Tuesday, 21 February 2012

Why a zero interest rate equals zero lending

Adam Posen is an American economist who currently sits on the Bank of England’s (BoE) Monetary Policy Committee (MPC). This is the committee that sets the UK’s interest rates in order to control CPI inflation, or at least that was the original idea behind the formation of the MPC in 1997 when Gordon Brown was Chancellor of the Exchequer. I mention this because a couple of weeks ago Mr. Posen was quoted in an article by Philip Aldrick in The Daily Telegraph as described British banks as “reluctant, risk-averse jerks”. He may be right, but is that such a bad thing, particularly given the reckless lending that preceded 2007? I thought we all wanted banks and bankers to be boring again. Obviously not!

It occurs to me, however, that one of the issues that both the Daily Telegraph article and Adam Posen’s recent comments apparently fail to highlight is the possible causal effect that low interest rates can have in reducing bank lending. The point that virtually no-one in economics and the political media has so far cottoned onto is this: when base rates are high banks are forced to lend virtually all the deposits they receive in order to pay the interest that they owe to their savers, but when base rates are low there is no such necessity. To understand why, consider this simple example.

In normal economic times bank base rates may be about 5%. So, suppose a bank receives deposits of £1m for which it must pay interest at a savings rate of 4.5%. If the bank is required to maintain a capital adequacy ratio of let's say 10%, it will only be able to lend out 90% of its deposits. But it must also lend sufficient money at a sufficiently high rate of interest so that it can bring in enough revenue through loan interest repayments in order cover the interest it owes to its depositors. At the very least that means it must lend all of the available deposits (£900,000.00) at a rate of 5% just to break even. It could of course lend out less (say £750,000.00) but then it would need charge a higher loan rate in order to make a profit (in this case over 6%).

When you add in the effects of competition between banks, that competition will have two effects. Firstly, it will force down loan rates (or force up saver rates); and secondly, that will then force banks to lend more and more of their available deposits in order to cover costs and maximise profit. This inevitably means that banks will be unable to sit on deposits. Instead they will be incentivised to make those deposits work as hard as possible, possibly to the extent where some banks try to circumvent the rules on capital adequacy. That of course was what happened during the credit boom with disastrous consequences. But that is not what is happening now.

Today base rates are anchored at 0.5% and look like staying there for several more years to come. As a result savers typically receive an interest rate of about 0.2% if they are lucky. Yet most loan rates still exceed 4%, while for credit cards and unsecured loans they are much higher still. Under circumstances such as these banks would only need to loan out about 5% of their total deposits in order to break even. The net result is that they can pick and choose with even greater selectivity than before who they choose to lend to, and how much they choose to lend. The credit market therefore becomes highly skewed in favour of the lender. So that would appear to explain, at least partially, why current levels of bank lending are apparently so weak. In which case is Adam Posen right to criticise the banks in this way? Or should some of the responsibility for this lack of lending also lie with Adam Posen and his colleagues on the MPC? After all, it is they who set the BoE's base rates and, as I have shown, it is those base rates that help to drive bank lending.

With UK interest rate policy set as it currently is, what has in effect happened is that lending rates have become decoupled from savings rates. Once you realize that then it becomes apparent that having base rates at 0.5% serves very little purpose as far as the wider economy is concerned. It certainly has no effect in stimulating increased loans to small businesses, and while that may not be the only reason for the poor lending record of banks, it is probably a contributory factor. The result is a credit crunch or liquidity trap where those with spare cash refuse to either lend it or spend it. The critical issue here is the same one you get in price deflation in a depression. Both are caused by the tendency of the rich to hoard cash when there is no financial penalty for doing so.

Normally, hoarded cash loses it value through inflation. That is why a small amount of inflation actually benefits the economy as it helps to drive the circulation of money through spending, investment and consumption. Similarly, un-loaned bank deposits normally lose value for the banks due to the costs of interest they incur that must be paid by the banks to their depositor customers. When inflation and interest rates are negative, however, these conditions no longer apply, and the cash or credit stops flowing. In short, when savings rates are close to zero the banks effectively have access to free money.

Of course there are other reasons for the general lack of lending to small businesses. One of the main ones is the competition for funds from house-buyers via the mortgage market. In the period immediately prior to 2007 over 75% of bank lending was on mortgages, with only about 6% being made available to small businesses. This represents a classic case of "crowding out". That is why part of the long-term solution has to be the establishment of a network of locally based investment banks in the UK based on the German model of financial support to its Mittelstand. What is clear is that the more choice banks have over where they lend their money, the less likely they are to lend it in support of the real economy. It is simply a question of reducing the number of options or degrees of freedom banks have. As Adam Posen is also quoted as saying: "We've got to change the competitive pressures on them, change the rules on them so they're forced to do the job right."

What the above statistics also show, though, is that like most of the UK's economic problems, the ongoing problem of underinvestment by UK retail banks in the rest of UK business is intrinsically linked to the perennial UK problem of property speculation and house price inflation. So you will never solve the investment problem unless you also solve the housing problem.

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