Originally published in The Huffington Post, 15 July 2012.
The Bank of England and HM Treasury officially launched the “Funding for Lending Scheme” (FLS) on Friday 13 July (read the announcement and details here), yet another covert operation to shore up the banks under the disguise of helping small businesses and households to access cheaper credit and thus stimulate the economy.
Sure, some of the money will find its way to you, me and our businesses. However, I guarantee that the vast majority of the funds the banks draw down from the scheme (with obvious glee) will not make its way to those who need it most. The reason is quite simple; lending to SMEs and households carries a high cost for the banks in terms of capital requirement and consequently has the lowest rate of return of any of a bank’s activities.
We look to the government and their related bodies to effectively set tactical and strategic policies that instill the right incentives within the private sector to do what is best for the UK economy. Is the government providing the right incentives to the banking sector to open up lending to SMEs and households? No – and they know it. Banks will have a channel to access cheap capital; how they use that capital is not, and will not be dictated to meet the specific need of SMEs and consumers.
The level of low cost capital available to the banks under the FLS is a factor of the credit they already extend to non-financial entities in the UK plus any new loans made to this segment. Without lending a new penny, the banks are eligible to access £80 billion of cheap capital from the Bank of England. To access more, they can simply lend to their core customers within the large corporate space, those with strong credit rating that also feed the most risky activities of the bank’s capital markets division through their requirements for complex derivative products.
A loan portfolio consisting of SME loans is considerably more expensive for a bank to hold then a loan portfolio consisting of large corporate and (financial) institution loans. A scaling factor of 40% (of the loan) or less is used when calculating the capital a bank must hold to cover potential loss on a large corporate or financial institution loan, compared to a 100% scaling factor for SME and consumer loans.
Looking at loan revenues: on average, a bank may earn 8% on SME loans and 5% on large corporate loans. This 3 percent benefit in no way compensates the difference in the capital requirement (cost) between SME and large corporate loan portfolios when calculating the return on capital, a core metric for effectively allocating money across projects/business units.
For a complete picture, lets also note the off balance sheet activities of banks – the complex derivatives they trade in the capital markets division that can reap them considerable revenues but cost the bank nothing in terms of regulatory capital.
Banks are privately held entities. They do what is best to maximize return for their shareholders. If a bank has one hundred (100) units of capital at its disposal, it will, like any other private firm, look to allocate that one hundred in the most effective way to generate the maximum level of return on capital.
So, if you ran a bank and have one hundred units of capital available, what would you do it with it?
Given the incentive structure, in this case, the capital requirements dictated by regulatory bodies such as the FSA, Bank of England, the EC and the Basel Capital Accord, you would logically do as the banks do, allocate as little of that capital to lending to SMEs in order to maximize shareholder return. This is why Project Merlin, the effort by the Government to tie banks to lending targets, failed – though a token effort was made due to brand necessity, the proportion of loans made to SMEs relative to large corporates fell considerably and continues to fall. This is also why the FLS will fail to meet stated objectives – the incentives are simply not there for banks to lend to SMEs. Given the current trajectory of regulation, I would even stick my neck out and state that banks will look to exit the business of lending to and generally providing SME services within the next 10 years.
So what? Let them. We can do better. The alternatives are already here and innovation in the New Finance sector is progressing at a lightening pace. Entirely new banking models such as Fidor Bank in Germany, Holvi in Finland and Simple and Movenbank in the US will soon migrate to the UK. There are already several young firms focusing on niche elements of financial services to deliver exceptional, transparent and cheaper services to SMEs and consumers. There are firms providing Peer to Peer based access to credit, such as Fundingcircle, Zopa and Fundingknight, other firms providing lower cost access to currency and international trade services, such as Tradeshift, Currencyfair, Transferwise and Azimo.
The Government will continue to support the banks albeit stealthily; avoiding association to bypass the negativity of the media and population directed at the banking sector. Financial services is the comparative advantage of the UK, the thing we excel at and the rest of the world wants from us. UK financial services drives wealth creation for us all, and the government knows this. We should therefore stop waiting for policy led solutions to the system – they are not coming. We should take it upon ourselves to instigate the change we need.
Orignally published in Entrepreneur Country, 19 June 2012.
