Thursday, 30 June 2011

Asking the wrong question

Today on BBC Radio 4, Francis Maude made the mistake of discussing the "affordability" of public sector pensions with the formidable Mark Serwotka. He lost the argument - massively - and various left-wing publications have been making political capital out of it ever since.

He should never have got into the argument at all.  Of course public sector pensions are affordable. Any public sector expenditure of any kind is always affordable in a sovereign country that issues its own currency and its own debt, and whose debt and currency are freely traded on international markets (pace the Modern Monetary Theory folk, I'm not going down the "debt is an illusion" route in this post!). 

The question should be, of course - do we WANT to spend the amount on public sector pensions that will be required to maintain them in their present form?

Public sector workers say "of course we do".  Generous pensions are a part of their pay package. They are being asked to take a pay cut, in effect.
On the other side of the argument, thousands of private sector workers, who either have no company pension or whose company pension is nowhere near as generous as public sector pensions, think it's unfair that public sector workers should receive better pensions than they do.  They think the money could be better spent on other things, such as uprating general pension provision for the elderly.

Public sector workers argue that their pensions are paid for through their contributions, not from general taxation, so this is an unfair comparison. I disagree. Every penny a public sector worker receives in pay - including pension contributions made both by themselves and their employers - comes from general taxation. Public sector workers are net beneficiaries of taxation in financial terms. Their pension contributions are paid out of general taxation.  Furthermore, as their pension funds are "unfunded" (i.e. current contributions go to pay current pensions rather than being invested for future pension payouts), in practice their actual pensions are also paid out of general taxation.  So to ask whether maintaining the existing defined-benefit schemes is a good use of public money is a perfectly reasonable question.

I don't buy the argument that someone put forward on BBC Breakfast this morning that because the private sector benefits from public sector functions such as education, therefore the private sector should fund better pensions for public sector workers than they provide for their own workforce.  Education is paid for out of general taxation. In other words, the private sector already pays the wages of teachers as well as the private sector workforce.  It is hard to justify the private sector providing better pensions for one set of workers over others purely because the first set are nominally employed by the state.

Of course, the private sector does provide better pensions for some people over others - notably corporate elites. It does so because it considers the work they do to be of greater value than that done by others.  I'm not going to argue here whether corporate executives really justify their gold-plated pensions, but the "work value" argument is the one that is used in both private and public sectors to justify high pay and benefits.  It comes down therefore, once again, to the value that we place on public sector work. Do we consider the work that public sector workers do to be of greater value than that done by private sector workers?  Is the work that I do, as a freelance peripatetic singing teacher, worth less to society than the work done by my state-employed classroom colleagues? Or is it equally valuable, but remunerated less simply because it is in the private sector? And is that because the private sector underpays or the public sector overpays?

In the end these comparisons of private and public sector remuneration are as irrelevant as the affordability question.  The real issue is the priorities given to different calls on public money, and the role of government in ensuring the welfare of its people. Is the remuneration of public sector workers, provision of adequate state pension provision, and protection of private sector workers from exploitation, of lower priority than paying the IMF to bail out yet more banks, fighting wars in Libya and Afghanistan, or hosting the Olympics (hat-tip to my brother Matthew Cooke for some of these questions)? Government can always find money to do whatever it wants to do. But the twin smokescreens of "affordability" and "unfairness" mean that people end up fighting with each other rather than holding government to account for its decisions.

Friday, 24 June 2011

The hole in the fence

It looks as if Osborne's decision to jump the gun and ringfence UK retail banking ahead of formal release of the Independent Commission on Banking may have been a good call. Not because ringfencing retail resolves the issues with UK banking - I stand by my remarks in my previous post - but because it protects high street banking from possible catastrophic losses arising from the European debt crisis.

The thinking seems to be that if the savings and borrowings of ordinary British people are protected, then investment banking - which everyone knows is the rich people's gambling den, isn't it - can be allowed to fail. And there is some merit in this view. Protecting ordinary British people from the consequences of profligate lending and spending by banks and countries alike in the Eurozone is an appropriate action for the UK government to take.

