Tits on a bull

In a decentralised market economy, financial intermediation between economic agents with financial surpluses and those with financial deficits (or, more accurately, between economic agents who would like to run financial surpluses and those who would like to run financial deficits) is an essential economic activity.  If this task if not performed effectively, it will still be the case that, ex-post, the sum of all realised financial surpluses equals zero, that is, realised saving equals realised investment – accounting identities are very insistent – but both are likely to be far from their optimal levels.  In addition to channelling resources from financial surplus units to financial deficits units, the financial system performs, through risk trading, a significant part of the total risk sharing that takes place in a society.  It also performs the portfolio management of much of the stock of financial wealth in existence.

The depth of the current crisis is such that the last two tasks of the financial system (risk trading and portfolio management) are being performed abysmally, and the first, the intermediation of financial surpluses and deficits, has effectively ceased to be fulfilled by our financial markets and banks.  Financial intermediation has all but ground to a halt.

Many systemically important financial markets are closed to new issuance.  Even secondary markets (for trading and pricing existing asset stocks) are badly impaired.  Banks have all but stopped lending to households and to non-financial enterprises.  Where banks are notionally still present as lenders, the financial terms and non-financial conditions (collateral and other covenants) are often prohibitively onerous.

We have no longer just a crisis in the financial system.  We have gone even beyond the stage where there is a crisis of the financial system.  The western (north-Atlantic) financial system we knew has collapsed.  If I may paraphrase that great ensemble of Nobel-prize winning financial wizards, Monty Python’s Flying Circus:

“This financial system is no more! It has ceased to be! ‘It’s expired and gone to meet its maker! ‘It’s a stiff! Bereft of life, it rests in peace! If you hadn’t nailed ‘it to the tax payer’s perch it’d be pushing up the daisies! ‘Its metabolic processes are now ‘istory! ‘It’s off the twig! It’s kicked the bucket, it’s shuffled off its mortal coil, run down the curtain and joined the bleedin’ choir invisible!! THIS IS AN EX-FINANCIAL SYSTEM!!”

Getting financial markets for illiquid assets going again will require public intervention, through the state acting as market maker of last resort, accepting illiquid assets as collateral for loans or buying them outright.  It makes no fundamental difference whether this happens along the lines originally proposed for the TARP, or by the government insuring the value of illiquid assets, as the US Treasury has now agreed to do for Citi Bank.  In both cases the government and the current owner of the illiquid asset have to agree on a price or a valuation.  The main practical ‘advantage’ of the insurance proposal over attempts at price discovery through auctions and similar mechanisms, is that the insurance plan hides the problem of valuing the illiquid assets behind non-transparent bilateral negotiations about the insurance premium paid and the level of the price guaranteed in the insurance contract.   Opaqueness and lack of transparency are obviously at a premium when tax payer resources are being funnelled into the black holes that are our leading banks and other financial instutition.

Getting banks to lend again is even more essential than getting primary and secondary markets for illiquid structured financial products going again.  It may be even more important than getting the regular commercial paper market going again, important though that is.  Small and medium enterprises rely overwhelmingly on banks for external finance.  Without access to bank loans, credit lines and overdraft facilities, countless SMEs that would be perfectly viable with a functional financial and banking system are threatened with bankruptcy.  Without working capital, businesses go out of business.  Banks are essential.  But they are not lending.  Why?  A number of possible explanations suggest themselves.

(1) Normal commercial prudence has finally resumed its rightful place, after many years of excess  Sound commercial judgements, made on a case-by-case-basis, produce the right supply of credit for each particular risky venture requesting financing.  These individual lending decisions aggregate into an entirely appropriate  volume of economy-wide lending that happens to be very low.  Don’t blame the banks.  Blame the entrepreneurs for not coming up with more creditworthy projects.

(2) In a world with multiple and quite different self-fulfilling equilibria, we somehow have ended up in the lousy equilibrium.  Here each bank, believing the state of the aggregate economy to be lousy, decides not to extend credit to a  would-be borrower that would be viewed as an acceptable risk, but for the dim view the bank takes of the aggregate economy.  When all banks act this way, they will, by severally and jointly witholding credit, produce the lousy aggregate economic environment that they assumed/feared when they individually turned off their credit spigots.  We just have to find some way of changing the focal point that coordinates individual banks’ actions to the good equilibrium.  In the favourable equilibrium each bank, believing the state of the aggregate economy to be good, decides to extend credit to a quite reasonable would-be borrower the bank would not have lent to had it believed the state of the overall economy to be lousy.

