At Conservative Party Conference, George Osborne announced that the Treasury would be investigating credit easing. Credit for this initiative was widely attributed to Sam Gyimah MP, who had launched a consultation on alternatives to bank lending for businesses earlier in the year. Subsequently it was announced that Sir John Gieve and I had joined an advisory panel, assisting Sam and his partner, NESTA, in the project. This morning, NESTA hosted an event on the topic.
Being on an advisory panel is not, mercifully, the same thing as being the main author of the ideas or responsible for or agreeing with all the findings. But it might interest readers (and it would help me) if I set out some of my thinking on this topic here.
I see there as being three key strands to the issue of credit easing:
- 1) Monetary policy
- 2) A quasi-“good bank” policy
- 3) A long-term policy for the structure of business financing
I shall explain and explore these in turn.
Our first strand is monetary policy. This has been the most widely discussed aspect of credit easing, but in my view is probably the least interesting. The idea here is that “credit easing” would be a form of or alternative to quantitative easing, as a mechanism for the Bank of England to expand the money supply. So, whereas under “quantitative easing” in the UK, the Bank of England overwhelmingly used the “new money” it created to purchase UK government bonds, in the US the Federal Reserve used much of its first round of new money creation to buy private securities (as it happens, especially mortgage-backed securities). It was widely suggested that in our own “QE2” the Bank of England should buy particular bonds — e.g. perhaps corporate bonds, to reduce interest rates and ease lending to businesses.
There are a number of difficulties with this concept, but it is worth highlighting two in particular. First, the key purpose of quantitative easing is to offset the contraction in the money supply induced by problems in the banking sector. Specifically, the goal is to increase the volume of bank deposits — if bank deposits were to contract (faster) then with less money about, prices might fall, and falling prices would mean that the burdens of household debts would rise, leading to defaults, further problems with the banks (as they suffered bad debts) and a vicious spiral. The goal is not to reduce interest rates, let alone to reduce interest rates in specific credit markets to specific companies or industries.
The most economically-neutral way to increase the volume of bank deposits is to purchase government bonds in second-hand bond markets. If the Bank were to intervene in specific credit markets, that would create significant distortions — lending would migrate to those markets / firms, and the Bank would be engaged in “picking winners”. Furthermore, how well placed would the Bank be to assess true credit risk in those markets? Think of the travails of the European Central Bank with its bad debts from the Greek government and banks. Then imagine the Bank of England going bust, lending to firms that didn’t pay.
The excuse for intervening in specific markets would need to be that those markets were suffering from some particular market failure, which intervention could offset. That was explicitly the rationale offered for credit easing in the US. But that brings us to the second problem: the Fed’s first-phase of quantitative easing, which was indeed credit easing of a sort, is regarded as having not been especially successful. That is why, in the US QE2, policy switched to purchasing US government bonds — just like the Bank of England’s first-phase quantitative easing. Why would we want to switch away from an approach that is regarded as having succeeded, and which others are now copying, to an approach that is regarded as having failed?
I do not rule out all intervention in specific credit markets under any circumstances, but there would need to be additional arguments beyond those offered so far.
A different short-term role for credit easing appears in our second strand: a quasi-“good bank” policy. Bank in late 2008 / early 2009, a number of commentators urged that, instead of bailing out the bust banks, if the government really insisted on being involved in the banking sector and really wanted to take responsibility for ensuring that lending continued, it should use the money it had available for bailouts to, instead, set up one or more new “good banks”. So, instead of making up for past losses, and risking throwing money away on new future losses, the government could set up a new, clean bank that had no legacy of bad debts, and was free to lend to businesses and individuals as their ventures and circumstances warranted.
One form credit easing could take would have much the same goal. Since the banks remain distressed (through some combination of past losses, future outlook, and regulatory response), the government could circumvent the legacy banks — go “beyond the banks” — and provide new resources for lending. This might be done generally, or focus upon particular classes of borrower believed to be poorly served by the legacy banks, e.g. small and medium-sized enterprises.
There are a number of forms such an approach might take. The government could set up new good banks with new capital. Alternatively, it could place government deposits, such as from tax receipts, (which traditionally sit in the Bank of England) into new or existing smaller banks, to promote competition and lending to specific classes of business. It could even do this on the basis of establishing ring-fenced deposits at these new banks, which were specifically and only to be used to support SME lending according to certain risk criteria. Or the government could invest in SMEs directly itself by purchasing corporate bonds, forming a view on which were the best recipients (i.e. conducting its own risk analysis). Or the government could facilitate the establishment of new architectures for brokering SME corporate bonds issuance and trade. And many other such ways.
In my view this kind of policy should be regarded as (a) very much a “second best” to creating proper mechanisms to allow banks to go bust, credibly resulting in losses for their bondholders and depositors; and (b) a reserve available in the event that a policy of allowing bank failures might seem to be running out of control and resulting in such an aggressive contraction in lending as to threaten social order or the loss of political sustainability of the allowing-bank-failure policy — much better to establish quasi-“good bank” lending policies than to bail out bad banks (though better not to have to do either). In the current environment, in which we have already bailed out banks and failed to allow space to be created for new entrants, diverting deposits into new or small banks might have the useful effect of promoting competition in the banking sector.
Our third strand is long-term policy for the structure of business financing. Traditionally, in Europe in general and the UK in particular, corporate bonds serve as a much less significant proportion of total corporate finance structures than is the case in the US. Even if we fear that mid-2000s structures reflected over-involvement in bonds, if we go back to the early 2000s in the US corporate bonds constituted about 11% of corporate financing, but in the UK only 2%.
There were those that believed that as the Single Market in Financial Services developed in Europe, European norms for corporate bonds would converge to the US level. When I was writing about this in the mid-2000s for the FSA and the European Parliament (e.g. see here Annex 2, especially paragraphs 4.29-4.31) my view was although there would be some convergence as a result of “technical” developments facilitating corporate bonds issuance and trading, the much higher levels of corporate bonds in the US were because of US regulatory restrictions, not UK or European restrictions. In particular, we said:
In our view, the differences between bond financing levels in the US and the EU are primarily attributable to historical features of US banking that tended to restrict the ability of retails banks to make commercial-scale loans and thereby encouraged the use of bond financing, rather than because segmentation within Europe limited the feasibility of bond financing (so that a reduction in segmentation would lead to convergence to a more “natural” US-style level)…[ In the US, historically, inter-state banking was prohibited and some states restricted, or even prohibited, branching. For many years this restricted the size of US banks and thus their ability to engage in on-balance-sheet transactions.]
It is of interest to observe that the pressure for regulatory change in the EU, in response to the financial crisis, has been very much to move in the direction of the older US regulatory model that gave birth to its large corporate bonds sector. The implication might be that, as current EU and UK regulations go through, we would expect that to be paired with a significant rise in the role of corporate bonds.
Insofar as these changes are regulation-driven, there could be a potential role for government in facilitating / smoothing the transition induced by its own decisions. Eventually, presumably, the government would stand back.
Neither NESTA nor Sam Gyimah is committed to the above accounts of the role or advantages / problems of credit easing. They are thinking about these matters in much more detail than I am, drawing on many sources. But that is my two-penn’worth for now, and may not be entirely without interest.