The trouble is, it's wrong. We are no longer in the banking of the 1950s, when ordinary people had their life savings in high street banks and building societies, and the only people with stock market investments were stockbrokers, who were "expert users" so could be expected to know how to manage their risks.  These days few ordinary people keep their life savings in bank and building society accounts. They have them in stock & share ISA accounts, long-term endowment policies linked to life insurance, and above all in personal and company pensions.  Although most of these are covered by FSCS insurance, none of them fall within the retail ringfence.  They are a major source of money for INVESTMENT banking.  Yes, that's right - the investment banking that is left exposed to the Eurozone debt crisis in the expectation that it doesn't matter if it is hit by catastrophic losses. 

Well, I don't know about you, but my pensions, my ISA, my long-term savings matter to me. I don't want them to disappear into a bottomless pit of Greek (or Irish, or Portuguese) debt.  But there is little protection for these forms of savings - the vast majority of the savings of ordinary British people: the FSCS compensation limit is currently £85k, which doesn't go very far towards replacing a lifetime of pension contributions.  And there is no doubt that investment banking, as a whole, is seriously exposed to Eurozone sovereign debt.

The ICB's comment was that institutional investors - are "better able to protect themselves" from losses due to failure of investments. That's the 1950s thinking again. Ordinary savers need protection from rapacious bankers. Professional investors should be able to take care of themselves.

The sheer illogicality of this is breathtaking. Both high street banks and institutional investors accept deposits from ordinary people which they invest on their behalf and pay them a return.  High street banks traditionally use savers' money to lend out to borrowers, although these days they are just as likely to lend that money to other banks or buy securities with it. Institutional investors either use savers' money to purchase securities themselves, or they lend savers' money to financial intermediaries - "shadow banks" - who use that money for trading on international financial markets.  In short, both high street banks and institutional investors are professional investors. And both of them are managing the savings of ordinary people.

It is reasonable to expect that all professional investors would demonstrate a prudent attitude to investment with the intention of providing the best possible return to savers for the lowest risk.  But the history of the last few years has shown that institutional investors have been (and still are) seeking for high returns without regard to risk - not in order to give a good return to savers, but in order to enrich themselves. And high street banks have lent out money in the most irresponsible manner, again not to benefit savers but to enrich themselves. Savers have been comprehensively failed by professional investors across the board.  There seems no reason to distinguish between retail deposits and other forms of savings when it comes to the need for protection from bad management and external risks - but that is what is being done.

So if the retail ringfence doesn't protect the majority of people's savings, what does it protect?

The most significant difference between bank deposits and institutional investments is that savers (including current account holders) can withdraw bank deposits with little or no notice, whereas all other forms of savings are tied up in such a way that either considerable notice of withdrawal has to be given (so the institution has plenty of time to find the money) or the money can't be removed at all without considerable penalty.  Because banks lend out deposits, they are always at risk of not having sufficient money available to meet withdrawal demands from savers.  When a lot of depositors try to remove their money at the same time (a "bank run"), banks can literally run out of money. This is what happened when Northern Rock failed and had to be bailed out by the taxpayer. 

Now, if depositors can be convinced that their money is not at risk even when the whole world is collapsing around them, they aren't going to remove their money, are they? So I think that real purpose of the retail ringfence is to improve depositor confidence and therefore prevent bank runs.

In other words, the retail ringfence is not to protect people, but to protect banks. 

And from the savers' point of view, there is a massive hole in that fence, through which most of their savings have escaped.

Thursday, 16 June 2011

Papering over the rot

A few years ago, I planted two young apple trees. I cut each sapling down to two feet, to encourage it to branch out, and encased each growing point in a plastic bag to protect it from beasties that would devour its new young leaves. And then I waited for them to grow.

