Monday, 3 November 2008

The Banks Won't Lend

Banks do not lend! At least not enough. Instead they appear to be doing what everybody hoped they would not do after receiving generous government help. They appear to be tightening credit conditions and to be hoarding the cash they have been handed. Over the past week we have seen two administrations, about as difficult as they come, the US and the French, both being very frank. The banks better start lending now, or else!

As if it were not enough that the monumental incompetence of US banks in handling the risks related to mortgage lending has thrown the financial sector worldwide into a crisis, it now appears that banks do not readily use the government grants to lend. Instead they appear to be hoarding the cash.

While it is easy to be populist on this one and condemn the banks for their apparently continuing greed when facing the consequences of their past actions, maybe the situation is indeed indicative of a simple fact: the banks are nowhere near to be out of the woods.

Banks are –despite any number of government subsidies and handouts – enterprises that work to maximise their profits under impression of the risks taken. When free cash is not taken and immediately used to boost profits, there are two possible explanations. One is that the banks still judge it too risky to increase lending significantly. The other is that a long-term view tells that there are better opportunities waiting around the corner.

Let us consider the first option, the perceived risk. Here it should be made clear that the crisis hitting the two opposing sides of the Atlantic are in fact very different in nature. US banks are primarily hit by a deluge of bad debts, and have to cope with enormous write-offs. European banks were to a much smaller extent hit by bad debts, even if some illustrious examples had in fact bought some nicely repackaged toxic debts. In Europe, the banks began to suffer in earnest when the interbank market froze up. In this respect the European banks are less severely hit than their US counterparts. Unfortunately, as the weeks pass, this difference is losing importance as banks worldwide are now setting their sights on the accelerating global downturn. Starting in the US, the world was already moving towards a slowdown when the Subprime loans began to go off like time bombs. It is a completely normal reaction from banks to rein in lending during downturns, and has been seen at the onset of every recession.

Looking at the most recent events on the economics front somehow leaves a clear impression of why banks are in no hurry to increase lending. They are simply afraid of throwing good money after bad money.

Last week saw the harrowing sight of a US Federal Reserve Chairman strongly recommending a senate panel to introduce a strong set of fiscal initiatives in order to boost the economy. In plain words: Even if the US government debt is at a post war high, Congress and President should simply increase government spending and care less about the long term effect of the financing. Bernanke effectively told US lawmakers to do something. This is a radical break with the caution usually characterising central bankers. It could easily be considered a sign that Bernanke is afraid of seeing the credit crunch seriously affect credit card debt, auto loans, commercial property finance (and from our own world, leveraged buyout artists and hedge funds). This message is fully understood by the banks, which on their daily business can follow exactly these sectors of the secondary credit creation. It simply indicates that there are still many, many losses out there to be dealt with and it makes sense not to throw the new money around too quickly. While the European economies are less severely hit than the US economy, today’s EU forecast for economic growth was dramatically lower than the forecast published just a few months ago, and the “risk scenario” was even more negative. European banks are likely to be more cautious going forward.

Of course politicians will posture and threaten. The question is just whether increasing loans now makes financial sense in the medium term.

Which leads us to the next reason for sitting on the cash. There has been absolutely no beating around the bush from politicians on both sides of the pond: the name of the game is consolidation of the banking sector. Hank Paulson has said it, Treasury spokespeople have said it. EU’s finance commissioner Almunia has said it. Governments across the European continent have said it. So the governments are very much ready to support further mergers and take-overs. It is all in line with my stated view that we are working towards a situation where each country are trying to anoint certain banks to come out the winners of this debacle. Participating in this game and coming out on top requires some free cash. It may be as simple as that.

I am not trying to excuse the banks. The recent history has shown the sector from its absolutely worst side. But it does not mean that the banks do not have very good and logical reasons not to spend the government handouts immediately. It is just my impression that the current political logic may tend to overlook such niceties entirely.

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