April 22, 2009

What does to encourage lending mean?

There is a lot of talk coming from the Government about monetary policies and packages that aim to fix the current economic crisis by encouraging banks to lend.

As far as I can tell, bank lending can mean many different things.

  • Letters of credit are issued against collateral.
  • Lending margin, prime brokerage, to allow others to invest in speculative assets which are pledged as collateral.
  • Business loans who's collateral is often collateralized by the pledge of a related (or unrelated asset)
  • Lending between Banks in the interbank market.
It seems to me that the problem is twofold.

Firstly, banks are willing to lend, but the acceptable collateral to do so has changed. The risk aversion doesn't lie so much in the loan as it does in the collateral pledge against the loan.

Banks made a business out of speculating with their balance sheets with respect of the assets they held on their books. As a result of leverage (borrowing to speculate on assets which were then used to collateralize those loans) and the unexpected outcome of exceeding expected loss (forecast risk), banks find themselves effectively stopped out of speculation. As they experienced this outcome, it makes sense that they would prefer no to repeat it (at risk of ruin). In this sense, banks have become too familiar with collateral.

If banks are to return to the old days of being primarily deposit and loan institutions, that would imply a disavowment of proprietary investment. If banks won't do it with their own money, they sure as hell aren't going to lend you money to do it. This is the crux of the problem.

Secondly, as we saw in Japan (early 90's onward) when banks don't lend to speculation, there is still the good old business loan (infrastructure, capex, new products etc.). Speculation aside, cheap money means nothing if you can't use it, and Japan early 90's there was just not that much to borrow for. The problem which we now face is a global downturn in economic activity. Even if cheap money is available for capex, business won't expand its balance sheet unless there is an economic reason to do so.

Perhaps government is looking to thaw the credit ice age by fixing the freezer.

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