One grew quickly, and soon pushed lovely young leaves against the plastic bag. But the other didn't. Mystified, I removed the plastic bag. Inside was a denuded shoot and a VERY fat caterpillar. 

I had ringfenced my apple tree to protect it and allow it to grow unmolested...but inside the ringfence was the very creature I was trying to protect it against.

Fortunately I was able to remove the caterpillar and the apple tree is now flourishing.  But of course I am not really writing about apple trees....

Today, George Osborne announced measures to force UK banks to ringfence their retail operations in separate legal entities. The aim is to protect retail depositors from possible losses arising from failures in investment banking operations.

Three of the four UK banks that were bailed out by taxpayers failed because of excessively risky retail lending (mortgages and corporate lending), and although dodgy investment banking was implicated in the failure of RBS, high-risk corporate lending was equally to blame. In other words, retail operations failed in ALL FOUR of these UK banks. No UK bank failed solely because of problems in investment banking - despite what the politicians (and the bankers) would have us believe.

So we ringfence retail operations. And inside the ringfence are our precious retail deposits - but also our mortgage lending at silly income multiples and ridiculous LTVs, and our highly-leveraged lending to dodgy businesses. And we haven't done ANYTHING to prevent such high risk lending happening again. Retail banks can still lend as much as they choose to whomever they choose, at whatever risk level they choose. And we can't raid investment banking for funds to support high-risk retail lending any more, because it's separated by chinese walls, isn't it?  So ridiculously risky retail lending will bankrupt our retail banks FASTER than before. 

Conversely, investment banking will no longer have to fund idiotic retail lending and its products will no longer be underpinned by junk loans. So investment banking might actually benefit from the retail ringfence (although cost of capital will be higher - see my blogpost Bank breakups, red herrings and elephants).

So does George really want to protect retail depositors? Well, to be fair, he probably does. Let's face it, he doesn't understand any of this stuff, and he's being advised by.....bankers.  Hmm. They caved in very fast over the proposal to ringfence retail, didn't they? Only Stephen Hester objected (a straw man, maybe). The rest have tamely acquiesced.  If this was REALLY going to hurt the banks surely they would have fought harder? Call me suspicious, but it's hard not to conclude that it not only doesn't hurt them, it directly benefits investment banking at the expense of retail.

In effect, the retail ringfence protects investment banking from the consequences of excessively risky retail lending, leaving retail depositors bearing ALL the risk of this lending. And because deposits are guaranteed, firstly by FSCS insurance and ultimately by the taxpayer, it means that the taxpayer is now on the hook for ALL retail lending losses that are not covered by insurance, capital or provisions.

Well, ok, capital reserves have to go up, a bit.....but 10% doesn't seem very much if the rest is to be borne by the taxpayer, does it?

The rot at the heart of our banking system is the system of guarantees provided to retail depositors that spills over into lending activities and encourages excessive risk-taking. The proposed ringfence does nothing about that rot. But it hides it under a thick layer of wallpaper so we cannot see the destruction taking place underneath. And when retail banks start to collapse again while the investment banking sector flourishes, will we blame the investment banks again - or will we finally deal with the real cause of the problem?

Reserve confusion

I have been puzzled for some time by the loose use of the term "reserves" when talking about banking. I hear people talking about the deposit multiplier (which itself is a myth, see my post To Lend or Not To Lend) as if the deposits taken from retail customers form part of the capital against which banks - supposedly - lend. Er, no, they don't. They form part of the CASH reserves that banks hold to support settlement of lending. Bank capital has a totally different composition.

Let me explain.

Cash reserves are the MONEY the bank has available in its cash reserve account at the Bank of England at the end of each day.  They are intended to cover the expected physical cash drawings of loans and deposits over the next day. In practice most retail banks don't have sufficient cash from deposits to cover drawings for the next day, so they borrow the money either from other banks (usually investment banks) through the interbank lending market or directly from the Bank of England.

