Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday, 30 November 2013

UK banks and the productivity puzzle: it may not just be about limited lending

Banks, in providing - or not providing - loans for start-ups, or for small firms to expand, can potentially play an important role in aggregate productivity growth. In the UK, Small and Medium Sized Enterprises (SMEs) make up about half the private sector economy in terms of turnover and employment. UK SMEs remain dependent on banks for the large majority of their external funding. So banks decisions on whom to fund, and who to no longer fund, could make a big difference.

The concern that I have discussed before is that a reduction in UK bank lending to SMEs, as banks try to rebuild their balance sheets, would hurt the ability of the more productive SMEs to expand. This in turn would impact on economy wide productivity. There is a longstanding concern that banks that have balance sheet problems of their own will keep ‘zombie firms’ alive to avoid writing off loans, and that this will restrict their ability to lend to new more dynamic firms. UK liquidations have been unusually low in this recession. 

The Funding for Lending Scheme (FLS) attempted to encourage greater aggregate lending by banks, although it did not initially discriminate between lending to SMEs and household mortgages. Subsequently the government’s Help to Buy programme threatened to divert more of the scarce resource - bank lending - from SMEs. (The possibility that lending to households could ‘crowd out’ lending to firms is examined in this study.) So it is to the Bank of England’s credit that they recently decided to focus FLS on SMEs, and the Chancellor - perhaps grudgingly - agreed.

However there may be another process behind the UK's productivity puzzle that has to do with banks, but not the volume of bank lending. About a third of bank lending to SMEs is accounted for by one bank: the Royal Bank of Scotland. (At the time of the financial crisis its market share was 40%: see the Independent Lending Review commissioned by RBS, page 25.) It has become increasingly clear that the RBS has been a seriously mismanaged bank. At the end of 2011 the Financial Services Authority issued a report which was extremely critical of the quality of management at RBS. Part of that poor management included a huge expansion in property based loans before the financial crisis. When those loans went bad, it was many of their SME customers who took the hit, according to a report just issued by Lawrence Tomlinson, the "entrepreneur in residence" at the Business, Innovation and Skills Department. Among other things the report alleges that RBS has been forcing viable businesses with short-term cash flow problems into its corporate restructuring arm with the aim of forcing foreclosure and then making a profit from selling off property assets.

When a bank does close down a firm, there is usually a difference of opinion over long term viability, and so the process is bound to be unpleasant. But from an economy wide perspective, you would hope that a bank was reasonably efficient at protecting those firms with innovative potential, because these firms will not only end up repaying their loans, but will be the basis for a mutually profitable future partnership. But Hamish McRae argues that gradually this ‘duty of care’ that banks once had with their customers has been replaced by a desire to flog products. And as the PPI scandal illustrates, banks seem not to worry about whether their customers need these products, as long as the sale is made. In terms of SMEs, some of the major damage may have been done by interest rate swaps: often complex hedging products which buyers may have not understood, or may have been missold. RBS appears to be heavily exposed to compensation claims involving these products.

This example nicely illustrates the problem that appears to be at the heart of banking today. Products like interest rate swaps could potentially be useful to small businesses, protecting them from risk. This is how the expansion of the banking sector was portrayed by the banks themselves - they were selling innovative products that benefited their customers, and therefore the economy as a whole. But if these products are mis-sold, either to those who did not need them or by false claims about what they do, it is just a case of successful rent seeking (using the term in its wider sense): obtaining money from bank customers and providing nothing useful in return.

It is very easy to get carried away with indignation at all this. As scandal after scandal emerges involving the UK banking sector, the only thing that seems to keep pace is the growth in bankers’ salaries. Growth which the UK government is trying as hard as it can to protect. And in the case of RBS, last year this bank even failed to keep its most basic service of operating a payments system going! But this post is designed to pose a rather different question.

Is it possible that this combination of rent seeking and incompetence by the UK’s foremost provider of loans to SMEs had impaired the ability of the bank to ensure that firms that were more efficient and productive survived? Did this bank, and perhaps other banks, become so engrossed in selling products to customers that it no longer allocated what loans it did make efficiently? Could this, alongside low levels of overall lending, be a factor behind the puzzle that recent UK productivity growth has been so low both historically and in relation to other countries? We will probably never get good aggregate data on this, but that does not mean it has not happened.



9 comments:

  1. Do you think there is much empirical evidence that:
    1. SMEs are the main drivers of productivity growth in the UK.
    2. The volume of bank loans has a statistically significant effect on productivity growth.

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    1. It makes sense that the process of entry and exit does improve aggregate productivity. New entrants are likely to start small, and need financial support to start. But that is not really an answer to your question, and I would love to hear from people who know more about any empirical literature.