(3) After years of excess and anything goes, the bean counters and risk controllers now rule supreme in the banking world.  There is little upside to lending and taking a risk, but a lot of downside.  Rolling over an old loan or extending a new one won’t help your bonus and it may cost you your job.

(4) Blind fear and panic rule the roost in the banking sector.  Bankers are shell-shocked and paralyzed. More Prozac please.

(5) Banks hoard cash and liquidity to retain or regain their independence.   The predator they fear is not Warren Buffett, foreign sovereign wealth funds or Qatari princes, but the state.  Banks where the state has acquired a preferential equity stake or another equity interest are often subject to dividend limits and restrictions on executive remuneration.  Paying down these government capital injections to regain full discretion over dividend payments and executive remuneration is a key pre-occupation.  Banks seek out new private investors, trampling the pre-emption rights of existing shareholders and at higher financial cost to the bank than would have been attached to a capital injection by the government.  All this just to retain their independence.  Whose interest is being served you may ask?  Not the existing shareholders.  Not the other stake holders, the banks’ customers or creditors.  Not the tax payers.  Could it be the incumbent top management?  Surely not!

I would put zero weight on (1) and  roughtly equal weights on the other four possible explanations.

What is to be done?  Banks that don’t lend to the non-financial enterprise sector and to households are completely and utterly useless, like tits on a bull.  If they won’t lend spontaneously, it is the job of the government to make them lend.  Banks have no other raison d’être. I can think of three ways to get them to lend using the coercive powers of the state.

(A) All domestic non-financial enterprises that currently have access to bank financing and whose loans, overdraft facilities, credit lines or whatever other financial arrangements expire during the coming year, have the right to an automatic one-year extension of the expiring arrangements on the same financial and non-financial terms as the expiring arrangements.   This mandatory ‘creditor standstill’ helps existing borrowers by providing them with a breathing space. It does, however, do nothing for new enterprises or enterprises that are not currently borrowing.

(B) Aggregate lending targets for lending to the domestic non-financial business sector are set by the government for each bank (last year’s total plus five percent, say).  The banks themselves can decide who to lend to and on what terms. Any shortfall of actual lending from the target is translated pound for pound into a Deficient Lending Tax.  Since not meeting the target amounts to throwing money away, the banks will lend.

(C) Nationalise the banks (paying as little as possible to the existing shareholders), fire the existing management and board of directors, and have the government appoint a new executive and a new board that are serious about meeting lending targets.  With 100 percent share ownership by the state, there is no risk of lawsuits about the executive or board of the  bank not meeting their fiduciary duty to the shareholders.  Full state ownership would make transparent and formal what is already true in substance: but for the financial support of the government (past, current and promised/anticipated in the future), there would no longer be more than at most a handful of viable cross-border banks in the north-Atlantic region.

It would have to be make clear that state ownership of  a bank does not mean that the bank’s existing or new debt is sovereign-guaranteed.  Limited liability applies even when the state is the only shareholder.  Whether existing or new bank debt of state-owned banks benefits from the full faith and credit of the sovereign government can be decided on a case-by-case basis.

With both Alistair Darling and Mervyn King  hinting darkly at the possibility of nationalisation of the remaining privately owned banks as a possible remedy for the bank lending strike, these proposals cannot even be considered radical.

Things are critical.  Unless the banks start lending in normal volumes very soon, this recession could indeed become another Great Depression.  We cannot wait for the banks to find their juju.  The government may have to take it to them.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

Maverecon: a guide

Comment: To comment, please register with FT.com, which you can do for free here. Please also read our comments policy here.
Contact: You can write to Willem by using the email addresses shown on his website.
Time: UK time is shown on posts.
Follow: Links to the blog's Twitter and RSS feeds are at the top of the page. You can also read Maverecon on your mobile device, by going to www.ft.com/maverecon