Capital is the EQUITY of the bank.  Under the accords agreed by the major financial centres of the world in Basel, it is divided into different tiers:

- Tier 1, which usually consists of retained profits and proceeds from share issues (common stock).  This capital is FULLY at risk in the event of the bank becoming insolvent

-  Tier 2, which consists of subordinated debt (debt which is repaid only after all other claims have been met, so might not be repaid at all), preference shares and other instruments that can be treated as equity (i.e. not repaid in the event of losses), general provisions (money the bank sets aside to cover loans it believes will not be repaid), revaluation reserves (money acquired as a result in change of value of an asset, for example through increasing value of property) and undisclosed reserves (retained earnings that for some reason have not been disclosed in the published accounts). This capital is also at risk in the event of the bank becoming insolvent, but only to the extent that Tier 1 capital does not cover the losses.

-  There is also a Tier 3, which consists of subordinated debt used only as a buffer against market risk losses. This does not form part of what are loosely described as "capital reserves" supporting lending.

Capital is the bank's "cushion" against possible losses, and it is only meaningful to talk about it in relation to bank debt.  This is unfortunate, because most of the recent writing on "capital reserve requirements" talks about it in relation to bank assets, which causes enormous confusion.  Bank debt - money the bank has  borrowed - mainly consists of retail deposits and issued securities. The larger the proportion of capital in relation to debt, the more resources the bank has available to call upon to settle losses and protect depositors and bondholders without having to call for assistance from taxpayers or seek a merger with a richer competitor (as Midland did when it invited HSBC to take it over).  Ideally banks that lend under the fractional reserve system - where they don't have to have 100% cash reserves available to cover their lending - need to have a reasonably substantial equity cushion available to protect depositors.  In practice banks have over the last few years reduced their equity cushions to tiny proportions and relied more and more on FSCS insurance and, as a last resort, taxpayers to guarantee depositors and bondholders in the event of losses. It is this imbalance that the Basel committee, and the UK's Independent Commission on Banking (ICB) attempted to address by raising capital requirements.

When the ICB produced its report recommending changes to banking structure, it suggested two changes to capital requirements. Note that these are quoted in relation to assets not liabilities, despite my comments above:

- that systemically-important banks (the ones that are "too big to fail") should have sufficent capital to cover at least 10% of risk weighted assets

- additionally, that banks that do both retail and investment banking should ringfence their retail operations in a separate legal entity with its own capital covering at least 10% of risk weighted assets belonging to those retail operations.

These requirements have NOTHING to do with cash reserves or bank deposits. But confusion is widespread. Even the estimable FT Alphaville blog got this wrong when it pointed out that retail banks don't have sufficient deposits to cover 10% of their existing lending.  They aren't being asked to hold sufficient deposits to cover this. Deposits are debt - not subordinated debt, just general debt - so don't form part of a bank's capital.  Really, the banks are being asked to increase their retained profits and/or issue more shares (or debt instruments that can become shares if necessary).

Now, I pointed out in a previous blogpost that the increasing spread between the awful rates paid to savers and the exorbitant rates charged to borrowers could be explained by the banks' need to increase their capital. Various people argued with me about this, but I stand by my remarks. Banks make money by lending at higher rates of interest than the rates they pay to depositors, and that difference (once other costs have been met) is either paid out in dividends to shareholders or is added to retained profits in Tier 1 capital. The wider that difference, the more banks earn and the more they can retain while still maintaining shareholder dividends. Increasing capital requirements is the best excuse you could possibly give the banks for ripping off both savers and borrowers.

