Last week we were lukewarm about the Project Merlin announcement and how it will (not) help improve the flow of finance for businesses. I want to elaborate a little here on why and in a subsequent post on what I think needs to happen to really start making some progress.
In the previous decade leading up to the financial crisis, credit growth ran rampant as asset price bubbles and increasingly complex financial innovation fuelled debt driven growth. As we all know this has proven unsustainable.
The retrenchment that has followed the financial crisis and ensuing recession has been economy wide. Banks, firms, and consumers have all sought to wind back their own debt.
With the recovery still shaky, a key to future growth is to boost investment. This is a sustainable basis for growth and is part of the answer of rebalancing the economy.
But there are important factors holding back investment. First and foremost is the great uncertainty regarding demand.
Manufacturers have rebounded strongly in the past year but they face an extraordinary degree of uncertainty: the impact of spending cuts on consumer spending threatens domestic demand and eurozone sovereign debt worries threaten demand from Europe, still by far our most important export destination.
On top of this surging commodity prices put a major squeeze on manufacturers costs. How far can these be passed through?
Access to finance is also holding back investment. The problem is most acute for fast-growing SMEs with limited collateral and often a degree of innovation. Exactly the sort of companies we want to help drive the recovery.
Crucially compared with the other challenges, access to finance is potentially able to be improved by positive action.
Banks have pledged to lend more in gross terms. As an intention this is positive. As a substantive commitment it's nearly worthless.
As Vince Cable said in March 2010, it is ‘perfectly possible for banks to achieve a gross lending target while withdrawing capital from [SMEs]'.
This is because the banks know many firms are paying down debt and so with this in mind they can make available loans in the knowledge that their net position may be to withdraw credit from the economy.
Why would they want to do this? Because the banks need to deleverage themselves and reduce the average riskiness of their portfolios. Both those desires suggest lower net lending from the banks is in their interests even if viable proposals are seeking finance for growth.
The Coalition Agreement picks up this net v gross issue too. Under banking reform section it notes ‘We agree that ensuring the flow of credit to viable SMEs is essential for supporting growth and should be a core priority for the new government...This will include consideration of…use of net lending targets'. (my emphasis)
But of course Merlin has only delivered a gross target. If target is even the right word.
Because as the Merlin agreement itself makes plain, the banks' position is that lending will be ‘subject to normal commercial objectives' (1.5), further that even these gross lending targets go beyond the banks' expectations of demand (1.3.2), and that the ‘committed lending capacity…is materially higher than…revised expectations [for what will be delivered] for 2011' (1.3.3).
Banks are after all businesses themselves looking to maximise profits. How could they justify lending to their shareholders that didn't deliver the highest possible profit? They see the current flow of finance as consistent with their criteria. Demand that meets these criteria will be met; that which doesn't will not.
Firms that are not getting the finance they seek are missing out because they're not suitable to lend to.
That's not to say the banks are totally oblivious to the need for action or the causes for a potential mismatch in demand in supply. Their Taskforce commitments included a number of worthy objectives such as reaching out via a mentor network, starting refinancing discussions earlier, being more transparent on their lending principles, and establishing better data on lending.
But the fact remains that the signatories to Merlin are all powerful members of a banking sector that can largely set its own terms. Profit maximisation for them does not equal welfare maximisation for the economy. The competitive forces aren't there to drive more lending even though viable unmet demand exists.
The banks have been clear on what they'll do and it is incumbent on the government to respond on behalf of the rest of us to bridge to gap to what the economy needs. Merlin's box of tricks unfortunately leaves us far from enchanted.