Why banks aren’t lending: They're too busy saving cash

I had recently read that in the UK, falling down the stairs kills more people every year than road accidents. Since then, I had been very careful while climbing stairs to my third-story apartment.

“Maybe it’s a Brit thing,” she said when I explained my latest paranoia to her.

“Maybe its not,” I replied.

“Never mind that! What I do know is that the British economy is in a mess. And this is despite the government intervening and rescuing all the big banks there. The idea was that the banks would start lending again, which would lead people to borrow and spend and thereby perk up the economy. But that doesn’t seem to be happening.”

“Yeah, it doesn’t seem to be happening primarily because banks are not lending. You see, there is an inherent contradiction here. Governments rescued banks in the hope that they will start lending money and at the same time, recapitalise themselves.

John Lanchester explains this rather beautifully in his new book I.O.U. - Why Everyone Owes Everyone and No One Can Pay. He says: ‘The banks are being given two totally incompatible goals. One is to rebuild their balance sheets... so they’re no longer at risk of going broke. The second is to keep lending money. They are being told to save and keep lending money at the same time. It’s not possible, and in the circumstances, it’s no mystery why banks are hoarding every penny they can get and calling in every loan they can: they’re doing it to in order to ‘deleverage’ and rebuild their capital as fast as possible.’”

“Hmm. Can you illustrate that ?” she asked.

“Okay. What are the liabilities of a bank?”

“The deposits it raises from the public and the corporates.”

“And what are its assets?”

“The assets are of course the loans it gives out and the investments it makes.”

“At a very basic level, that is correct. And we will stick to that. Other than this, the bank also has something known as capital, also referred to as shareholder’s equity or net worth. This consists primarily of  the money the promoters have put into the business, the money the bank raised by issuing shares in the stock market and the profits that have accumulated over the years as reserves.

So let us say that the deposits of a particular bank are at $29 billion. At the same time, it has net worth or capital at work of $1 billion. Then, its assets will stand at $30 billion, which are basically the loans the bank has given out and the investments it has made. Such a bank will have a leverage of 30 because it has assets worth $30 billion against a capital of $1 billion.

Now suppose  because of the financial crisis, about $200 million of the bank’s loans go bad. This loss will have to be adjusted against the capital at play. Thus, the capital or net worth comes down to $800 million. The assets, meanwhile, shrink to $29.8 billion. This leads to a situation where the net worth of the bank goes up to 37.25 (29.8 billion/ 800 million). If the bank wants to come back to its original level of 30, it will have to shrink its assets to $24 billion. And how will it do that?” I asked.

“Well, it will have to call back loans and at the same time not give out new loans,” she answered.

“So there you have it. Assuming everything else stays the same, the bank in this case will have to shrink its assets by $5.8 billion (29.8 billion - 24 billion). This will obviously be done by calling back loans and selling investments. What you see is that a loss of $200 million can cause the bank to shrink its balance sheet by $5.8 billion. Of course, a lot of these banks lost money due to the financial crisis and are not trying to deleverage. Given this, where is the question of going out there and lending more money? Even governments coming to the rescue of banks hasn’t helped.

As Gary Dorsch points out in his investment newsletter Bond Vigilantes Set Sights on Sovereign Debt, ‘The world’s wealthiest nations responded to the crisis, acting in solidarity, with a rescue package of $12 trillion, equal to a fifth of the entire world’s annual economic output.’ A substantial portion of this money went into rescuing the financial system, but that doesn’t seem to have helped primarily because banks are in what you could call the ‘once bitten, twice shy’ stage, and do not want to lend. Also, they are trying to deleverage.”

“But hasn’t this rescuing pushed governments over the edge as far their own debt is concerned?”

“Yes it has. McKinsey carried out a study and concluded that deleveraging typically begins two years after the crisis and goes on for 6-7 years after.

Another study, This Time is Different: Eight Centuries of Financial Folly, carried out by economists Carmen Reinhart and Kenneth Rogoff, looks at financial crises over the last 800 years and concludes that three years following a crisis, the outstanding debt of the country doubles and unemployment goes up. Also, once the debt-to-GDP ratio crosses 90%, the growth rate slows by 1%.”

“Very interesting.”

“The public sector debt of countries like the US and the UK is growing towards 90% of GDP. The IMF now estimates that the debt of the G-20 nations, which includes some of the most heavily indebted countries of the world like the US, Japan, Italy, etc could reach 118% of GDP in 2014. All in all, all the debt raised in the hope of initiating a recovery, may not work out well.”

“There you go again. Pessimistic as always!” she remarked.

(The example is hypothetical)

References:
I.O.U. - Why Everyone Owes Everyone and No One Can Pay, John Lanchester, Simon & Schuster, 2010
This Time is Different: Eight Centuries of Financial Folly, Carmen M Reinhart and Kenneth Rogoff, Princeton University Press, 2009
The Ring of Fire, Bill Gross, www.pimco.com, February 2010
Bond Vigilantes Set Sights on Sovereign Debt, Gary Dorsch, www.sirchartsalot.com, February 2010