I have read blogposts that argue that increasing capital requirements should have no effect on the cost of bank lending - since it is only replacing bank debt with equity - but may make lending harder to obtain.  I beg to differ. I think that increasing the capital requirement is unlikely to affect availability of lending, and certainly is unlikely to improve the risk profile and management of lending.  But it will increase the cost.  It generally costs banks more to raise equity capital than it does to borrow on the interbank markets or issue bonds, so forcing banks in effect to replace debt with equity will raise their cost of capital and they are likely to pass this on to their customers.  And diluting shareholders' capital by issuing new shares almost always depresses the share price, with consequent impact to existing shareholders. Disguising new share issues as convertibles such as preference shares doesn't fool the markets. Increasing capital by rights issues or new convertible debt issues is going to be unpopular with shareholders and institutional investors, who in the end call the shots - after all, they control the remuneration of bank directors. Small wonder then that banks prefer to increase retained profits by raising borrowing rates and depressing savings rates. It's a no-brainer, really.

Monday, 6 June 2011

To lend or not to lend?

A couple of days ago I wrote a post showing how higher reserve requirements increased the cost of borrowing and depressed interest rates on savings.  Today, Tim Worstall came out with a similar argument in his blog.  However, he lost the plot when he started talking about the money supply and the way in which bank lending contributes to its expansion.  That's because he seems to believe that bank lending decisions are driven by the availability of reserves - this is known as the money multiplier theory.  Nothing could be further from the reality.

Any bank credit controller will tell you that availability of reserves doesn't come into the equation when lending decisions are being made.  Customer credit scoring, relationship with bank, credibility, affordability, provision of collateral or guarantees - yes, all of those are considered in depth.  But whether the bank has sufficient reserves to support that lending? Nah.

Bank lending decisions are driven ENTIRELY by commercial considerations.  The effect of higher reserves, therefore, is NOT to restrict the amount of lending that banks can do. What higher reserves do is increase the cost of borrowing, not reduce the availability of credit. (I should make it plain here that I am talking about cash reserves, not equity capital reserves - which protect customers against the possibility of loss due to insolvency. Capital reserves may also increase the cost of borrowing but not for the reasons given in this blog.)
 
It works like this.  Say that at close of business on Monday, Bank A has a total loan balance outstanding, including new loans, of £10m - and to keep it simple let's assume that all of that is made up of unsecured lending to individuals of average creditworthiness, so the amount "at risk" is also £10m.  Suppose on that day it also has £1m of liquid assets (such as retail deposits) in its reserve account at the Bank of England. If reserve requirements are sayy 7%, the amount it HAS to hold in that account at the end of the day is 7% of £10m, i.e. £700,000.  But it actually has £1m in the account. So it has a surplus of £300,000 in its reserve account.

Meanwhile, Bank B has also lent out £10m at 100% risk, but it only has £400,000 in its reserve account.  It should have £700,000.  So it borrows £300,000 from Bank A to cover its deficit.  This is interbank lending and it is usually done at LIBOR, which is currently about 30 basis points (that's finance speak for 0.3%) above the Bank of England's base lending rate.  The result is that both Bank A and Bank B meet but do not exceed the reserve requirement on that day.

This is, of course, a ridiculously simplistic example. But on any given day banks are supposed to maintain in their Bank of England reserve accounts an amount in liquid assets equal to the reserve requirement for the total "at risk" amount of their lending.  Any shortfall is made up by borrowing either from other banks (if funding is available) or as a "last resort" directly from the Bank of England.

So reserve allocation is done RETROSPECTIVELY. There is no limit on the amount of lending banks can do during the day.  But they must, at the end of the day, balance their books.  The more they have to borrow to support their lending, the higher the rates they will charge to their borrowers.  An increase in reserve requirements usually has to be met by borrowing more - by attracting savers or by borrowing from other banks.  Interbank lending is an exceedingly cheap form of financing and the cost can be fully passed on to borrowers, whereas attracting savers would mean increasing the interest rate paid on savings accounts - a direct, unrecoverable cost.  It's a no-brainer, really. Clearly the banks are going to borrow, aren't they? 

