. But central banks have been successful in guiding credit to the right sectors previously, because the banks rely on the faith of the central bank to stay in business. The IMF has previously discouraged the use of this so-called "window guidance" because it has been abused in certain countries (e.g. to aid speculators or political cronies). But a transparent programme could work. A longer term alternative is to create new banks that never lend for speculative purposes - in Germany, for example, 70% of banks (about 2000 of them) only lend locally. Spain had a similar system, but then required its local 'cajas' to lend nationally, with devastating effects.

Finally, Richard said that the banks' could lend more to productive firms and still meet their capital requirements. But they need to lower the bar to obtaining credit (which German banks have commonly done during a downturn) and to incentivise staff for making productive loans. Currently, it's easier for bankers to earn bonuses for supporting speculative activity.

Baroness Kramer explained that Parliament is focused on four main aspects of the financial crisis: the market failure to provide bank credit to productive small firms; capital/cost barriers to launching new banks; encouraging peer-to-peer finance platforms; and ensuring that the Financial Services Bill and the up-coming Banking Bill are fit for purpose. 

Susan said that the Joint Parliamentary Committee on Banking Standards should have the membership and resources to get to the root cause of market failures and make improvements to fix them. While the evidence of market failure is clear, more evidence of the underlying problems and causes is very much welcome (even after the deadlines for submissions have expired). There is a belief amongst some in the House of Lords that the same regulator should be responsible for addressing market failure, as well as enterprise risk and market abuse, because they are all linked. The FDIC in the US provides an example of how this can work.

Proposals to reduce capital/costs that prevent the launch of new banks include reduced capital requirements for local banks that won't be systemic; and the regulation of a common banking platform that takes care of most operational risks, so that small banks could simply 'plug-in'. Susan observed that credit unions only cover about 2% of the borrowing population, so are not a replacement for new, local institutions.

Baroness Kramer has led the way in proposing amendments to the Financial Services Bill to proportionately regulate peer-to-peer finance. In the course of discussing those proposals, it appears that the Treasury has conceded that there is already a provision in the Financial Services Bill that could enable such regulation. However that still leaves the job of agreeing the detailed secondary legislation (and any further enabling legislation) required, so the industry should keep up the pressure in that regard.

Finally, Susan praised the white paper that underpins the Banking Bill as containing 'pretty good' language on enabling new entrants to the banking industry. However, it is going to be important for everyone to be vigilant in ensuring the spirit of this is captured in the provisons of the Bill.

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