The Bank of England says evidence is emerging that risks it identified related to Brexit are beginning to crystallise. One of the risks the Bank identified is high levels of household debt.
However, to keep the financial system stable and offset a potential recession it is relaxing regulations to stimulate UK bank lending. In effect, it is also encouraging households and businesses to take on more debt.
One of the biggest risks to our economy is therefore being used as the primary solution. Even if this hair of the dog strategy works, should we be worried?
A discomforting strategy
No matter what side of the Brexit debate you are now on, (i.e. whether you believe the Brexit will prompt a recession or not), this strategy has to be a little bit discomforting.
It shows that the primary tool to thwart the crystallisation of any risks to our economy is to encourage more bank lending and thus more private sector debt. It is also disconcerting that policymakers seem overly comfortable with treating the main cause of the last crisis as the key solution.
For example, in a recent statement, former chancellor George Osborne even declared, “The last time Britain faced an economic shock the banks were at the heart of the problem.” but this time round, “…banks and building societies are now part of the solution”.
Even more unsettling, in the very report in which the Bank of England announced that it wanted to stimulate UK bank lending, it identified the “The high level of UK household indebtedness” as one of the “most significant near-term domestic risks to financial stability”.
It is as if policy makers are ignoring that when you try to stimulate more lending, the flip side of the coin is that you are increasing levels of private debt.
The Bank of England’s plan to stimulate lending
As noted in the Bank of England’s 2014 (March) quarterly bulletin, banks create new money when they make loans and when they buy assets. Accordingly, 97% of all money exists in the form of electronic bank deposits – debt money issued by banks – while the other 3% exists as notes and coins – sovereign money – issued by the government. As Positive Money has suggested ever since our inception in 2010, and as Geoff Tilly of the TUC wrote in a recent article, this means that in theory and in practice, “there is no limit to the amount of money that can be created in an economy.”
However, to prevent any over-lending from turning into a crisis, the private banking sector is encouraged to hold capital against its lending portfolios, a 3% capital ratio (or leverage ratio). That is to say, for every extra £100 that the bank wishes to lend out, it must retain an extra £3 from its earnings or raise an extra £3 from its shareholders. This is meant to act as a sort of cushion to absorb losses should any of the extra loans default[i].
At the beginning of the year, the Bank of England’s financial-policy committee announced that it was introducing a “countercyclical capital buffer”[ii]. This requirement was meant to ensure that banks would hold an additional 0.5% of capital against their loan portfolios, with the intention that it would eventually increase to 1%. Banks were warned that the requirement would become binding after March 2017.
On July 5th, in response to the Brexit vote, the FPC reduced the buffer back to zero. This move relaxes regulations, freeing commercial banks from the future requirement of having to hold £5.7 billion in capital. According to the governor of the Bank of England, Mark Carney, this:
… will reduce regulatory capital buffers by £5.7 billion, raising banks’ capacity for lending to UK households and businesses by up to £150 billion.
Where are the flaws in the plan?
Other than the inherent contradictions to thwarting financial instability and a recession by encouraging more lending and hence more debt, it is worth asking whether the plan will actually work.
Firstly, there are good reasons to believe that capital ratios do not necessarily restrict bank lending – as is often suggested:
1) Banks profit through charging interest on loans. Profits increase shareholder equity (the difference between assets and liabilities), and therefore increase capital. Higher capital supports further increases in lending. Provided that the loans are repaid this will lead to further increases in profits and shareholder capital.
2) Banks can also engage in securitisation. This allows banks to package assets (loans) on their balance sheet and sell them on. This has the effect of freeing up the capital, which was being held to cover potential losses on those loans. As a result more (new) loans can then be made by banks even though existing debt owed by firms and households remains outstanding. This increases the pace of lending (and new money creation).
3) In boom periods banks are able to raise additional capital through new share issues. Consequently, banks will face little difficulty increasing their capital through this avenue during boom periods.
In addition, when the 0.5% requirement was initially introduced in March, the FPC noted:
“Almost all of these banks had capital resources in excess of the 2019 Basel III requirements and the 0.5% countercyclical capital buffer. The FPC recognised that these banks might want to rebuild capital over time in order to retain some excess over regulatory capital buffers, but their current position meant that any such action was able to take place gradually.”
So relaxing this constraint is unlikely to have any perceptible impact anyway.
The other problem, as noted by Tilly, is that bank lending is not only supply constrained but also demand constrained. That is, relaxed lending constraints (in so much as they work anyway) will only boost banks’ ‘capacity’ to lend. Banks will also need customers to come in and apply for new loans. Given uncertain economic conditions and potentially poor prospects for growth, there is no guarantee that there will be an extra billion pounds of net new lending in the coming year.
The final problem with this solution is that even if there is an extra £150 billion of new lending, it will most likely fail at stimulating an increase in private sector incomes, and is likely to lead to more financial instability.
Currently 80% of new lending goes to the property sector or the financial sectors. For the most part, this lending does not directly contribute to growth in GDP, which is a measure of new (final) goods and services produced each year and a measure of the income that the economy generates. This is because most lending is used to buy already existing assets that nobody has to be paid further to produce.
It therefore increases the level of private debt but does not lead directly to an increase in people’s income – as no new goods and services are actually created. As Hyman Mynsky suggested, when the level of private debt increases faster than private sector incomes, our economy becomes unstable – and more susceptible to financial crisis.
This hair of the dog strategy shows the extent to which the monetary policy toolbox available to the Bank of England needs to be updated. It further demonstrates how unsound are the foundations on which our economy rests. If anything, it fully exhibits why the toxic role of banks in supplying money to the system must be addressed, why we need another way of getting money into the economy, and why we need Public Money Creation.
[i] There are plenty of issues with capital ratios (not to be confused with reserve ratios). Needless to say, when a bank is in danger of becoming insolvent, a 3% capital buffer is unlikely to thwart insolvency, because when the economy is contracting after a boom, non-performing loans tend to be far greater than 3% of a bank’s assets.
[ii] If total debt owed by the private sector (other than banks and financial institutions) as a percentage of GDP rises above its long-term trend, then borrowing is regarded as becoming increasingly problematic and banks are required to increase the amount of additional capital they hold by retaining also a counter-cyclical buffer. If the ratio drops towards or below its long-term trend, then it is assumed the economy can safely accommodate more debt and the buffer is reduced, eventually to zero. According to data released by the FPC, in March 2016 private debt was 1.43 times annual GDP, and it was estimated to be 19.2% below trend. At its peak in September 2007 at 1.62 times annual GDP it had been 9.66% above trend.