Less From the Pulpit, More From the Pew

The Church of England's terrible muddle over pay day lending shows that it's out of touch with the details in the payday lending market. Just as we've seen in other markets, pontificating from the top down is no substitute from working on problems from the customer's standpoint. So, a little less output from the pulpit's point of view and more from the pew's would be no bad thing.

As mentioned previously, the challenge for borrowers who need or want to borrow short term is finding a combination of speed, convenience and affordability. In March, the OFT's own research revealed that 90% of online customers found the it "quick and convenient" to get a short term loan and 81% said such loans make it easier to manage when money is tight. Customers expressed their satisfaction in terms of decision speed (36%), convenience (35%) and customer service 27%). The majority of payday customers (72%) only borrow for a month. So, the critical issues seem to be how to ensure the other 28% are better able to understand the risks of rolling over short term loans, and how to avoid it; as well as cutting the overall costs for those who use short term financing. 

The root causes of these problems do not lie in the cost of payday loans. Short term borrowers are often working amongst the contractual fine print of late fees, cancellation notices and so on. Allocating money to debts 'just in time' is a high risk occupation. One slip can make life hell in a non-financial sense - maybe the kids won't have school shoes, there will be no heating or the landlord will finally lose patience. Credit cards, debit cards and cheques are useless from this sort of timing perspective, because they don't tell you how much you have left to spend at the time you use them. There can also be an accounting lag between when you pay and when the transaction lands on your account, so you can find yourself 'surprised' by a payment you thought had been accounted for days or even weeks previously. And the amount of interest and other charges is only known when it appears on a monthly statement. We hear a lot of noise about APRs, but not so much about the timing problems or the scale of fees payable when you get on the wrong side of bank products - these are far more relevant to short term borrowers, and why many remain 'unbanked' by choice.

In these circumstances, rather than playing money-lender, it would be better if the Church could foster the development of an application or other means of presenting to a borrower the most affordable short term finance option, based on the analysis of the borrower's own transaction data from existing creditors (including cancellation rights and late fees), and the costs of different finance products (including charges for missing a payment). This really only requires a commitment on the part of all the typical creditors and financial services providers to make their product and pricing data available in machine-readable format, which the government has been pushing them to do as part of the voluntary 'Midata' programme. That data can then be analysed and the results made available either online or physically, via mobile phone, computer or print-out. 

No doubt the Devil is in the detail underlying such a service. But surely the Church isn't bothered by that?

More Sunlight Needed On Perverse Tax Incentives

Our continuing economic woes seem to reveal a UK Treasury that has lost touch with the fundamental tax and regulatory problems in the UK economy and is unwilling to engage openly and proactively on how to resolve them.

Not only did the Treasury lose any grip it had on the financial system when it mattered most during the last decade, but the rocky passage of the Financial Services Bill and the need to create a joint parliamentary Commission on Banking Standards also reveal that any such grip remains elusive. This, coupled with the UK's bizarrely complicated system of stealth taxes and incentives, demonstrates the urgent need for more transparency and openness in how the Treasury is going about the task of addressing our economic issues.

The latest example comes with the news that the government might revisit the bizarre decision to delay the revaluation of business rates, which are still based on the higher rental values of 2008. The task of setting business rates every five years lies buried in the Valuation Office Agency, an 'executive agency' of HM Revenue and Customs within HM Treasury. So it's nicely insulated from anyone who might complain about the impact of the rather occasional exercise of its responsibility. Instead, businesses have complained to Vince Cable, over at Business Innovation and Skills, and he's bravely (insanely?) promised to do what he can. However, the hermetically sealed nature of civil service silos means the Valuation Office Agency can safely ignore the issue.

Anyone else afflicted by perverse public sector tax issues faces the same problem. 

UK-based retailers are wasting their time by complaining they are disadvantaged compared to international businesses that are better able to minimise their tax liabilities. Not only is this a welcome distraction from the bigger issue of how the public sector wastes money, (which the Cabinet Office has been left to address), but the Treasury hides behind BIS, no doubt laughing-off the complaints as an example of businesses not understanding how the arcane world of taxation really works. The trouble is the Treasury doesn't understand how that world really works either. Nobody does. That was the whole point of Gordon Brown's stealth approach to taxation. But this should be no excuse for the department that's supposed to be in charge. The Treasury needs to take responsibility for understanding and explaining how it all works, including the unintended consequences.

Similarly, the Treasury needs to take responsibility for the fact that the UK's small businesses face a funding gap of £26bn - £52bn over the next 5 years. Here, again, BIS has had to act as a human shield, even threatening to launch its own 'bank'. Yet HMT has allowed four major banks to get away with controlling 90% of the small business finance market while only dedicating 10% of the credit they issue to productive firms. This, despite the fact that small businesses represent 99.9% of all UK enterprises, are responsible for 60% of private sector employment and are a critical factor in the UK's economic growth which has slipped into reverse yet again. Meanwhile, the Treasury continues to resist allowing a broader range of assets to qualify for the ISA scheme, which currently incentivises workers to concentrate their savings into low yield deposits with the same banks that are turning away from small business lending just when it's needed most.

More sunlight please!

Does Ana Botín Have Any Clothes?