Now, it is a fact that credit is not as widely available as it used to be and lending criteria are much tighter. But that's not because of higher reserve requirements. Banks have been roundly (and rightly) criticised for taking excessive amounts of risk particularly in corporate and mortgage lending.  Northern Rock and Bradford & Bingley banks failed because of highly risky mortgage lending.  Excessively risky mortgage and corporate lending caused the failure of HBOS and the subsequent bailout of Lloyds TSB. And excessively risky corporate lending contributed to the collapse of RBS.  As Lord Levene said on the BBC's HardTalk programme the other day, it's a bit much to criticise banks for taking excessive risks in lending and then moan when they start being more careful about how much they lend and to whom!

In Tim's defence, I would have to say that the money multiplier (or deposit multiplier) theory is mainstream economic theory and widely promoted by all sorts of people. It just happens to be wrong.

Friday, 3 June 2011

Free market fairy tale

The other day, I had a debate with various people on Twitter as to whether there was any such thing as a free market.  I think we agreed to disagree, and personally I still question whether a really free market can exist at all in an advanced economy. But one thing we do agree on is that the banking "market" is anything but free.

Yesterday I wrote a post pointing out that the banks actually set saving and borrowing interest rates according to market demands and the needs of their business, not according to the base rate - despite what people think and the media say.  And I identified the real cause of the increased spread between borrowing and savings rates as being the introduction of higher capital and liquidity requirements to make banks "safer".  Safety comes at a price, and that price is less lending, higher rates to borrowers and lower rates to savers.

Having capital requirements for banks at all is direct government interference in the market, which creates distortions and gives certain categories of customer a raw deal.  The question we have to ask ourselves is whether additional regulation is needed to protect the customers disadvantaged by the regulations we have already introduced.  Regulation tends to beget regulation, as each time another regulation is added the commercial organisations react to it in ways that disadvantage other consumer groups.  The "red tape strangles business" we hear from politicians of right-wing persuasion arises from this tussle between regulator and regulated. These politicians tend to try to persuade rather than regulate, but the effect is still the same.

Here are some of the current distortions in the retail banking market.  Note how many are "sacred cows"!

  • Unlimited taxpayer guarantee of retail deposits
  • Capital reserve requirements
  • Liquidity requirements
  • Bank of England funding support for payments
  • Interbank lending rate (why is there only one LIBOR rate?)
  • Bank of England base rate (why doesn't the BoE charge different rates according to institutional risk?)
  • Single fiat currency issued only by the Bank of England
  • The Bank of England (why do we have a "lender of last resort" at all?)
  • Project Merlin (why should the banks lend more to SMEs just to "get the economy growing"?)
And how about these distortions in investment banking (a much larger savings market):

  • Tax relief on pension savings
  • Tax relief on other forms of savings such as ISAs
  • Requirements for pension funds to invest highly in "safe" securities such as government debt
  • Bans on short selling of CDS and government debt in EU, US and other countries
These are not exhaustive lists.  No doubt there are many more examples.

A free market in banking would look very different from what we currently have:

  • No government guarantee of retail deposits, or anything else for that matter.  A bank that failed would not be bailed out by taxpayers, however large and important it was.  Savers would lose all money not covered by voluntary bank insurance schemes
  • Savers would be charged by banks for insurance to protect their savings in the event of bank failure. They would of course be free to refuse this insurance and take the risk.  There would be a growth of private-sector insurance schemes protecting savers - and of course an attendent risk of mis-selling (nobody ever said that a free market couldn't be corrupt!) 
  • No free banking. Banks would charge for every bank transaction
  • Banks could lend unlimited amounts of fictional money. They would have no need to hold reserves except for funding.  But they actually might increase their reserves - read on.....
  • All bank funding would come from the interbank market. There would be no lender of last resort. If the markets stop lending banks would fail.  Banks would be forced to put in place longer-term funding strategies: their current practice of lending long and borrowing VERY short would have to end. Because of this, banks would be likely to hold reserves voluntarily because of the risk of losing short-term funding. There would be a greater need for them to attract retail deposits, particularly longer-term notice deposits, and savings rates would rise due to the increased competition.
  • Banks of varying sizes would face different funding rates depending on the interbank market's view of their risk. Smaller banks would either charge more for borrowing or suffer margin reduction.  They would be likely to become niche players - offering very high savings rates to sophisticated investors who don't mind risk, or focusing lending on high risk individuals and businesses at very high rates.  We are seeing some of this developing already (companies specialising in payday lending, for example).
  • There might be more differentiation in the market - more players specialising in different things.
Oh, and there would be no IMF, of course. The very existence of a supra-national body whose sole purpose is to "maintain the stability of the international financial system" creates the largest distortion in the banking market and disadvantages the greatest number of customers.

