Sweet, sweet credit: an explanation behind Morgan Kelly’s terminology
I was recently speaking at the Economics teachers conference; of course the state of the Irish economy is always a topic for conversation. We reminisced about Morgan Kelly’s comments back in March 2014, and together we discussed what the man on the street (or the students in the classroom) could make of them.
Morgan Kelly, professor of economics at UCD, has been nicknamed “Doctor Doom” and is generally credited for accurately predicting the 2008 crisis in Ireland. The predictions in question, widely relayed and commented in the media, can be found in this video:
I was also interviewed on the Moncrieff show on this exact theme; you can listen to the podcast or download it here. (Click to play, right-click to choose “Save as…” and save to your computer)
So here are some terms he uses, that I thought might warrant some explanation.
Economics is split into two main sections. Micro-economics refers to an individual economy: a person’s, a household’s or a company’s. Budgeting and managing cashflow, for example, are aspects of micro-economics.
Bank Stress Test
The European Central Bank is currently examining the stress tests of all of the European banks to see how much “bad stuff” (in different guises) they could handle in both a conservative and adverse scenario.
For example, if interest rates rose, how many of their loans would go from performing to non-performing? Non-performing, for a loan, means that people aren’t repaying back the full amount, if at all. If interest rates rise, it becomes more expensive to repay a loan. This will affect the demand for new fixed rate loans contracted after the interest rate rise, but also existing loans on a “floating” interest rate: how many of these loans are there, and could the debtors repay their increased debt? If they can’t, can the banks absorb the shock of this? If the economy went through worse-than-predicted growth or even decline, where demand for lending might fall by x%, how would that affect their profitability? Indeed, banks make their profits from lending money – if the economy is so bad that people don’t ask for loans or are refused loans, the banks’ main source of profits is endangered. It is these types of questions that a stress test seeks to answer.
Now, let’s look at this another way. Where does the money come from to lend? The answer naturally is, in the main, from deposits. There is a strong assumption that the loans will be repaid and that the deposits are eventually withdrawn. But consider what might happen if those loans aren’t repaid. At what point does the bank go from being able to sustain a certain amount of bad debt, to having a threat to its ability to make good on ATM withdrawals? There is a lot that can happen in between, but again, the stress test is designed to identify which end of the range the bank is closest to, and what could trigger an acceleration towards one end or the other.
Now, if the answers aren’t pretty, the most likely thing to happen is that the ECB would demand that the banks increase their capital-to-lending ratios. Put simply, this means that banks would hold more money for each loan that they sell. A bank’s “assets” take several forms: capital reserves, of course (a bank “has” money: all the profits that it’s had from previous years as well as equity capital that it’s raised from shareholders that doesn’t have to be repaid), as well as loans: this is money that the bank doesn’t have as of now, but is promised to be paid back at a future date. Yes, part of the bank’s “wealth” consists in future loan repayments. But this is “future” money and debtors can default: so if a bank’s capital-to-lending ratio is too low, that is, if the bank has too big a proportion of “future promised money” in their books, compared to real, actual reserves, the bank is vulnerable to debtors not repaying their loans. So the ECB might ask the banks to correct that and to increase the proportion of capital, compared to the proportion of money lent.
You can only do this two ways; either lend less or get new capital. New capital can be obtained through more investment from its shareholders, also known as a rights issue. This is where the banks go back to their shareholders (their equity holders) and say “We need more money. We are willing to offer you more shares, at a discount, so that we can bring in that new money” – money that the bank won’t have to repay since it’s not a loan, but a rights issue. The return for the shareholder is that they get new shares for a lower price than currently available on the market.
Who is the SME sector
and what jobs do they create?
An SME is a Small to Medium Enterprise that has fewer than 50 employees and has either an annual turnover (sales or revenue) or balance sheet (total assets less total liabilities: the company’s full worth) not greater than €10 million. According to the Irish Banking Federation, they account for 70% of persons engaged in employment and 51.5% of the turnover of the country.
They can often represent a much higher proportion in rural areas and, as anybody will know that has started one, an SME will put you on a steep learning curve. These skills are very transferable and this experience often leads to higher employability if the SME owner decides to divert towards corporate life.
The ECB has basically kept pumping
that sweet, sweet credit into our veins
Morgan Kelly is referring to the various measures that the ECB has taken over the past few years.
One of these measures is ELA, “Emergency Liquidity Assistance”. ELA is the practice of allowing national central banks to lend money to capital-starved banks against collateral that wouldn’t be accepted at the ECB. The collateral of a loan is that asset claimable by the debtor, that would be seized if the debtor doesn’t repay their debt. In the case of a mortgage, the collateral will most often be the house that has been bought with that mortgage: if the mortgage isn’t repaid, the house might come under foreclosure as we have seen happening in the USA.
The OMT (Outright Monetary Transactions) was another unprecedented move where the ECB decided that they would, without limit, buy up various government bonds in order to calm the bond markets. If the ECB buys up government bonds, this has several consequences: bond prices go up since bonds are “in demand” and liquid (they can be easily sold since there is demand for them). This move also restores confidence: if the ECB announces that it will buy up bonds, then bondholders can be reassured that they can get rid of the bonds by selling them to the ECB if they so desire. This is effectively the ECB funding stressed government to an unlimited level and it did have the desired effect.
According to Morgan Kelly, such measures might have given us the false impression that “the ECB will sort it out for us”. But the ECB can’t keep on doing this forever.
Foreclosing on loans
If a loan is not performing (i.e. the SME is not keeping up all of its payments), the bank can put it right up to the SME to give it the collateral for the loan instead. In many cases, the only thing to actually take would be the business itself. Since an SME is probably only worthwhile if the owner/entrepreneur is running it, then that means that foreclosing on the loan could drive the company to the wall. It’s different when speaking about property, as foreclosing on a property means taking the collateral for the loan, which is be the property itself and it can be sold independent of the owner.
Non-core property debt
If an SME loan is non-core, it means that the loan itself isn’t specifically related to the business, or the operating of the business. Let’s say that I sell widgets out of my office and I buy the building with a mortgage. The premises itself is important to house the goods etc., but if push came to shove, I could move everything to rented accommodation and continue trading as normal, all else equal. However, the widgets themselves are core: if I don’t have a product to sell, then I can’t operate, whatever the environment.
In an ideal world, you would write off all of the problematic debt, recapitalise the banks with printed money and then start anew. However, the issue with this is “moral hazard”. This term refers to behaviour which encourages people to no longer act morally. For example, what would stop any given SME, or in fact every given SME, from borrowing up to the hilt and strategically finding their way into difficulty, if they know that they’re going to be rescued?
Secondly, where do you draw the line between those who get debt forgiveness and those who don’t? How do you incentivise SMEs to repay their debt after a competitor gets a good deal?
So is Morgan Kelly right?
It basically depends on how aggressive the ECB decides to be in the “clean up”. If the entire banking system decides to take a softly-softly approach and allow these companies to work their way out of it, the impact would be muted, but the balance sheets of the banks will nurse these losses for a long time to come.
If they take an axe to the accounts and ask companies to step up to the mark right away, in order to rebalance the banks’ capital-to-lending ratio, it would be shorter as the impact wouldn’t be stretched over a long time, but it would be a huge shock that could leave companies reeling.
One does have to think about motivation here:
(a) Who would actually benefit from another demise of an economy in Europe, particularly its poster boy of recovery?
(b) Who would actually benefit from forcing many of its customers to walk away from its own business?
(c) Who would actually benefit if the company, which is the only collateral to the loan, was to crumble?
Are you on the list?