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  2. Simon,

    I have quite a few concerns with this that I won't go into here. But my main observation would be this. RBS was indeed the market leader in loans to SMEs before the crisis. It has reduced its SME lending considerably since, as indeed have most banks. This has nothing to do with GRG, which is concerned with disposing of distressed corporate and other loans. But it has much to do with corporate lending staff who have had their fingers very badly burned and are terrified of getting it wrong again. Andrew Large found that risk aversion by lending staff was a key factor in the collapse of SME lending at RBS. I think we often forget that it is not "banks" that make lending decisions and allocate capital, it is people.

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    1. Frances
      My concern is with aggregate UK productivity. Suppose there are two types of firm: those that need loans and those that do not. It seems plausible that those firms that need loans will also be (potentially) higher productivity firms, so increased risk aversion in supplying loans could reduce productivity growth. I think we are agreed on that.

      But suppose also that having a loan makes you more likely to be subject to rent extraction by the bank. That rent extraction could fatally damage the firm. In which case rent extraction would also lead to a reduction in aggregate productivity.

      This would not happen if those in the bank giving loans to firms could prevent this rent extraction by other parts of the bank – the selling products part. Whether they can do that depends on how well the bank is managed. Does this make sense?

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    2. Simon, I think it's more complex than that. The same people who sold the loans also sold the IRHPs - they were sold as a package in most cases and the IRHP was often made a condition of the loan. Really what caught everyone out - the banks as much as the businesses that had bought IRHP - was the extended period of low interest rates, which made the IRHPs toxic because they prevented the businesses from taking advantage of low rates and in some cases even cost them more. I don't disagree that the IRHPs could have been partly responsible (among other things) for poor productivity, but the problem really is the fact that they acted as an obstacle to monetary policy transmission.

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  3. I think the definition of a credit crunch is relevant here given we're in one, especially where this refers to "a sudden tightening of the conditions required to obtain a loan". Pre-2008 conditions where progressively loosened, most famously with cov-lite lending, to a stupid/unrealistic extent for 2 reasons - banks are collateral based lenders and certain banks had stupid growth targets. Putting those things together (along with the additional cash securitisation and wholesale funding provided) and you got the asset price bubbles we saw.

    Now, banks have far more conservative loan to deposit ratios (i.e. far less wholesale funding) and securitisation is less of an option. They've also, as has been said, had their fingers burned when to comes to setting condition, which can also be read as the more reckless executives have been early retired off to a Spanish golf course. ,And at an institutional level, the more reckless banks have variously failed, been bailed out, exited the UK or been taken over, taking their credit "policies" with them.

    From the above, I guess the question of whether productive firms are being starved of finance still stands, however I'd suggest recasting it as have conditions swung from too loose to too tight (or if you wanted to be generous - are they now more realistic). Its also not clear that lending Pre-2008 was especially productive given so much of it was tied up in boosting commercial property values.

    In the background/as an aside - the Enterprise Finance Guarantee is (was?) how government provides no asset SMEs with the collateral they need to borrow. From Jan 2009 - March 2010, this was to support £1.1bn of loans. In 2010/11 it was for £0.5bn. (Making credit cheaper via the FLS doesn't address the basic need for collateral). Similarly, after 2009 there was a notable YoY reduction in Publicly backed venture capital and loan funds in the UK.

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  4. Simon,

    You say, “you would hope that a bank was reasonably efficient at protecting those firms with innovative potential..” I doubt the average bank manager has, or ever has had much of an ability to detect “innovative potential”, because a bank manager would need a VERY GOOD technical grasp of what the borrower was producing in order to be able to do that “detecting”. And I doubt that most bank managers have that grasp. Their speciality is lending on the basis of solid collateral, like property.

    “Innovative potential” lending will come from business angels or others with relevant technical knowledge. As an example, I think Siemens, the German firm, does a lot of lending to those it does business with. It certainly has its own bank.

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  5. The issue seems to be more related to the zombies firms that the actions of banks. Zombie firms use up a range of resources that would be better used elsewhere such as skilled labour and capital but also their existence is a distraction for banks who focus on limiting losses rather than generating profits through more lending. As their moniker suggest, these firms should be allowed to fold but are kept alive by low interest rates and banks not wanting them to show up as losses. Furthermore, the zombie firms take away market share from companies that could prosper. Banks have a role to play in this but it seems to be more of a rational calculation focusing on their own survival. The only way out being a massive input of funds by the government or international body to allow for banks to clear out their books. For more on the impact of zombies on the economy, see http://yourneighbourhoodeconomist.blogspot.co.uk/2012/11/zombies-causing-havoc-with-monetary.html

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  6. Experian say there is no evidence that zombie firms are damaging the economy. See http://www.pieria.co.uk/articles/zombie_alert and http://www.telegraph.co.uk/finance/comment/10484595/Zombies-They-are-a-myth.html.

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