Bank lending: from one unwise extreme to another

WHAT INNOVATIONS has the financial services industry introduced in recent decades that boosted economic growth? Answer: the ATM; and only the ATM. That is the view of Paul Volker, America’s former central banker-in-chief.

Two Irish central bankers, Sarah Holden and Fergal McCann, were Volker-esque in their bluntness to the banks this week. Their study has answered – as definitively as it is possible to do – a big question: are banks meeting the demand for loans from viable businesses? No, is their convincing conclusion. This is a very serious matter.

A well-functioning banking system is essential for growth. That is particularly true in Europe where businesses depend on bank financing much more than US companies, who often bypass banks by, for instance, issuing their own corporate bonds.

That is one reason why the European banking system is much bigger relative to the size of the economy than the US one (which, in turn, partly explains why stabilising the system has been more difficult).

When the international credit bubble began to inflate in 2003-04, Ireland’s banks sucked up foreign credit in vast quantities. The system became exceptionally large even by European standards, mainly because Irish banks leveraged up in what became a competitive frenzy, with each institution trying to maintain or grow its share of the market. Most of their lending went into the property sector.

At the beginning of 2003, property development companies collectively owed their bankers €16 billion. When the banking crisis erupted in September 2008, their outstanding loans had soared to €106 billion. That was more than twice the €51 billion in loans to all other types of businesses (excluding other financial firms and €9 billion lent to builders).

In just over five years, net lending to developers rose by a staggering 558 per cent. When it came to business banking, Irish financial institutions devoted a massively disproportionate amount of attention to those seeking property loans.

Worrying evidence of a very narrow range of corporate banking skills comes from lending figures to non-property businesses. Such lending rose only modestly during the bubble. And the more a sector was internationally traded and the more high-tech it was, the lower lending growth tended to be.

Over more than 5½ years of one of the biggest credit bubbles in world financial history, outstanding loans to manufacturers rose by 84 per cent, to agriculture by 78 per cent and by just 52 per cent to business services firms. These are not high rates for companies in a growing economy, and are lower still when adjusted for inflation.

Lending growth to the IT sector was lowest of all, and it started from a very low base. All IT firms in the economy combined had bank borrowings of just €760 million in 2003. Despite the potential of that sector to grow sustainably, that figure had increased by just €350 million by the peak.

That individual property developers were routinely doing deals involving loans that exceeded the total borrowing of the IT sector gives a good indication of just how insanely skewed lending priorities were.

Incentive structures were part of the problem. During the bubble, loan officers were rewarded in terms of bonuses and promotion by lending as much as possible. As the industry came to believe property was a one-way bet, their superiors did not query property loans.

Things could hardly be more different now. The banks’ balance sheets have to be downsized because they are so bloated. That involves shrinking loan books. The message from head offices to loan officers is: don’t lend. Remuneration and promotion prospects now depend, in large part, on lending as little as possible. Having to listen to industry’s spokesmen say otherwise has become a teeth-grinding sufferance.

Business has suffered a most brutal corporate credit crunch as a result of the banking fiasco. Consider the IT sector again. If there is expertise in the banks on the IT sector, it has not translated into capital allocation prioritisation.

All of the very modest increase in lending to the sector during the bubble has been reversed. As of the beginning of 2012, lending stood at €570 million, nearly half of its peak and below even 2003 levels when records were first compiled. Of that, small- and medium-sized IT enterprises accounted for just €176 million.

Undoubtedly, that low level is partly explained by limited demand, but all told it does not paint a pretty picture.

There are few businesses looking to invest in high growth sectors, banks do not have the skills to identify and assist companies with potential and they have little incentive to lend. This does not augur well for jobs-rich recovery.