Export financing - will shadow banking come to the rescue?

A leading article in the FT newspaper carried the title, ‘Non-banks colonise former bank territory’. This term of shadow banking may appear alien to us in Malta so as a start, let me try to define the concept. This is simply the provision of capital by loans or investments to companies by other companies that are not banks. The article in the FT mentions a number of examples as providers of credit such as insurance companies, credit investment funds, hedge funds, private-equity funds, and broker dealers.

So one may well ask what is new in this type of lending. The major difference is that it is not as yet regulated as a banking function and because of this freedom of operation, some are branding it as a panacea at a time when banks are shrinking their balance sheets and undergoing intensive ECB mandated audits.

For adherents of shadow banking, they make a case for it to continue unhindered by excessive regulation so as not to stifle the enormous economic benefits of market-based financing by inappropriate and stifling regulatory policies established for large, deposit-taking banks.

It is true that retail banks in Malta can be applauded for supporting industry sectors during the recession but many are witnessing a change of heart and their rate of lending is slowing as is happening in Europe. On the other hand, banks in the U.S. are better capitalized and much safer today than before the financial crisis. Even so shadow banking still brings enormous economic advantages to a wide range of businesses and employees, and fills a real gap in the US market.

As the G-20’s Financial Stability Board noted in its policy framework last year, shadow banking creates “competition in financial markets that may lead to innovation, efficient credit allocation and cost reduction.” Not every one agrees that bashing bankers is the preferred national sport and these old timers yearn for regulation minimizing the benefits of shadow banking.

Banks are lending less in order to comply with Basel III and other regulatory requirements. In addition, European banks are pulling out of emerging or growth markets and trying to lick their wounds due to Jon performing loans. At the same time, even in Malta there is a pressing need for finance, particularly at more competitive rates and especially for exporters.

The government wishes to promote economic growth and create new jobs, which in turn need to be financed. Businesses too need financing and numerous existing loans in the market need to be refinanced. If banks cannot or will not provide the financing required, alternative sources of financing such as corporate bonds will fill the gap. Currently, we read about a persistent dialogue between the Governor of the Central Bank and the banking community on the low levels of lending and the relative high rate of interest on loans.

The Central Bank governor reminds us that Malta has the fifth highest rate of bank lending interests rates after Cyprus, Greece, Portugal and Slovenia, while Labour MP Silvio Schembri, who chairs the economic and financial affairs committee, is also of the belief that interest rates are too high for small and medium enterprises. They are fragile and desperate to get credit and expand operations.

All this is happening at a time of disinflation where shockingly, our annual rate of inflation as measured by the Harmonised Index of Consumer Prices in April stood at 0.5 per cent ( 2013- 0.9%), whereas the annual moving average rate was 0.8 per cent. All the while banks mostly pay 0.3% on savings accounts to depositors but the top rate charged to industry and SME’s is higher than that dictated by E.C.B.

The Chamber of Commerce reports that credit growth had also slowed down since the financial crisis in 2008, almost approaching the zero level in 2013 – perhaps as a cautionary measure by banks in the face of non-performing loans and other defaulters. This seems to be more prevalent in the ailing construction industry.

The Chamber of Commerce has echoed concerns over the declining levels of bank lending yet it was convinced the decline in demand for commercial credit does not relate solely to restrictive interest rates but is due to business uncertainty (quoting drop in demand from manufacturing, import and distribution).

We read how the Chamber of Commerce thinks shrinkage of bank lending, particularly to larger companies, is a result of a reduced appetite and not because of the excessive cost of interest. It points to problems on competitiveness and loss of markets as new products are being channelled to low cost countries.

It is not pleasant to remember that Eurostat reported a drop in exports of €700 million or 21 per cent when compared to the previous year. Still, one cannot ever forget the enigma of how banks continue to report double-digit growth in profits since the onset of the recession.

Again one can still hear the war cry by Central Bank Governor, who extols the perils of lending rates that have gone into negative balance and, if they were not stimulated, that the economic forecasts would not be reached. With regard to lending rates, compared to the rest of Europe, the governor says that we do not seem to follow the ECB trends. Is he seeing something that the Commission is missing when lately it congratulated the finance minister on the exemplary growth of the economy? 

As can be expected, the views of the ex-minister of finance come with a word of caution. Opposition Finance spokesman Tonio Fenech said credit growth appeared to be very weak and sowed doubt if the EU forecasts for Malta could be attained. He said these forecasts were not export-driven but domestically driven.

Acting as a doubting Thomas, he remarked that this apparent shrinking in bank lending, coupled with weak retail and weak credit growth, indicated uncertainty in attaining the set targets. So what is the medium term solution, given that banks are becoming more risk averse?

The answer is found in an interesting study published in last month’s edition of The Economist, where it examines the impressive growth of this sector. It was the crisis of 2007-09 that brought the scale of shadow banking to light; or rather, made a process that had been accepted as a benign force of financial innovation and competition into a political problem.

Four years ago, Paul McCulley, then of PIMCO, argued that the growth of the shadow banking system, which operated legally yet entirely outside the regulatory realm “drove one of the biggest lending booms in history, and collapsed into one of the most crushing financial crises we’ve ever seen”. 

After Paul McCulley first coined the term, it became clear that “shadow banking” was both a stroke of genius and an unfortunate choice of words. Unfortunate because “shadow” banking resonates with “shady” or underground economic activity.  Taking a leaf from the recent Economist report, one meets the following extract quote - “In most countries, only banks can hold deposits guaranteed by the state, and only banks have a standing offer of credit from the central bank.

“With these privileges come lots of rules and restrictions. That is because banks, although essential to the smooth operation of an economy, are vulnerable to runs, which in turn can cause recessions. Banks have since had their room to manoeuvre severely restricted to make them safer. New accounting rules and Basel III have made it much harder for them to hide suspect assets in off-balance-sheet vehicles. In effect, lending by banks must be labelled as such”.

All this does not mean that local banks are about to fade away; only that their relative weight in the financial system may start to diminish as other financial institutions proliferate and grow. To conclude, shadow banking systems in other countries has so far escaped regulation, primarily because it did not accept traditional bank deposits and this in turn lowered costs, enabling better lending terms to SMEs.

Can the introduction of shadow banking gradually become part of our solution to the phenomena of declining credit? It is important to stop and consider the Green Paper on shadow banking issued two years ago by the Commission, which debated the wider implications of imposing regulations on shadow banking. In Malta, traditional bank loans have so far been the dominant form of funding and alternative capital markets are still in their infancy.

Will the drop in lending pave the way for growth of capital markets? This may be too early to materialise although many companies have succeeded in issuing unsecured corporate bonds to finance their capital requirements.

Certainly while there is undoubtedly a need to learn the lessons from the financial crisis, i.e. reduce systemic risks and promote financial stability, there is also a pressing need to facilitate more bank lending at competitive interest rates to bolster the economy and boost job creation.