The Bank of England yesterday warned banks not to lend too cheaply or easily because it could store up problems that would come home to roost during the next economic downturn.
Pen Kent, an executive director of the Bank, told a conference of bank credit managers that temptations were growing ever stronger to relax banking standards in order to maintain or increase market share.
Banks were under pressure from corporate borrowers to lower their standards of risk assessment, pricing and monitoring, as customers demanded cheaper loans with fewer restrictions. But Mr Kent told the bankers to take more care in all three areas.
Despite warnings by the Bank, pressure from customers for easier terms had led to a further weakening of loan covenants over the past 18 months.
Covenants are the clauses in loan agreements which set minimum performance standards which the borrower must meet. If they are broken, the bank has the right to renegotiate the loans. But many banks are agreeing to easier covenants to keep or attract customers, said Mr Kent.
He added: "The temptation consequently grows ever stronger to relax some standards for the sake of improving or even maintaining a presence in the market.
"In many ways there are parallels between the credit function and the Bank's own monetary policy objectives. Both must resist short-term temptation for the sake of avoiding pain months or years ahead. Both must monitor for any sign of over-heating and take action to rein back as appropriate."
In several businesses such as property, which has had a difficult recent history, cross-default clauses and other penalties were being negotiated away altogether, he said.
Borrowers who insisted on this did themselves a disservice because they scared away the best lenders. Sensible covenants benefited both sides.
Mr Kent said companies were turning to the securities markets for money, or borrowing from large numbers of banks at the same time. He warned that one of the common features of the big company collapses of the last recession was the large number of lenders involved with each company.
They proved to have little knowledge of the borrower and even less loyalty when it got into difficulty. Borrowers should keep the number of banks with which they dealt as low as possible.
The Bank is also concerned at a fall in the amount of security taken for loans, and an increase in non-recourse loans to projects, that are not guaranteed by the parent group. He told bankers to enter these high risk situations with their eyes open. Risk had not been priced rigorously enough, he said.
Mr Kent backed a trend under way towards smoothing the cycle of bank profits and losses, by setting aside money to pay for defaults in good years, based on analysis of what the cost will be in the bad years. Most banks wait until loans go wrong before they set aside money to pay for bad debts, which exaggerates the swings in profits.
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