Friday, 26 February 2010

RBS, Lloyds, lending and taxpayer value

Robert Peston has been working hard reporting on results from RBS and Lloyds the last couple of days.

A couple of points.

He claims that taxpayer's money has gone down the drain at RBS, because:
we as taxpayers put in £25.5bn of new equity into this bank last autumn...but...the equity of this bank has increased by less than £16bn to £80bn.
So almost £10bn of the £25.5bn we've only just put into RBS has already been wiped out by losses.
Well, that's half true. £10 billion has indeed been wiped out by losses. But it's not £10 billion of our money, it's £10 billion of the former shareholders' money.

Our £45.5 billion has bought 84% of that £80 billion in equity, a £67.2 billion asset.

The reason we're not in profit yet is because the market is still applying a discount due to uncertainty over future losses. We don't know if those losses will happen yet - it depends mainly on economic recovery - but on the book value of the bank, we got a good asset at a discount, and the writeoffs are still coming out of that discount.

So let's not be too worried about whether our tax money is going down the drain yet...the old shareholders (who, after all, got some nice dividends when the going was good) are the ones who lost their equity when their gamble failed.

My second point - and much more important than whether we make a £10 billion profit or loss on the taxpayer's bank shares - is how quickly the economy is going to recover. Every 1% of growth that comes a year earlier is worth £14 billion per year to the country, a cashflow with a net present value of several hundred billion (depending on your unit root assumptions). So getting back to growth as soon as possible is absolutely critical. Here the news is less certain:
What we're not getting is oodles of credit funnelled to businesses vital to the UK's economic recovery.
By its own admission, Royal Bank has flunked the government-set target of providing £16bn of additional loans to "credit-worthy" businesses...In fact, there has been a £12.2bn reduction to £151bn during the course of the year in the total volume of loans provided by Royal Bank to companies.
And Lloyds:
...has a contractual arrangement with the Treasury to increase lending to UK businesses by £11bn and to home-owners by £3bn both in 2009 and 2010.
Is that in fact what happened? Has it met those lending commitments?
Well, Lloyds' published numbers do not tell that story.
In every segment of Lloyds operations, loans and advances to customers fell: by £6bn in its retail bank, by £43bn in its wholesale bank (which deals with businesses) and by £1bn in its wealth and international division.
Breaking that down further, mortgages on its balance sheet decreased by more than £10bn, credit for transport, distribution and hotels was almost £4bn down and loans to manufacturers dropped by £4bn.
So - at least from these two banks - we don't have an increase in lending. But do businesses want to borrow?

Well, there's lots of anecdotal evidence suggesting they do. You only need to go round the room at any small business event to find plenty of people who want to borrow from the bank and have been turned down. But many of these businesses just want to borrow to paper over a fall in cashflow and are not genuine investment opportunities.

The main reason these people are being turned down - as far as I can see - is because their cashflow is not enough to service the loan. This usually means that they are a small firm, seeking a loan to make a risky long-term investment, instead of for safe capital expansion such as buying another machine in a successful factory. This is the kind of investment that's often thought to be more appropriate for equity investors than lenders, because equity investors can capture some of the high upside while lenders can't.

Then, is equity investment rising or falling? We don't know - but it isn't really core business for the banks (though they used to lend lots to private equity houses which would invest on their behalf). However, there's a reason why equity investment might not be the right answer here.

First let me take a step back to the fundamentals: are there appropriate opportunities to invest? Not according to one view. Adam P, commenting on Worthwhile Canadian Initiative, has said:
[In a recession] investment falls immediately too, but this does not raise the marginal product of capital because the marginal product of capital depends on the level of the capital stock. The marginal product of capital rises only slowly as depreciation reduces the capital stock. Thus investment falls further than consumption and stays depressed longer.
In the absence of a monetary response to bring the real rate down the recession won't end until the capital stock falls to the point that the marginal product of capital, and hence the natural interest rate, again equals the real rate, at which point full-employment is restored.
This is a technical way of saying: there are no good investment opportunities because the factories we built in 2007 can still produce more than enough to meet today's shrunken consumer demand. Until demand rises, or can be clearly predicted to rise strongly in the next few years - or until the old factories break down - it won't be worth building new ones.

The most likely way out of this, as Martin Wolf hints in a pessimistic but good article in the FT and Paul Krugman agrees, is for some foresighted people to be able to foresee good investment opportunities in some new area. We might be helped in the short term by a rise in consumption in China or Germany, but the more hopeful scenario is that there are opportunities to invest in some new technology area or a gap in capital stock somewhere in the world.

Apparently nobody is spotting these opportunities. Robert Peston says:
Royal Bank says the money is there to be lent, but that bankable businesses don't want to borrow - or, at least they don't want to borrow enough.
...shocking official statistics...on investment by British business... showed that in the last three months of 2009 business investment fell almost 6 per cent to a level not seen since 1992.
It looks as though - as per Japan in the 1990s - unconfident British companies are choosing to pay down their debts rather than invest for the future.
A simple view of capital markets theory says that this doesn't matter: if company debts are repaid this makes more capital available for venture capitalists or savers to invest in other ways. And this is the argument I referred to above, which says that equity investors such as venture capital firms should be stepping in now.

But this neglects George Akerlof's theory of "the market for lemons". There's a severe asymmetry of information in the investment market. VCs have to be conservative when they invest, because they don't have access to the same market information that the managers of firms do. Plenty of firms will come along asking for VC money and, essentially, gambling on an idea that may or may not work. If it does, they get a share of the winnings. If it doesn't, it's the VC's money that's gone up in smoke, not their own. The VC can't really tell - unless, like the Silicon Valley VC community, they are themselves market experts - whether the managers are pitching a really solid idea or just taking a punt. And thus, standards for VC investment need to be higher than they would optimally be.

This is why internal investment within the firm is such an important mechanism. Because someone who runs a companies and also controls capital can see an opportunity and make their own judgement about investing in it. And that kind of investment is financed not by VCs, but (indirectly) by banks. Managers who see an opportunity and believe in it, can put their own and their shareholders' money on the line by not paying out profits in dividends, but instead mortgaging the existing cashflow of the company to borrow and invest in that new opportunity.

What this means:

  1. Small businesses aren't necessarily the answer to growth. They are good for bringing new ideas to the economy, which has a spillover effect that justifies government subsidy in the small firms loan market. But they don't bring together two essential elements: the cashflow on which to secure borrowing, and the market knowledge on which to be confident that borrowing to invest is worthwhile.
  2. Large firms are able to get cheap finance in the equity and corporate bond markets, if the opportunities are there.
  3. Medium-sized firms can get bank finance if their cashflows are safe enough - though they probably are regarded as a poor risk by banks at present. Some government intervention might be justified here, on the basis of nudging the economy from a low-investment equilibrium to a higher one.
  4. But there's no obvious answer to the real challenge, which is: how can we demonstrate to managers of medium and larger firms that there will be more demand in the future and they should invest now. If we can't show this, investment won't happen and the low demand will be a self-fulfilling prophesy. If we can, the investment that does happen will stimulate aggregate demand and the investment will turn out to be justified.
On this last point, I do have one idea which I will lay out in my next article. Until then, do continue to fiddle with the institutional details of the banking system, play with capital requirements and support aggregate demand with fiscal and monetary stimulus. It's all fine, but it papers over a fundamental fragility in our economy; and that fragility is what I'll propose a real solution for.

I'll give you a clue. It's all based on one word, and it begins with D. Place your bets, please.

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