Paul Tucker: Credit conditions for firms - stability and monetary policy
Speech by Mr Paul Tucker, Deputy Governor for Financial Stability at the Bank of England,
to the Association of Corporate Treasurers' Annual Conference, Liverpool, 18 April 2012.
* * *
It is quite a few years since I last spoke to an ACT gathering and it is very good of you to ask
me back.
Since then, many of you have been close to the front line of the financial crisis that overtook
us nearly five years ago.
Bridging the financial economy to the real economy, you have had to navigate a demanding
obstacle course while the real economy "rebalances". That means that businesses - the
productive part of the economy on which our prosperity depends - are having to adjust after
years, preceding the crisis, when spending was loaded too much towards household and
government consumption, the country's income from net trade was too weak, and investment
was too heavily weighted towards commercial real-estate construction.
That rebalancing has some way to go. While many of the planned tax increases are already
in place, government consumption will continue to be scaled back for the next few years.
There is also a risk that households will spend less than expected in order to rebuild their
balance sheets, holding higher liquid savings than previously as a precautionary buffer.
On the supply side, as the world economy recovers, the balance of production will continue
gradually to shift towards exporters and towards firms which, given sterling's large
depreciation since mid-2007, can now compete somewhat more readily against importers.
For sectors primarily serving domestic markets, the adjustment is more challenging. Some
face both higher costs for imported inputs to production and weaker demand - not just
temporarily but persistently - for their final output. On the ugly side of this rebalancing, there
has already been an increase in vacant properties on the high street, which is also facing
structural change due to on-line shopping. Some of those properties will no doubt be
converted to other uses over time, but I know it will not be easy for the firms affected or for
their employees. Company insolvencies have ticked up, and will likely continue to do so for a
while.
Credit supply and the corporate sector
Recovery will come, and the necessary adjustments will occur, over time. But it is made
harder for you by the problems in the financial system. You have faced first tightening, then
in late 2008 frozen, and now a prolonged period of tight credit conditions. Many of you must
have worried at times about the safety of your cash balances and other liquid investments.
You will have wondered about the soundness of the counterparties you use in the capital
markets. And, for the past couple of years, you and your representatives at the ACT have
also had to grapple with the array of regulatory reforms reshaping the financial system,
internationally and domestically.
It is clear that credit conditions prior to the crisis were unsustainably loose - reliant upon a
financial system whose net worth was too low and which was overly dependent on flighty
short-term wholesale funding. Banks of all kinds are themselves having to repair their
balance sheets and adjust their business models. They face headwinds in doing so. First,
legacy portfolios - bad and impaired loans - act as a drag on profitability. In the UK, that
particularly affects the two big banks directly rescued by the government. That matters a lot
because they were particularly significant in UK business banking before the crisis, holding
just under half of the stock of such loans. Second, the lingering threat of some kind of
implosion in the euro area has led to elevated funding costs for banks. The longer that
persists, the more it will be passed on to bank customers. In the UK, the government has
introduced a scheme to reduce bank funding costs provided they are passed on to SME
borrowers. And on the Continent, where the position is more precarious, the ECB's long-term
repo operations have broadly similar effects, giving banks there time to restructure their
liabilities and so leaning against the risk of a sharp contraction in the supply of credit.
This environment is affecting firms in very different ways. Some companies find themselves
with little need for external funds, and so are relatively insulated from tight credit conditions.
Indeed, the corporate sector as a whole is currently running an unusually large cash surplus,
despite challenging demand conditions. A notable example is energy extraction. UK oil
companies have run a large cash surplus - amounting to 1-2% of GDP - for much of the
past decade. This accounts for around half of the overall corporate cash surplus over the
period. But it's not just oil companies. The manufacturing sector as a whole is currently a net
lender to the UK banking sector: it has more cash on deposit than funds borrowed. Other
sectors look to have less healthy cashflow positions in aggregate - construction and real
estate, hotels and restaurants amongst them.
For many companies, therefore, external finance remains important.
For large companies, the bond markets are an option. Some of you have switched the
balance of your financing from the banking system to the bond markets. Over the past three
years, the Chief Financial Officers of large companies have consistently rated bond finance
more attractive than bank borrowing. Such firms seem, on the whole, to have made smaller
cuts to investment and employment.
Large companies with good access to the capital markets and healthy cash-flow positions
may, for the moment, be well placed to support the financing of smaller firms. Either via
vendor financing, where a company allows a customer to purchase a product or service on
credit. Or by extending credit directly to some of their suppliers. Or by supporting their supply
chain indirectly by setting up programmes to allow suppliers to borrow against unpaid
invoices. ACT data suggest that so-called "buyer driven receivable programmes" have been
growing in recent years. And there is some anecdotal evidence from the Bank's network of
Agents that larger firms are helping out smaller firms a bit.
But it is fanciful to entertain the notion that anyone other than the banking system can be the
main backstop for working-capital finance - for small and large companies alike. Banks are
unique in that their deposits comprise the money we all use for day-to-day purchases, so
they and they alone can provide liquidity insurance (provided they are financially sound).
For much of our history, the Bank of England worked with the grain of that by lending against
bankers' acceptances in our monetary operations: the famous Bill on London. The bill market
atrophied in the mid-1990s, and withered away completely a few years later. But during the
crisis I have wondered more than once whether a revival would be useful - although it was a
market that relied upon guarantees from banks whose names were close to undoubted. That
is for you, as corporate treasurers, and bankers to pursue if you wish to.