In a fawning interview in Monday's Telegraph, Ana Botin, CEO of Santander UK and billionaire's daughter, is lauded for having run a start-up and quoted as saying she will be “accelerating” the expansion of the bank’s small business lending. But does this really justify such fawning tributes, or does the emperor have no clothes?

According to BIS, the stock of lending to UK non-financial corporate businesses was £506bn in December 2011.  The department estimates a potential credit gap over the next five years of between £84bn and £191bn for the business sector as a whole, of which between £26bn and £59bn is estimated to relate to smaller businesses. BIS says bank lending may grow, but the ability of bank lending to increase may be constrained by the ability to raise capital and meet higher funding costs. The big four banks control over 90% of the business finance market, leaving the likes of Santander with very little indeed.

At any rate, the important factor here is not the amount that Santander actually dedicates to small business lending. It's the proportion that its small business lending activity represents of its overeall credit creation. Richard Werner, the economist, estimates that UK banks generally dedicate only 10% of their credit creation activity to productive firms. He says that it's critical to grow that proportion because credit aimed at productive firms is the only signficant driver of economic growth as measured by GDP - which is flat. Credit that goes to consumption only fuels inflation, and credit for the purchase of non-GDP assets simply drives up the prices of those assets. In Germany, by contrast, 70% of banks (about 2000 of them) only lend locally and supply about 40% of SME finance.

Against this backdrop, Santander's claims don't merit much attention at all. To achieve it's proposed 'acceleration' of lending to small businesses, Santander UK suggests it will use some of the £2bn capital allocated to its failed acquisition of 316 RBS branches and some of the £1bn it has drawn down as part of the public subsidy given to banks in the form of the Funding for Lending Scheme. The bank announced £500m additional asset financing last Thursday. Yet its gross business lending only stands at £10bn, even having grown 20% year on year since 2009. “This is net new lending,” claims, the CEO, but then says this represents switching from other banks. So it may not be net new lending to SMEs generally, i.e. funding that is going to SMEs who can't otherwise get it.

So, while she talks a good game, Ana Botin and the bank she runs have no clothes. 

Image from ElaineByrne. 

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.

Strength in Diversity

Following the discussion on the concept of a Social Finance Association, it was interesting to read the guest post on Zopa's blog by Rob Garcia, Senior Director of Product Strategy at Lending Club, attempting to classify types of social finance as 'crowdfunding', 'microfinance' or 'peer-to-peer lending or investing'.

Having had to spend far too long studying the distinctions between US and UK regulation in this area, I must respectfully disagree that 'crowdfunding' necessarily involves 'pooling' or a lack of nexus between 'funder' and 'fundee'. Similarly, any of these models should be capable of operation on either a for-profit or not-for-profit basis, or for any purpose, social or otherwise. The essence should be that each facilitator enables people - rather than the facilitator itself - to determine the allocation of their own funds directly to other people, businesses or projects, whether the businesses or projects are operated for-profit, social purposes or otherwise). In other words, people remain in day-to-day control of the management of their money, not the facilitator.

While precise distinctions between the various different social finance models may be important at one level, and a diverse range of business models is certainly good sign for the strength of the sector, the sector must also be ready to differentiate itself from traditional financial institutions and models - unless it wants to be regulated in the same way.

Social finance models were vital alternatives before the global financial crisis, let alone now and for the foreseeable future while traditional institutions adjust to new capital and regulatory constraints. But the existing regulatory framework makes it painfully slow and expensive to launch social finance platforms. To help foster confident innovation and competition, and enable the new sector to flourish quickly enough to provide much needed funding, financial regulators should clarify what is permissible within or outside the scope of regulation.

Image from the Trade Association Forum.

A Social Finance Association?

The past 5 years have seen the launch of many innovative business models aimed at enabling people to provide funding directly to other people and businesses via online finance platforms, rather than 'traditional' financial institutions. The terms 'crowdfunding' or 'social finance' seem to encompass most models out there.

The 'social' element is critical to the success of these models, because there are very real social and economic benefits to people - rather than financial institutions - sharing most of the margin between savings/investment rates and funding costs.

But I've witnessed firsthand how social finance platforms and their members tend to wrestle with the problem that social finance does not fit neatly into our financial regulatory framework, which is designed, ironically, to force recalcitrant 'traditional' providers to deal fairly with consumers. We are also currently victims of the delay and uncertainty caused by reforms to that regulatory framework. Because when they aren't rescuing banks or attending to 'business as usual', the key regulatory staff are understandably taken up with figuring out the new regulatory regime rather than vetting the legality of innovative business models that may remain outside the regulatory perimeter.

These problems add a huge amount of time and expense to starting and developing a social finance business, precisely at the time when banks are both lending less and paying lower savings rates.

Of course, it's common for the participants in new market segments to jointly discuss the development of the sector, including the characteristics and boundaries of regulatory 'safe harbours' and if/how they ought to be regulated. An appropriate forum for such discussion makes it easier to innovate and compete. But it also creates an efficient contact point with regulatory officials and opinion formers for discussing policy and regulatory concerns which individual participants wouldn't otherwise voice for practical reasons of time and cost, or for fear of inviting adverse attention.

There is no need for incorporation or office space. Trade associations often begin on ad hoc, unincorporated basis in response to a threat or opportunity that presents to all the participants.

Has that moment arrived for social finance?

Image from the Trade Association Forum.