Central Bank Follies – QE, Negative Interest Rates And Regulatory Capital by Michael Sonenshine, CEO at Symfonie Capital
This post is long. It is a compilation of posts on each topic. I’ll get to the bottom line up front.
- Quantitative Easing (QE) keeps banks liquid, but does little else for the broad economy. If anything, it incentivises banks to buy government bonds (and soon to be high grade corporates) rather than focus on core lending activity.
- Sub-normal and now negative interest rates distort asset prices. Investors are crowded out of low-risk assets and crowded in to higher risk assets, all the while reducing their reward / risk ratio.
- Faced with compressed interest rate spreads banks resort to broad based fees. This is a regressive tax on people and businesses who can least afford it and have little or no alternative.
- Continual rounds of QE and interest rate cuts undermine the economy by transmitting negativity and pessimism. If people and businesses are continually afraid of the next looming financial crises they are more likely to reduce spending and reduce investment.
- Increased drive on the part of central banks to raise banking capital adequacy ratios reduces the overall capital available for banks to lend encourages banks to lend to an increasingly narrow segment of businesses and consumers, ironically, those who need credit least.
- Risk weighting capital toward collateralised and secured loans forces banks to focus on the credit backstop rather than credit fundamental. Any smart lender should put the ability and willingness of a borrower to pay ahead of the collateral the lender offers. Collateral is merely a backstop and when projects fail, the collateral is often a poor backstop at best.
- Reduction in risk taking by banks must be accompanied by support and encouragement for the emergence of alternative lenders – i.e. the P2P lending industry ( sorry if that’s a self-interested view, but even if I weren’t a P2P lender and if I didn’t run a P2P lending fund I’d still feel the same….really!).
Negative Interest Rates
Now for the Meat and Potatoes
I’m not a macro economist by training, so take what I say here with a grain of salt. Still, you don’t have to be a rocket scientist to realise that something is wrong in Frankfurt, Washington, Tokyo and London.
They say the road to hell is paved with good intentions. Central bankers in fact have good intentions. They see themselves as the guardians of the stability and security of our financial system and in this respect they are not far from the truth.
Mark Carney, governor of the Bank of England, recently remarked that monetary policy has certain limitations. Central banks can help economies cope with economic shocks that disrupt the financial system. By adopting sound monetary policies Central Banks create the foundation that underpins money as a medium of exchange.
So why is it that central bankers around the world seem to be continuously inventing new tools and techniques to jump start the world’s economies? Is it possible that we’ve reached the point where the doctors are over-medicating the patient?
Is it not possible that in their rush to help central banks are now doing more harm than good? Have we reached the point where monetary policy is producing absurd and perverse outcomes?
It’s harder to be the player than the fan, but the more I look at the direction central bank policy around the world has taken, the more I fear the policy ship has gone dangerously off course.
The trends I find most worrying are zero and sub-zero interest rates, the constant effort to push liquidity into the financial markets and the obsession with bank capital requirements. Let’s take them one at a time.
The Obsession with Bank Capital
We are nearly a decade after the onset of the sub-prime mortgage sector that is commonly looked upon as the trigger for one of the world’s greatest banking crises since the Great Depression of the 1930s.
Policy makers around the world had little choice but to bailout the banking system. The bailouts meant firstly that banks received infusions of fresh capital. Secondly the inherent riskiness of banking generally was subjected to intense scrutiny. The conclusion of policy makers was that banks should be significantly deleveraged. Third, the overall riskiness of bank lending came into question and the inescapable answer was that banks should redefine the way they look at risk so that going forward they make less risky loans.
Of course, with more capital and less leverage banks are much more resilient in the face of loan losses. But at the same time the emphasis on reducing the perceived riskiness of bank lending actually undermines efforts to reignite global economic growth.
The relentless focus on bank capital has has changed the character of bank lending and in ways detrimental to the global economic recovery. Risk weighted capital requirements set out by regulators force banks to emphasise relatively low interest rate secured loans in their product mix at the expense of higher interest rate unsecured loans. Also what’s changed is loan to value rates. Regulations and capital requirements have reduced the amount of bank lending available on a project by project basis.
In principle there is nothing wrong with a lender preferring to make one type of loan over another. But systematically, in their rush to improve the stated financial condition of the banking sector central banks have given banks incentives to turn a blind eye to credit worthy projects and left wide swatches of the economy underfunded and underleveraged. Ironically, the losers are companies that operate in some of the world’s fastest growing and most profitable sectors. Let’s look at some examples before we move on.
The software, retail, engineering and design sectors share one thing in common. Mostly they are asset poor and hence collateral poor. They require capital to fund inventory and labor for a period until they receive full value for the goods and services they sell. The faster the sales growth, the more capital they need. When sales turn down the cycle works in reverse. They reduce inventory and labor purchases so working capital needs decline and for a period of time they become highly cash generative. They may be strong companies, well run, highly cash generative. Yet systematically their access to bank capital is constrained. The result is that many companies are less profitable than they could be and many banks leave profitable lending opportunities on the table.
Many SME’s fall into the same credit trap. SME’s are the back bone of the global economy. SME’s are owned by small groups of private shareholders, often families. They live from their businesses, so they draw income, leaving little in the way of retained earnings. We can see many examples of highly credit worthy, cash generating businesses whose access to bank lending is constrained only because bank lending models focus on balance sheet metrics rather than cash generation. The result again is that many SME’s are capital constrained and underfunded and banks leave profit opportunities on the table.
Ironically, many SME’s fail not because they have bad businesses, but because they don’t have the working capital to meet demands of growth nor the working capital to