Why bank lending can never be the same again

The government has said on a number of occasions that it wants the banks to resume lending money to home-buyers and small businesses at the same levels as before the start of the credit crunch. There’s only one problem: doing so would be a sure-fire way to bankrupt the banks. And either the government doesn’t know it (in which case it’s stupid), or it does know it (in which case it’s lying to the public).

If you want to understand why bank lending can never be the same, look no further than Robert Peston’s post on HBOS’s last financial results as an independent entity. HBOS was amongst the most willing of lenders to both companies and home-buyers, and it has ended up with 47% of its business loans going bad. And, when you’re lending a total of £116 billion to business, that’s a lot of potential for loss – a risk which will now have to be paid for by the taxpayer.

Most of the cash that will inevitably be needed to bail out bad loans made to eager businesses will come from individuals. The government will, undoubtedly, continue with its “business-friendly” rates of corporation and capital gains tax, and businesses will continue to attempt to minimise the amount of tax they pay through every legal means at their disposal.

Although the main rate of corporation tax remains an equitable-sounding 28%, few big companies actually end up paying anything like that. According to The Guardian’s excellent corporate tax database, FirstGroup, for example, paid £7 million in tax on £152 million pre-tax profits in 2008 – an effective tax rate of just 4%. And this wasn’t an exceptional year. Over the previous four years, FirstGroup paid at most 10%, with an average of just 5% tax paid.

There was nothing illegal about this. Ironically, one of the principle ways that FirstGroup, and many other companies, managed to reduce their liability for tax was to take on more debt. The company’s net debt increased from £516 million in 2007 to over £2.1 billion in 2008, meaning that it moved from holding debt of roughly twice its annual operating profit to over six times annual operating profit. The interest on this meant its tax liabilities dropped dramatically. As long as it could service the interest payments – and it could find a willing lender – this was a surefire way of increasing the profits it could return to its shareholders.

Thus, companies have a vested interest in borrowing as much as possible in order to reduce their tax liabilities – which, when money was cheap to borrow, meant an easy way to return more money to their shareholders. Who can blame companies for taking any and all money that was on offer?

And lots of cheap money there was, too. Chinese and Indian growth rates which regularly hit double figures, coupled with the tendency of newly-enriched citizens in those countries to save higher proportions of income than us debt-crazed Westerners, meant there was lots of money around for our banks to borrow in turn. After all, their potential rates of return were huge, thanks in part to one of the biggest property bubbles the world has ever seen.

“Your house is worth how much?!?”

This property bubble was arguably most acute in the UK. Annual house price inflation in London hit 17% in the middle of 2007. With interest rates at less than 5%, this meant that the simple act of buying a house and doing nothing with it earned you a better rate than almost any other kind of investment. It meant that it made complete sense to take up a mortgage that stretched your finances to the absolute limit. And thanks to all that cheap money sloshing around the banks, they were happy to lend. After all, they, too, were quids-in.

There was only one problem. Sooner or later, the bubble had to burst, and house prices inflation had to at the very least calm down and at worst collapse completely.

The reason was simple economics. Price increases are driven by either increased demand for something or reduced supply. The housing stock generally increases, as we build new houses. So house price inflation is largely driven by more people being able to afford to buy homes.

This increase in potential buyers can happen under two circumstances: an overall increase in their income, or banks being willing to lend more people more money. And while incomes have increased generally over the past thirty years, they have nowhere near matched the overall increase in the average price of a house. Hence, banks had to lend ever-larger multiples of your household income: from three times income to four, and even five times. Where next? Six times? Seven? Ten? Sooner or later, the banks had to call a halt to lending.

In the end, the banks didn’t stop lending – instead, the people who were lending all the money to them stopped. As the full horror of the bubble (and how close it was to bursting) started to dawn on the people lending money to banks, they became more cautious, with the result that we see today.

Banks stop lending silly amounts, which means that demand for houses drops. This forces prices down, which means people who did the wise thing and stretched their mortgage as far as possible are stuck paying out more than they can really afford, with no way to sell and get their debt paid off. Companies which took on massive debts because it was a sensible way to reduce tax and grow their business (on paper) find they can’t roll-over the debt when it’s due, which means they either go bust or lay off staff, or both. And those people who are laid off can no longer afford their mortgages, which means they default – leaving banks like HBOS with huge liabilities.

No way back to the old days

There is no going back. Banks will never again lend five times salary to someone buying a house for the first time, because they won’t take on the risk. This means house price inflation will, once prices hit a proper level in tune with demand, tend to be much more in line with wage increases and overall inflation. And companies will be able to borrow big sums only when they can show real returns, rather than just because they want to reduce their tax liabilities and pay an extra-fat dividend.

All of us bear some measure of responsibility for the mess we’re in. Bankers should never have lent as much money as they did. Companies should have put their duties to keep their business efficient and on an even keel ahead of the easy gain of borrowing to improve the balance sheet. And individuals should have been less greedy, seen a house as somewhere to live rather than an investment, and not borrowed beyond their means.

All of the decisions we all made – bankers, businessmen, and individuals – were understandable. But they were also stupid and wrong, and we’re all going to have to pay the price and get back to basics. The burden can’t fall only on the backs of ordinary tax payers: companies have to start paying real levels of tax on profits, instead of joke-like figures of 4% or less, and bankers have to sacrifice short-term bonuses in favour of long-term responsibility.

Most of all, we will have to go back to the only way in which you can achieve real economic growth: increased efficiency and productivity. Making better products, using less energy to do it, using and making information more wisely than before.We will have to learn again how to increase the richness of our lives through hard work, rather than cheap borrowing. Things have changed, forever.

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  • http://jkaonline.typepad.com JKA

    Robert Peston's post is most misleading, the bank has written off 47% of the loans identified as bad just 6% of the total commercial portfolio not 47% of the whole book.
    JKA

  • http://www.facebook.com/profile.php?id=608866690 Liam Proven

    No, Ian, I don't agree. The thing is, human memories are *short*. Well under a generation. The people running businesses are not the old phartes in the boardroom – they are only vaguely steering the overall direction. It's the Young Turks, the hungry kids who want to do well. & they won't remember what happened 10y ago, let alone what happened 2-3X that long past.

    Which is why we are in most of the problems we are in today. Problems that in some cases our grandparents solved, but our rulers and movers & shakers have no idea ever existed.

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  • James

    People are often looking for the best interest rates when it comes to banks – in the current economic climate they are hard to find. It is even harder to find loans or mortgages unless you are in a very secure position with your finances.