Bank of England Governor Mark Carney. Photo: Bloomberg (under Creative Commons Licence)
£150bn new lending is a tall order, even for Mark Carney
Since the referendum vote, the Bank of England has been working tirelessly to protect the economy. But the announcement the other day of an increase in banks’ “capacity for lending to UK households and businesses by up to £150 billion” needs to be taken with a big pinch of salt (hence ‘up to’). The media, however, did not hold back – they all headlined ‘Bank of England …
- signals £150bn Lending Boost’, Sky
- relaxes purse strings for ‘£150bn boost”, Times
- releases £150bn of lending amid warnings on stability’, Guardian
- pumps £150bn into economy to keep credit flowing’, Evening Standard
The trouble with this kind of initiative is that it is rooted in the theory and practice of credit creation and far from straightforward to unravel. Ultimately we must not kid ourselves that it will be adequate to support the economy without serious action from the government. (TUC action plan: here.)
Since the financial crisis the mysteries of credit creation are perhaps a little less mysterious – not least with the Bank of England themselves creating £375bn through ‘quantitative easing’. Tuesday’s announcement however was not related to quantitative easing.
As the Bank of England (BoE) have reported themselves, money is created when banks make loans; banks do not sit there waiting for deposits to come in and then lend them out; the act of lending creates deposits. Here’s the BoE version:
In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money. The reality of how money is created today differs from the description found in some economics textbooks:
- Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
- In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.
As a result – and in theory – there is no limit to the amount of money that can be created in an economy.
But obviously various arrangements exist to prevent banks getting carried away, most of which were proven inadequate by the financial crisis which was rooted in over-lending.
Since the crisis, the BoE and other authorities have acted to try and ensure that over-lending does not happen again.
Yesterday’s announcement follows from relaxing one of these measures.
Banks’ capital and lending
Banks hold ‘capital’ against lending, to protect in the event of loans going bad – “absorb losses that could otherwise threaten a bank’s solvency” as the BoE puts it.
They define capital as follows (nobody said this stuff was easy):
Capital can be considered as a bank’s ‘own funds’, rather than borrowed money such as deposits. A bank’s own funds are items such as its ordinary share capital and retained earnings — in other words, not money lent to the bank that has to be repaid.
Since January 2016 major UK banks are required to meet capital requirements in the form of a ‘leverage ratio’, so that capital is held as a set proportion of total lending. The requirement was 3.1 per cent – this is comprised of fixed and counter-cyclical parts.
Overall the total of bank lending in the economy is around £2 trillion, suggesting capital assets are required to be £62bn. In fact the Bank tells is the ratio is 4.9 per cent (Financial Stability Report, July 2016, p. 20), suggesting the amount is almost £100bn.
If banks are permitted to hold less capital then in theory they are freed up for extra lending. The Governor tells us that reducing the counter-cyclical buffer from ½ to 0 per cent …
… will reduce regulatory capital buffers by £5.7 billion, raising banks’ capacity for lending to UK households and businesses by up to £150 billion.
(that’s a leverage ratio of 3.8%).
Supply and demand
However that is a very mechanical application of ratios, and ignores wider behavioural considerations. The creation of credit is a function of both supply and demand, which vary in force over time and according to wider economic considerations.
Ahead of the crisis demand dominated, with for decades high growth in credit creation. The authorities simply allowed the supply of credit to follow according to demand (endogenously, as the jargon goes).
Credit creation, annual growth
(for credit creation here I have used M4 lending)
As is obvious from the chart, since the crisis lending has basically stagnated. This is undoubtedly related to demand. But others argue that regulatory response to the crisis has been too severe, so that supply too has been restrained. Banks may have had to prioritise building capital buffers ahead of lending – and we have seen examples of very harsh treatment especially of small businesses.
More detailed lending statistics show a rather dismal position.
Bank lending to UK residents, £ billion
Note in particular a non-existent increase in credit to non-financial businesses (and this is generally true ever since the financial crisis). My sense is that this slump in lending is a function of both supply and demand. The private debt overhang and wider depressed conditions as a result of government spending cuts have not fostered a dynamic or positive environment for business – and plainly this will be severely exacerbated by the leave vote. But equally I find it difficult to conceive that supply hasn’t had a role.
To the extent that supply has had a role, relaxing regulatory conditions can make a difference (though might ask why any such change wasn’t made sooner if it was a problem).
But if demand is dominant it is quite possible the change won’t make the slightest difference. The FT – themselves avoiding any hyperbole in headlines – remark that Mark Carney “accepted the problems were more likely to stem from a drop in the demand for loans in the UK”.
Either way the mechanistic application of solvency proportions to give £150bn is a vast exaggeration of the likely effect. Note also that over the past year banks created only £60bn of credit, and 80% of that went on mortgages.
The purpose of this is not bloodymindedness, but to emphasise that while the action may be useful, it will not make a great deal of difference to overall economic conditions. To re-iterate: the Bank of England cannot be expected to do this alone.