Here we go again – bailing out the bankers under a veil of helping out small business.
I read the following article, published in the Wall Street Journal (and I am sure elsewhere) with a knowing smile on my face.
Lets leave aside the irony of a bunch of wealthy politicians preaching to a bunch of wealthy bankers at an expensive and exclusive black tie event about how they are going to help “the little people” (I love the pic!), and focus on the proposal.
“Mervyn King announced plans to flood banks with cheap funds in an attempt to jump-start lending to British households and businesses….”.
Let me tell you a little about how banks work. They are privately held entities. Like other firms listed on the stock market, they do what is best to maximize return for their shareholders. If they have 100 units of capital, they, like any other private firm, will look to allocate the 100 in the most effective way to generate the maximum level of return on that capital.
Banks are not responsible for saving the economy, that is the job of the government through public policy and expenditure and by delivering the right incentives to the private sector to do what is best for the whole while also helping themselves.
So, by providing cheaper loans to banks is the government providing the right incentives to the banks to open up lending to SMEs and households? No – and they know it.
All the government is doing is helping the banks more easily raise capital. How they use that capital is not, and will not, be dictated. Yes, some of it will find its way to you, I and our businesses. However the vast majority will go towards the capital markets functions of the banks and in lending to large corporates. The reason is quite simple; lending to SMEs and households is the most expensive activity for a bank to conduct in terms of capital utilised.
A loan portfolio consisting of SME loans is considerably more expensive to hold then a loan portfolio of large corporate loans. Obviously the revenue the banks earn also defines the return on capital. Let’s say, on average, a bank earns 8% on SME loans and 5% on large corporate loans. This 3 percent difference in no way compensates the difference in the capital requirement between SME and Large corporate loan portfolios, which can be as large as 20%. Now also factor in the off balance sheet activities of banks – the complex derivatives they trade in the capital markets division that can reap them considerable revenues but cost the bank nothing in terms of regulatory capital.
So, if a bank has 100 units of capital available, what would it do it with it? Well given the incentive structure, in this case, the capital requirements dictated by regulatory bodies such as the FSA, Bank of England, the EC and the Basel Capital Accord, they would allocate zero of that capital to lending to SMEs in order to maximize their shareholder’s return. This is why Project Merlin, the effort by the Government to tie banks to lending targets, failed – though a token effort was made due to brand necessity, the proportion of loans made to SMEs relative to large corporates fell considerably and continues to fall. This is also why the stimulus package announced at the event covered by the Wall Street Journal will also fail – the incentives are simply not there for banks to lend to SMEs. Given the current trajectory of regulation, I would even stick my neck out and state that banks will exit the business of lending and generally providing SME services within the next 10-15 years. SMEs should be looking at the new finance/Fin-tech sector for support as it is fundamentally the future for SME finance and banking services.
As a spin on the Government proposal and the general conditions for banking at the moment, why don’t you help me take advantage of the situation? I promise at least 20% Return on Equity for any investor who will help me set up a bank. Here is my high level business plan – any takers? 😉
- I employ some currently unemployed bankers (adding value to the economy)
- We raise £1 billion of equity
- We use the £1 billion to buy as much high-grade securities as we can (minus set up costs), paying maybe 4-5% coupon
- We use the securities as collateral to borrow £9 billion from the BofE at overnight rate of 0.5%
- We buy another £9 billion of securities at similar rates as the first batch. At this rate, we are earning at least £400 million per annum
- We continuously roll the overnight position with the BofE, pledging more of the security pool in collateral if required on margin calls
- We go public. After costs, the bank is earning at least £200 million a year with a high capital ratio (10% equity-to-debt), and the balance sheet will be clean (all low risk securities). Potential valuation of 20-times earnings: £4 billion. We sell 25% of the company for £1 billion
- Put the £1 billion raised to good use – go back to Step 3
- When market cap hits £10 billion, sell another 10% of the company for £1 billion. Go back to Step 3 again
- Expand to US. Fed is lending at 0.25%. Repeat formula. Start focusing on PR and social issues, buy branch networks from defunct banks and start making actual loans to retail and corporate consumers
- Exit for a ridiculous valuation. We all win!