Keynes On Why Banks Don't Lend (and a proposal how to correct this)

One of the major challenges the ECB faces, so it says, is to get banks to increase their lending to the real economy. This is of particular importance in Greece where, I understand, one reason which slows down any economic recovery is that banks, burdened by non-performing loans, don't make new loans even to good borrowers. I came across a paper which John Maynard Keynes wrote in 1931 and where he described very aptly, in my opinion, why banks don't lend during economic crises.

"For, so long as a bank is in a position to wait quietly for better times ... nothing appears on the surface and there is no cause for panic. Nevertheless, even at this stage the underlying position (i. e. the large portion of weak loans on the books) is likely to have a very adverse effect on new business. For the banks, being aware that many of their loans are in fact 'frozen' and involve a larger latent risk than they would voluntarily carry, become particularly anxious that the remainder of their assets should be as liquid and as free from risk as it is possible. This reacts in all sorts of silent and unobserved ways on new enterprise. For it means that the banks are less willing than they would normally be to finance any project which may involve a lockuup of their resources".

According to the analyses which I have read, the amount of non-performing and/or impaired loans on the books of Greek banks is staggering. In such a situation, every bank will attempt to keep the remainder, as Keynes calls it, in good shape and only add to the remainder, i. e. make new loans, if they are literally perceived to be risk-free. In today's Greece, it is presumably next to impossible to find risk-free borrowers in the private sector. Net result: banks don't make new loans regardless of how much money the ECB throws after them.

By nature, bankers behave pro-cyclically: in boom times, they go overboard taking on risk because they have convinced each other that the boom will last forever. In recession times, they will slam the brakes on lending because they have convinced each other that the situation can only get worse. The credit rating systems which banks apply reinforce this pro-cyclical behavior: during the boom, ratings automatically improve; during the recession, ratings automatically deteriorate.

During recessions, lending officers of banks hear almost daily a message like the following from their managements: "Go through your portfolio. Identify all customers which might develop problems. Reduce exposures where you see potential problems. Negotiate more collateral. And by all means --- make new loans only where we don't increase our risk. We already have far more risk than we can handle!" It is quite impressive to observe how quickly formerly go-go lenders can convert into risk-averse administrators!

What can be done about that? The most effective way would be to take the non-performing and/or impaired loans off the books of the banks so that they are left with only the good remainder. Being no longer burdened with problematic and/or frozen assets, banks would quickly develop an appetite for making new loans. After all, banks need to make good loans to earn a profit. Banks would still not be making new loans to questionable risks but they would adequately supply the strong part of the economy with financing.

Loans can be taken off banks' books in two ways: (a) at book value or (b) at whatever the loans are deemed to be worth in reality. The difference between the two values is the potential loss behind those loans. If loans are taken off the books at book value, banks make a bonanza: they get rid of their problem assets without any negative effect to their bottom line. Instead, the potential loss is moved to the party which takes the loans off the books. If loans are taken off the books at whatever the loans are deemed to be worth in reality, the banks go bankrupt. After all, the reason why they haven't written down their loans to fair value is that they don't have enough capital to support the losses.

The Bank of Greece, I understand, refuses to take the bad loans off the books of the banks at book value and move them into a national 'bad bank' for a very good reason. That way, the BoG (i. e. tax payers) would assume all the losses and banks could merrily return to making good profits. If the BoG were to avoid these losses, it would have to take the loans off the books at whatever they are worth, leadings to immediate capital insufficies on the part of the banks.

Below is an alternative which I have not seen being discussed as yet. It rests on the (correct) premise that Greek banks, if they could unload all their problem loans at book value, would overnight become rather profitable institutions. Given the lending margins and service fees which I have seen applied by Greek banks, Greek banks should be among the more profitable ones in Europe if they had no credit risk to provide for.

Here is the alternative: the BoG would purchase all problem loans at book value with the only proviso that the banks will eventually, perhaps over a period of 20 years, have to buy them back out of their earnings. Put differently, as long as banks have problem loans 'outplaced' to the BoG, the entire annual pre-tax profit would have to go to the BoG. If it takes the profits of 20 years to buy back all the loans, it means no dividends for 20 years.

Banks enjoy a unique advantage over normal businesses in the way they operate. Whereas normal businesses need to turn their assets around all the time in order to make a profit (cash-inventory-finished products-accounts receivable-cash), banks get paid for keeping their assets on the books (make a 10-year loan; you work once and collect interest for 10 years without any further work). And banks are assured to get paid more for their assets than they have to pay for the funds which finance them. Thus, it is literally inconceivable that a bank would not make a decent pre-tax profit if it had no risk costs (this is assuming that the bank does only commercial business and no trading on its own account where it would face the risk of trading losses). Put differently, a bank has a built-in earnings power before risk and the only question is how that earnings power is used. Normally, it is used to provide for risk, build up equity and pay out dividends.

In my proposal the entire earnings power of the banks would be used to pay off, over 20 years, the problem loans which they sold to the BoG. If dividend pay-out is stopped for 20 years, the banks' shares might plummet and today's shareholders might feel wiped out. However, today's shareholders would know that, in 20 years from now, their children would be rich again. Obviously, if a bank needed less than 20 years to buy back its bad loan portfolio, it could return to paying dividends that much sooner.

In this proposal, the BoG would not be giving banks tax payers' money to make up for loan losses. Instead, the BoG would be giving the banks time so that they can finance their losses out of their own profit.