It's an interesting model, isn't it? Note that savers would be likely to do VERY much better under such a model, but borrowers would have to pay more.  So it is fair to say that the present regulated banking system systematically discriminates against savers in favour of borrowers.  If the government prefers to maintain a regulated system, then this is an area that needs addressing through additional regulation. It is not reasonable to expect banks to offer a better deal to savers voluntarily. There is no reason for them to do so.

Thursday, 2 June 2011

Feckless spenders, prudent savers and the Bank of England

There is a myth going around that the low Bank of England base rate (currently 0.5%) benefits "feckless spenders" at the expense of "prudent savers".  Quite apart from the value judgements inherent in those labels, this is completely untrue and very unfair to both the Bank of England and borrowers.  Yes, savers are getting a raw deal at the moment. But that's not because of anything the Bank of England has done.  It's all to do with the commercial banks.

Interest rates to many unsecured borrowers are currently sky-high, having rocketed since the financial crisis. Typically these are people who are struggling a bit - they are maintaining their minimum payments and maybe a bit more, but they have a lot of debt and rarely pay off anything completely, so they are regarded as high risk and therefore hit with high rates. Interest rates for more creditworthy individuals are much lower, but that is because they are seen as a less risky proposition and therefore a good lending prospect - and banks really do like lending as long as the risk is low, as I've explained in previous posts.  So interest rates for people who don't really need credit are low in order to attract them.  These are the headline rates that are advertised by the banks.  The much higher rates actually charged to people with dodgier credit records are kept well under wraps in case it puts off the low-risk customers the banks really want to attract.  Now, I'm not criticising the banks for charging different categories of customer widely different rates. That is normal market rate-setting behaviour.  But it has absolutely nothing to do with the base rate. 

Mortgage rates are still low, and we are told that that is because the base rate is low, but I doubt it. I think it is because the housing market is still overvalued, so the value of collateral is high. If house prices fall significantly (as Morgan Stanley predicts), mortgage rates will shoot up irrespective of what is done with the base rate. This is because more people will be in negative equity, so mortgages will be partially unsecured, which increases the risk.  Also, difficult economic circumstances are already increasing the rate of mortgage defaults and repossessions, and this will also drive up mortgage rates.  Again, the rates really have nothing to do with the base rate.

On the savings side, savings rates are currently below inflation. Admittedly Libor is rising a bit because of the Greek disaster, but it is still below 1%, and as I said above, unsecured lending rates are sky-high for a lot of people. So for financial institutions to be paying less than inflation on savings is disgraceful.  Savings we lend to banks are put at risk in order to earn a return, and we pay through our taxes to protect them.  If banks aren't even going to protect our savings against inflation, why on earth do we lend them the money? They have no right to our money. They should pay us a proper rate of return for lending it to them.  And if they won't, then we shouldn't lend it.

I want to make it clear, once again, that I am not blaming the banks for commercial rate-setting behaviour.  It is perfectly reasonable for them to try to pay savers as little as they can get away with. But nor should the Bank of England's low base rate policy be blamed for the fact that savers are losing out.  That's a myth fostered by commercial banking to distract attention from the real issue.

