econgineers

How does it matter if money is cheap nowadays, if nobody has access to it?
Money is simply not available.
Banks have stopped lending to individuals and corporations.

Although there are clear indications from the Bank of England that further cuts to the bank rate might be ahead, however how will that feed into the real economy if loans are simply nonexistent?

What is the solution?

Nobody has the right answer yet, and like most problems it might not have only one plausible solution. In order to move forward towards an acceptable solution we may analyse the following:

- Government giving more guarantees to banks, so that banks feel less exposed to the credit and counterparty risk.
If the government would give more guarantees to banks, this could lead into a new problem: long and prolonged subsidy of the financial sector, creating a dependency on state backing. The moment that the economy would show signs of recovery the government would find it hard to retrieve these guarantees, as it is likely to cause an immediate reaction by banks which wouldn’t be keen to lend without them.

- Government lends money directly to corporations and individuals, cutting the middle man (banks).
By lending directly, the government would invariably increase the competition for building societies, credit cards, and banks. It would force some lenders to participate in the market to protect their market share.

- Corporations and individuals find funding externally (i.e. in the form of foreign investment).
Finding funding externally is a bit of a challenge for individuals, but might be possible for medium and big corporations, that in many cases are linked in one way or another to other countries, activities and industries.

The truth is that none of the propositions above is ideal, nor what one would have wished for our economy, as in one way or another we are being bailed out of trouble by either the state (tax payer’s money) or by external investors. In some situations we need to find the least detrimental solution, and this is one of them. The cost of doing nothing and taking the “conservative” approach of not bailing the economy out of trouble would most likely result in a much higher price later.

However, the worst possible outcome is to carry on backing banks, giving out guarantees, and extracting the toxic-loans the banks have in their balance sheets.

It would be no solution to the economy to continue acting like a loving parent puppet in the hands of a spoiled and manipulative child.

So what is the solution then?

Stick and carrot.

Do not bail the banks. Natural selection needs to happen (within the financial sector), the strongest shall survive and the weakest should perish, giving their place to the next in the chain.
This would guarantee skilled, hard working and efficient banks carry on, without compromising the quality of the services offered to the public. Getting rid of failing banks is not a bad idea. Most of them are failing due to their own lack of business judgement and excessive risk taking. To keep them, could be dangerous in the long term. It might corrupt healthy institutions by disseminating inefficient, negligent, and irresponsible practises. And although such professional conduct has proven to not work, it has been overlooked through a lack of consequences. This might instigate a sense of impunity, and give little incentive to honest, hard working institutions to keep their professional code.

It is true that corporations and business are at stake, and these do need some kind of support, as they are the ones that provide employment to the real economy. A rescue plan should have been targetted at this layer of the economy, by offering financial support through these difficult times. The government is trying to act on this, with fiscal policy (i.e. VAT cut) and BOE monetary policy (bank rate cuts). However, banks are unable to pass on the cuts in interest rates to the real economy; banks are simply in no place to lend money. They don’t have it. Most banks do not have the money available to lend it out and the ones that do might not want to lend it while asset prices will carry on falling. So although the government bailed banks so that they could carry on facilitating business in the real economy, this is simply not happening. There is not much that the government can do about it, without direct interventionist policies. So how can the government increase availability of cash? Well, tackle it from a different angle. If they would make available funds through an alternative route, such as building societies, this would challenge lenders into participating by threatening part of their market share. It would also accelerate the “clean-up” process that the financial sector is going through, as only the positive cash balance banks would be able to participate in the lender’s market.
Additionally, increasing the market share of these smaller players, would greatly improve competitiveness in the financial sector. This is especially important given the recent trend of consolidation amongst the large banks, which seems destined to create a banking oligopoly, with all the market distortions which that brings.

by Andrea Graves
12.01.2009