Brian Pitman, chief executive of Lloyds Bank, told the Treasury Committee of the House of Commons last week that the health of the financial sector was linked with that of its customers. If the financial sector cannot be nursed back to health, will its customers ever recover without its help?
In a research study published today ('New Players New Rules: Financing the 1990s' - Lafferty Publications), I survey the last decade and the prospects for the three main types of finance - bank loans, bonds and equities - as competitors to supply the needs of the public and private sectors in the G7 countries.
Many people's vision is blurred by the hype generated by the international financial markets about their own rapid expansion. Domestic financial markets are still many times larger than international markets, and have caught up with their rate of growth thanks to deregulation by domestic authorities seeking to win back market share.
The result was an explosion of credit in the late 1980s, followed by belated attempts at re-regulation. Banks threatened by securitisation went in for a last hurrah of old-fashioned credit expansion, and are now having to shrink or freeze their assets to stave off disaster.
Commercial property is in most countries at the core of the banks' difficulties. Instead of giving half the normal weight to mortgages, the Basle agreement on capital ratios should have given double the normal weight to commercial property. The speed of expansion of property lending took supervisors by surprise, and they were not quick enough in their reactions. For banks, commercial property is a threefold hazard: as borrower, as collateral for other borrowers, and as part of banks' own capital.
In every G7 country except Germany, banks failed to make sufficient provision for the fall in property values. They are praying for a lift in the market, which seems unlikely in view of the overhang of vacant space and the time lag between falling capital values and falling rents.
Banks are trying to increase retained profits to bolster their capital ratios in the face of stagnant asset growth, falling leverage, rising provisions and customer resistance to bigger margins. Some banks are doing well only in countries with a strong regional basis, such as Germany, Italy and the US.
Primary securitisation, in the sense of banks losing share to new bond issues, has been evident in the international markets, where bank lending fell to just over a quarter of total flows in 1991. Yet domestic bond markets still account for eight times as much as the international markets in terms of outstandings, and are increasingly dominated by governments, public agencies and banks, to the detriment of non-financial corporate issuers.
The recession has swelled budget deficits, and thus government use of bond markets. Banks have had to issue bonds and equities to achieve their capital ratios, and where financial institutions have failed, governments have had to issue more bonds to finance them, as in the case of the US thrifts. The growing weight of money in investment funds is shifting from equities to bonds but public-sector bonds offer a smaller - though perceptible - risk than corporate bonds offering little extra return.
The US has been unique in extinguishing huge tranches of corporate equity by takeovers, buy-ins and buyouts, substituting junk bonds which have made investors suspicious of corporate risk. Elsewhere, new equity issues have made spasmodic and limited contributions to corporate financing, varying with volatile stock markets. The so-called international equity market will continue to be dominated by huge privatisation issues, yet another example of governments crowding out corporate borrowers.
The worldwide reform of equity markets has made secondary markets more efficient for large professional investors, and given profits mainly to US securities houses protected from competition by the Glass-Steagall law. It has done little for the retail investor, or for small and medium-sized companies.
The best hope for the future is that secondary securitisation, the transformation of bank loans into securities, will in other countries follow the lead of the US. It is still of trifling importance elsewhere, despite the hopes raised at the time of Big Bang in 1986, because of the regulatory obstacles that still need to be dealt with.
Banks have a comparative advantage in originating, monitoring and servicing loans (those that do not will be taken over by those that do). Investment institutions have the balance-sheet capacity to hold securities which the banks lack. In the US, there are dollars 1,200bn publicly guaranteed securitised mortgages, dollars 265bn securitised bank loans to the private sector and about dollars 60bn short-term receivables backed by commercial paper.
In the UK, the Accounting Standards Board has only recently lifted its insistence that securitised loans should be shown in full in banks' balance sheets, which would defeat their whole purpose. It has now agreed that only the residual risk should be shown. This is the type of obstacle that needs to be tackled before securitisation can develop.
Secondary securitisation will not in itself result in an additional flow of finance if it results only in a switch of the same assets fron one form into another. It could, however, allow the banks to generate new credits for the recovery, and capture the resulting non-interest income stream, while needing only a fraction of the capital required for an increase in their balance-sheet assets. Techniques such as over-collateralisation can be used to give such securities a higher rating than the underlying bank loans, making them attractive to investors.
There remains the problem of dubious corporate bank loans dragged down by falling property values. In some countries, such as Japan, the banks are setting up subsidiaries to get these off the balance sheet. Such 'junk loans' could be successfully securitised only with government guarantees. Governments may yet have to intervene to shore up the property loans that they failed to prevent. At least government guarantees with a risk factor of less than 100 per cent are cheaper than the outright expenditure of public money on 'bailing out the banks'.
The author is UK adviser of the Association for the Monetary Union of EuropeReuse content