The base rate is the rate at which the Bank of England lends to banks, and it governs the interbank lending rates. The rates commercial banks offer to savers and charge to borrowers have nothing to do with this. Banks are free to set whatever customer lending and borrowing rates the market will bear, irrespective of the base rate. They are currently choosing to set very low savings rates and high borrowing rates in order to recapitalise their balance sheets and maintain their RoE in the face of higher capital requirements.  And because there is insufficient competition in the banking sector - and in my opinion there is a bit of price-fixing going on as well, disguised as a mythical "tie" to the base rate - they can get away with this because there is nowhere else for savers or borrowers to go.

So feckless spenders and prudent savers are all in it together, really.  Along with the Bank of England.  But instead of pointing the finger at the profiteering banks and demanding that the government take action to improve competition and eliminate price-fixing, these groups are fighting among themselves and blaming each other. And the banks rake in the money.

What NOT to do with a corporate surplus

Yesterday I issued a blogpost asking why the Government wants to cut corporation taxes when businesses are sitting on historically large financial surpluses that they are not investing in equipment or people, or even paying out as increased dividends to shareholders.

I wonder sometimes if people actually read what I say. One comment on the blog gave me the standard reasons for cutting corporation tax:

"Cutting the rate of corporation tax reduces the pre-tax rate of return required and so more projects will generate a sufficiently high return to justify investment. Hence more capital investment, higher productivity, higher wages, more output...."

 Here is the quotation from the Bank of England's May inflation report again:

Private domestic demand growth could be boosted if more of the historically large corporate financial surpluses were spent on capital investment or transferred to households in the form of higher wages or dividend payments

In other words, businesses are not investing the money they ALREADY HAVE. Why on earth would giving them more money make them any more likely to invest?

I want to know why businesses are not investing their financial surpluses in equipment and people. I want to know why they are not paying out their financial surpluses as higher dividends - which would greatly help the savers of the UK, whose returns on investment are currently dreadful.  To me it looks like a massive decline in business confidence.  Businesses are battening down the hatches and waiting for better times.

What is the government going to do about the slump in consumer demand that is making it difficult for businesses to sell their existing products and services - and therefore unreasonable for them to expand?

Wednesday, 1 June 2011

What to do with a corporate surplus

From the Bank of England's May inflation report:

Private domestic demand growth could be boosted if more of the historically large corporate financial surpluses were spent on capital investment or transferred to households in the form of higher wages or dividends.

So corporations are running surpluses while the economy lacks capital investment and households have falling real incomes.

Why, exactly, does the Government want to cut corporation tax?

And so it begins....housing doom & gloom

In my recent post Illusions and delusions: the lure of credit and the price of debt I predicted further falls in house prices leading to negative equity and increased mortgage foreclosures as people struggle with rising prices, high debt levels and tax increases.  Today's news supports my prediction.

Morgan Stanley reports today that it expects a 10% fall in UK house prices over the next two years, which will leave Lloyds TSB (the UK's biggest mortgage lender) with a negative equity overhang of about £90bn by December 2012.

The FSA warns that banks have insufficient provisions to cover anticipated defaults on mortgages and are moving people in financial difficulties on to interest-only mortgages to avoid having to increase bad debt provisions.

Although the Bank of England's weak growth forecast does suggest that base rates won't rise much for a while, increasing risk to mortgage lenders may nevertheless lead to increases in mortgage rates.  I expect a significant rise in average mortgage rates within the next year or two whether or not the base rate rises. The squeeze on lending will continue, with lenders demanding high deposits and tightening of credit criteria.

Rents are already rising as more people - especially younger ones - give up on the idea of owning their home and turn to the rental sector instead. The average age of a first-time buyer has risen to 37.

Anyone remember this from the 1990s? mortgages turning bad, many households in negative equity due to falling property prices, rents skyrocketing...oh, and banks pretending it isn't happening, of course. Or are ostrich banks a more recent phenomenon? 

The housing market is currently even more overvalued than the market of the 1980s that crashed spectacularly and caused misery to thousands.  And households are already terribly overstretched in other areas, with falling real incomes and high debt levels.

The housing market crash twenty years ago will look like a minor blip compared to what is coming.  Get out the sandbags, everyone.....