Friday, August 1, 2014

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.


  1. Very nice proposal of yours. If i say i had the same idea (but not so technical) you won't believe me.
    Question: the balance sheets of a bank will change also? i mean for example the total assets or the total loans will appeared much less?


    1. Whether the bank's balance sheet total changes depends on how the BoG pays for the problem loans which it takes off the bank's books.

      1) If the BoG pays cash, the total doesn't change: where the bank had 10 BEUR problem loans on the asset side, it now has 10 BEUR cash. That form of payment is highly unlikely because the BoG doesn't have the cash.
      2) Most likely would be that the BoG would pay by issuing a 10 BEUR bond in the bank's favor. The bank's balance sheet total would not change: where the bank had 10 BEUR problem loans on the asset side, it now has a 10 BEUR BoG bond. It could then use that bond as collateral to obtain ECB financing.
      3) Finally, the balance sheet could be reduced in the following situation: assume the bank has 10 BEUR funding from the BoG; i. e. it has a loan from the BoG. The BoG could say: 'we pay for your 10 BEUR problem loans by reducing your debt to us by 10 BEUR". In that scenario, the balance sheet of the bank declines by 10 BEUR.

  2. Exchange on the subject with Prof. Yanis Varoufakis:

    YV: Something like what you are suggesting would work. Except that you also offer a full explanation of why the bankers will fight tooth and nail to prevent it: "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." So, what can be done? Well, let us not forget that the government still has a very large stake in the banks. It could, if it were not a criminal gang, appoint new boards of directors (free of the Mr Sallas's of the world) and come together with the BoG to implement your proposal. But then again, if they were to do that, why not just create a state owned bad bank whose 'assets' would be gradually retired using the banks' profit stream? In the end, it is all a matter of ending the stranglehold bankers have over the state. Pure and simple.

    KK: In my way of thinking, the BoG (and the state) would tell the banks the following: “This is a completely voluntary offer. If you chose to take advantage of it, it is your voluntary decision. We hope you will because it would guarantee you your jobs and it would guarantee your shareholders that, eventually, their shares would be worth good value again at some point in the future. However, should you decide against the offer, you should be aware of the following: from now on, you are on your own. Any implied government support under which you may have worked so far will be officially withdrawn. If you get into trouble, you are in trouble. If you face the threat of failure, you will fail. If you fail, you will lose your jobs and your shareholders will lose their investment. And, by the way, you might face personal criminal law suits for having knowingly entered into risks for your shareholders which risks you could have avoided by voluntarily accepting our proposal”.

    YV: On the Greek banks, I disagree. The bankers will simply assume that the threat you suggest is non-credible (in game theoretical terms). Why will the bankers believe that they will lose control of the banks if they throw them on the rocks when the last time the threw them on the rocks (2010-12) they were rescued by the taxpayer, were allowed to keep full control of the boards, and, to boot, the banks were returned to them at huge taxpayer losses soon after (see the recent share issues in which the taxpayer was not allowed to participate). Moreover, given the fact that 'their' banks are the only source of funding for the mass media, their stranglehold on public opinion and on the politicians is greater than ever. They know that any threat issued by politicians, like the one you suggest, will be for show only.

    1. About your proposal Klaus and Prof YV. Your proposal is logical but it may assessed as insufficient or unpractical because a bank possibly can't have for 10-15 consequtive years only profits,or investors to show discourage in acquiring stocks of a bank that will not pay a dividend for 15 or 20 years. The good think about your proposal is that a balance sheet of bank would be far more transparent (performing loans) and with better CAR, even above 20%.
      For me the only way banks can really serve their role is to have two different "pockets" one from which they will produce profits and one other to repay loans.

      My small addition to your proposal is more costly for taxpayers money but create a motive, bankers not to reject the basic idea of your proposal which is much more fair as it is for taxpayers interests.

      1) In order greek bankers to recapitalize banks during 2013 they use warrants. HFSF which is major shareholder of banks was to examine recently a possible public proposal- to buy the warrants with a profit for shareholders (and hedge funds) of those warrants. This proposal however has many technical difficulties- and for sure cost for taxpayers money. ( I don't have any stocks or warrants in any greek bank).
      2) A slightly different version: 90% of profits to repay a loan and the remaining 10% to be payed to shareholders of a bank.So if a bank has 100 mil profits for a period the analogy is 90 mil to repay loan and 10 mil for the shareholders.

      About Prof YV.

      Alexis Tsipras before almost 2 years during the crisis said: "I wish we had become Argentina". The amusing photo posted after recent events in Argentina.

      My difference is that YV never criticize Alexis for 2-3 major directions of his policies not for details. Many are much better and fair compared to government policies.

      In an article about recent events in Argentina YV is confusing:

      "In 2001, Argentina went bankrupt. Very simply, the state did not have the money, and did not find the new loans needed to pay $ 100 billion public debt. Argentina defaulted, devalued the currency, saw a quarter of its GDP vanishing, but WITHIN TWO YEARS (with the help of increased demand for exports from China) was found to grow dramatically - see graph which records the per capital GDP of the country in dollars"...

      Ex finance minister Prof N Christodoulakis respond to YV that Argentina's per capital GDP of 2013-14 is equal to 1995.

      Its a question, Argentina of 2014 is in much better position than the Argentina of 2000 in GDP per capital given also the fact that inflation still is not credibly measured?

      PS: It's obvious-- for me-- that YV has well hidden political aspirations for highest role e.g finance minister or even more ---but not less---This is good if you are straightforward to opponents but especially to friends.
      Its easy to accuse Merkel for bad decision making in europe and criticize her denial to reduce unsustainable greek debt (sic), but far more difficult to talk about things which need to change in internal policy issues as you may accept bad criticism, even unfair.

      Your proposal is good Klaus (2 & 3).