Monday, November 30, 2009

Good Debt, Bad Debt

The latest statistics from the Central Bank (table B2.2) show a continued contraction in lending to businesses (or should that be borrowing by businesses?) Should we worry? As I've noted before, sometimes the wisest thing in business is not to lend/borrow - even when the money is available.

But it begs the question: are we in danger of over-shooting as we swing from credit bulimia to debt anorexia? It's happening in the UK too, as reported in the latest Bank of England report on individual lending showing that consumer credit is now contracting.

We can learn lessons about business lending from the UK as well. Take the recent (and excellent) CBI report on The Shape of Business - The Next Ten Years. In relation to the banking crisis it has this to say about business banking:
The legacy of the credit crunch is expected to have significant implications for the cost and availability of bank finance for a considerable period. There are a number of reasons for this:

• There will be increased scrutiny and regulation of the financial services industry. Such regulation is likely to constrain banks’ ability to take as much risk in their lending practices as they did prior to the credit crunch, which will impact businesses’ ability to access credit.

• The capacity of the banking sector has reduced considerably as foreign banks have withdrawn from the UK corporate lending market. During 2007, they accounted for around 60% of the growth in lending to UK businesses. These lenders are not expected to return in such significant numbers, so the aggregate supply of credit available to businesses will remain constrained. While foreign banks were more frequently used by large businesses compared to small and medium size enterprises (SMEs) (85% of which use one of the big four banks), the impact of reduced capacity in the banking sector is likely to affect all businesses seeking finance as lending to large businesses by UK banks will displace some lending to SMEs.

• Bank lending will also be constrained during the lengthy process of balance sheet repair, with capital diverted for some time.

• Finally, the mis- and under- pricing of risk which characterised the period leading up to the recession has already been reversed, and is unlikely to be repeated by the next generation of market participants who were witness to these mistakes. Tighter due diligence requirements and higher borrowing costs for businesses will be the result.
Ditto Ireland. This can only mean less business lending/borrowing for the foreseeable future. As the CBI report notes:
Given these trends, the coming decade will see companies operating in a climate in which the availability, cost and degree of freedom to use capital is more constraining than in the recent past. This is expected to have an impact on companies’ finance strategies and may lead them to seek alternative sources and types of capital.
Worse for Ireland, too much of the commercial borrowing that was undertaken during the boom was to acquire assets that are not only worth a great deal less than the monies borrowed, but are failing to generate any revenue whatsoever to fund borrowing repayments. Dirk Bezemer has written brilliantly about this, here he is in FT:
Lending to the real sector is self-amortising: it creates a debt, but also the value-added to repay principal and interest. Such loans enlarge the economy in proportion to the debts created and are financially sustainable. By contrast, loans to create or buy financial assets and instruments are not, by themselves, self-amortizing. In a credit boom, successive owners may sell the asset at a profit, but their buyers will have to shoulder proportionally more debt in order to acquire the asset, balanced (for the time being) by the asset’s value. Asset trading may be individually profitable; but it is a zero sum game, sustainable only if the real economy furnishes enough money to support the rising debt burden. Beyond a point, the lure of capital gains diverts funds from real-sector investment, and households’ rising debt-service cuts demand for real-sector output. In both ways, excessive growth of financial asset markets is self-defeating.
He argues in his paper This Is Not A Credit Crisis that part of the solution to the overhang of malinvestments we now face is to shrink the financial sector. Here he is again:
Not all that long ago, the US economy did well with a financial sector only a third of its present size. Do we really need all of the other two thirds?

We should move away from supporting finance in toto. The new policy should be limit support to banks that serve the real economy. If some of the other financial firms specializing in asset price manipulation go bust, this will not the end of the world. This, after all, is what bankruptcy is for. It is a legally acknowledged and orderly debt workout mechanism and the natural consequence of commercial overexposure. Inevitably, there will be collateral damage to investors among firms, households and pension funds. To the extent that this has real-sector repercussion via falling demand and incomes there should be provisions to compensate. This may be financed out of the liquidity withdrawn from today’s blanket bank support, so it need not come at an extra cost. Most importantly in the longer term, this policy will allow the debt overhead - and the speculative part of the financial sector - to shrink back to more normal levels. This latter objective is important and is not achieved under present policies.
Eventually Irish businesses will identify new opportunities for the profitable production of goods and services that will justify borrowing money to invest in their realisation. Let's hope the banks have recovered sufficiently from their bad lending decisions of the past so as not to stymie good lending opportunities in the future.


  1. Nice article

    Did the rot start when we attracted the IFSC and fell in love with finance as a business in itself?

    Whither the IFSC?

  2. It is always gratifying when one sees that one's comments have been taken on board :-)

  3. @Anonymous
    Good question: so long as there are internationally traded goods and services there'll always be a need for financial services to support them. Though probably rather less than we have been used to. Result: a smaller future for the IFSC?

    Yes, I was partly inspired by your comment on my previous post. Meant to acknowledge that in this post but was up against a publishing deadline (i.e.: getting out to work ;-) Thanks for inspiration, happily acknowledged.

  4. The blog was absolutely fantastic! Lots of great information and inspiration, both of which we all need!b Keep 'em coming... you all do such a great job at such Concepts... can't tell you how much I, for one appreciate all you do!
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