What happens when banks are not lending
We looked at government deleveraging in a previous article; corporate and individual deleveraging also have implications for the general state of our economy. Indeed, if the government, businesses and households are all saving and paying off debt at the same time, they are not spending. Which means wealth creation, and as a result economic recovery, is dramatically slowed down.
No spark to light the match
The amount of lending by banks to businesses has fallen sharply in the last number of years. Specifically, lending to SMEs contracted by 16.5% and lending to all enterprises contracted by 7.7% between Q1 2010 – Q2 2012, according to Central Bank figures.
Banks not lending money to businesses means businesses have less access to capital. This has a very tangible impact on economic activity, since it means that businesses receive a constricted supply of a crucial product, namely, money.
Most businesses will need a certain amount of credit to “oil their wheels”: they will buy supplies on credit, transform them in some way in order to sell them, and when they’ve sold them, they will be able to pay back their original supplier.
A business might be able to “borrow” or get credit from suppliers on a 30-day basis, but their own sales cycle might be 60 days. Which means there is a 30-day “lean gap” between the moment they have to pay their supplier, and the moment they get paid themselves. This is not a mark of bad management, and perfectly viable businesses find themselves in this situation as a matter of normal business activity.
To fill that gap, bank financing is essential. If a business can’t get access to that, the whole cycle comes to a halt.
Banks not lending impacts what is known in economics as the Multiplier Effect. The Multiplier Effect, together with the Marginal Propensity to Consume, explain how money trickles through in an economy, enabling more people to do more of the things that require money.
Say a business creates €100 in new money and puts €90 into the bank. The bank lends out €81 to another business, who spends €72.90 on supplies. The supplier then puts €65.61 into the bank. The bank lends out €59.04 to a customer, who spends €53.14 on a car repayment, and on and on and on we go.
In the above example the “Marginal Propensity to Consume” is 90%; according to economic theory, this is the portion of any amount of money that will be “spent”. And as you can see “spent” is defined as parting with money in some way, since putting money into the bank qualifies as spending.
The Multiplier Effect measures the impact of the initial €100 – and for each €100, it tells us that an additional €1000 is created in the economy. That comes from the following formula: 1/(1-MPC) or (1/1-0.9) = 10 times. Essentially, for any new €100 earned, it generates 10 times that amount. A business not being able to create that €100 to start with, for lack of finance, means the wealth that could have been created, is not.
And it’s not just formal lending through bank loans – there’s overdraft, too. If banks decide to cut overdraft facilities for businesses, it means businesses have no flexibility in their finances. This can lead to a company going into the wall and not paying creditors. Which leads to bad debts, default and a general fall in confidence. This is a perpetuating, continuous, vicious cycle.
In order to repay its own debts, the government has had to take 20 billion out of the economy in the last couple of years. Again, this has prevented people from receiving money and being able to spend it, be it as civil servants, contractors to the state, capital project workers, taxpayers and/or as recipients of benefits.
Add to this another 20 billion that the banks haven’t lent, and you have a recipe to choke economic recovery.
But why would they do that?
Now let’s take the perspective of the banks for a while. In October Permanent TSB announced it had €1.74 billion in excess of the amount it is required to hold, in accordance with European Banking Authority regulations. There are similar results at Bank of Ireland and AIB, among others. With that money, several banks invested in high-yield bonds (like Irish government bonds might have been) which boosted their profits and had the additional effect of bringing down the cost of government borrowing.
There’s also no denying that businesses have become riskier to finance; they’re a bigger bet to lend to. But might it be that banks have gone too far and been too cautious?
Add to this that many businesses have been turned off by the closed door policy of these institutions over the past number of years, and are also suffering apathy surrounding appeals to the banks’ decisions and refusals to grant loans. In Q3 of 2012, only 36 appeals were made, of those 15 are ongoing or withdrawn and 21 have been completed, with 14 cases resulting in the bank’s refusal being overturned. Based on an admittedly small number of cases, this still represents a 66% success rate, and a much-needed, though minuscule €1.18 million extra being injected into the economy, as a result of taking the extra step.
It’s time for banks to start fully engaging with the SME sector again, but it’s also time for businesses to take that extra step if they get turned down and just consider it another part of the process.
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