IN THE debate about why Britain’s monetary policy is not working, there has been too much focus on whether the Bank of England should buy more government bonds or move to negative interest rates. Both miss the point. The primary reason monetary policy is not working is that the transmission mechanism is broken. There is no credit growth in the UK.
This is a function of the deleveraging of banks and, in particular, the drive to raise capital ratios. If banks need to increase their capital ratios they can do so by raising capital in the market, retaining profits or cutting the size of the balance sheet (which normally involves reducing lending). With investors reluctant to provide capital, and profits under pressure from losses and compensation payments like for the payment protection insurance scandal, it is the balance sheet (and hence lending) that has taken the strain.
Lending to non-financial companies has fallen by around £10bn a year since the financial crisis, and continued to fall last year despite the introduction of the Funding for Lending Scheme (FLS). The net result is that, on one measure, money supply growth has been negative since 2010.
If it really wants to support the economy, the Bank of England needs to act to get the transmission mechanism working. FLS was meant to be the solution, offering banks cheap money if they lent it out. It helped on the funding side, but not on the capital side. Small business lending, in particular, is very capital intensive – with a bank currently having to put up around £10 of capital for every £100 that is lent. That is between three and five times as much capital as a bank needs for a mortgage, which is why mortgage lending has responded more positively to the FLS.
One of the ideas in the FLS was to allow banks to use their capital buffers to lend without having to commit additional capital to the loan. The problem is that the Bank then completely undermined this by declaring in November that the banks’ capital buffers were insufficient, and that they would have to raise more capital. We advocated in our recent note on capital requirements Gold Plate or Lead Weight? that the Bank of England reverse course, or at the very least allow the new capital to fund new lending. Whether they will listen is doubtful, since Bank policymakers seem intent on trying to make the banks as safe as possible, rather than prodding them into lending. If the Bank continues down this route, it will find that FLS continues to fail.
There is one other way, however, in which the Bank could promote credit growth and it requires it to change the assets it buys when it carries out its quantitative easing (QE) programme. Technically, the facility that the Bank uses to do QE is called the Asset Purchase Facility. When it was drawn up, the then chancellor Alistair Darling had hoped that it would be used to buy corporate assets. Bank governor Sir Mervyn King, however, wanted to buy gilts. Although the bank did buy some corporate bonds early on, the programme was small in size and was soon dwarfed by gilt purchases. The time is now right for the Bank to revert to buying corporate debt.
One way banks used to reduce the weight of loans on their balance sheets was through Collateralised Loan Obligations (CLO). In simple terms, a bank would take a group of loans on its balance sheet, package them together and then divide them into tranches. The highest quality tranche should fit in with the type of asset the Bank of England was originally meant to buy. Were it to do so, it would be a way of reducing the capital demands on the banks of lending to small businesses. We would suggest the Bank buys CLOs based on new lending that qualifies under the FLS, with the banks keeping a sizeable proportion (say 50 per cent) on their own books. That way the Bank of England would be confident that the banks were lending on commercial terms.
This would be a way of opening the credit channel in the UK by allowing banks to lend, but not to run up against capital constraints. In effect, it would be the Bank of England lending to SMEs, but channelled through the banks. The Federal Reserve in the US has done similar things in parts of the US credit market that were not functioning, and called it credit easing. We think this is one reason why the US economy seems to be recovering when the UK is not. It is about time the Bank took a leaf out of the Federal Reserve’s book and truly started to ease monetary policy.
James Barty is senior consultant for financial policy at Policy Exchange. @PXFinance