The Bank of England did try to help a couple of years ago via its Secured Commercial Paper
Facility, on which my Markets colleagues engaged actively with the ACT. Suppliers were to
be financed by banks, against a claim on their large-firm customers. By bundling together
portfolios of such claims into securities, the lending bank was able to "discount" the resulting
paper at the Bank, thereby obtaining off-market funding. In effect, the scheme offered banks
providing invoice-financing a way to fund the lending involved. There has been an increase in
invoice-based financing by banks, but take up of the Bank's facility has been very limited. It
remains open should there be further interest.
However they are delivered, improvements in working-capital finance, while important, are
insufficient. For longer-term finance, I hope that businesses and the City can work together to
broaden access to the corporate bond markets. Since the onset of the crisis, there has been
a marked pick up in the number of UK companies successfully raising funds from the sterling
bond markets for the first time. Here, I do think the Bank acting as a de facto market maker
of last resort in corporate paper helped revive the market in 2009, by alleviating the inventory
risk faced by cash- and capital-strapped dealers in those markets. And the Monetary Policy
Committee's quantitative easing has helped, by encouraging longer-term investors out of
gilts and into the bond market. But the number of smaller companies tapping the sterling
markets remains low. More needs to be done by the industry.
A number of initiatives are underway. For some while now, the London Stock Exchange has
been supporting the involvement of retail investors in the corporate bond market. The recent
Breedon Review made a number of suggestions intended to help open the door to non-bank
sources of finance for SMEs. And the Government is entering into a scheme to co-invest with
the private sector in managed funds that will lend to SMEs.
Dare I say it, but securitisation might even play a role. Nearly £1bn of long-term financing
was recently raised in the London markets by offering investors a first claim on a £1.5bn
portfolio of loans to small businesses with a typical turnover of under £2 million per annum.
The funds were raised at a lower cost than many bank issuers would face in their own name.
A few other banks are thought to be exploring similar deals. It is important, though, that the
lessons from badly designed securitisations in the past should be learnt. Almost the most
important lesson is that to be healthy the securitization market, like any other capital market,
needs a bedrock of real, unlevered investors. Holders and traders who have borrowed to
make their purchases have a tendency to sell when the weather deteriorates. We have seen
where that can lead.
If one thing is clear from that brief and incomplete survey, it is that, sadly, the repair of the
credit system will take time.
Stopping this happening again: the Financial Policy Committee
So will the even broader task of putting in place better "rules of the game" for the financial
system.
For all the measures in train internationally on banks' capital, resolution regimes,
over-the-counter derivative markets, central counterparties, shadow banking and so on, they
will I fear eventually be found wanting. Conditions change. One generation's reforms are
eventually overtaken by the evolution of the structure of the financial system or by temporary
bursts of misplaced exuberance.
At its simplest, that is why the government has established the Bank of England's new
Financial Policy Committee - to ensure that the moment when the financial system's
resilience is critically impaired does not get overlooked; that it is anticipated and appropriate
action is taken. A standing body, meeting regularly, transparently, and backed by powers to
take decisions on regulatory measures - the FPC is the body charged with being on the
case. It won't be perfect, but it can be much better than the pre-crisis regulatory regime.
The initiative to create the FPC is necessary, because both macroeconomic policymakers
and financial regulators have had to learn some tough lessons. On the one hand, we all need
to be attentive to the effects that easy monetary policy globally can have on risk-taking
behaviour. On the other hand, financial regulators cannot afford to focus exclusively on the
health of individual banks and dealers as though they were isolated atoms. The financial
sector is a system that hangs or falls together. Moreover, it is swings of exuberance and
caution that drive excessive fluctuations in the supply of credit to firms and households. The
FPC is about filling the space between monetary policy and microregulation - in an
admittedly inelegant phrase, "macroprudential" policy: policy that is focused on the resilience
of the system as a whole.
The FPC will not be a talking shop. It will have powers. At times, this will affect you directly.
We have advised the government that, alongside controls over banks' leverage and
risk-weighted capital requirements, the FPC should have the power to make the banking
sector (and other financial intermediaries) hold more capital temporarily against exposures to
sectors going through a dangerous boom. Sometimes that will be within the financial sector,
as the run up to the latest crisis illustrates. On other occasions, it could be part of the real
economy. History points to commercial real estate as an obvious example. Property-related
borrowing booms have often driven financial stress. In those circumstances, simply
increasing the headline capital requirement might prompt banks to cut lending to sectors of
the economy that were not overly exuberant while maintaining lending into the booming
sector that seemed to offer wonderful returns. That would be perverse. Better, sometimes, to
try to address a bubble at its source. This could be unpopular, but such is the job of taking
away the punchbowl. We will explain our decisions.
I cannot emphasise enough that the FPC will not indulge in attempts to micromanage the
banking system or the allocation of credit. Nor will we be excessively activist, trying to
fine-tune credit policy. This is about stability, which is an absolute precondition for steady
improvements in economic activity and employment. The goal is to make the financial
system resilient, to contain destructive "busts", and to do so without impairing the contribution
that the financial sector makes to the economy's medium-term growth.
Can the FPC help right now?
The benefits of the new regime for stability will take time to come through. That might leave
you asking what the FPC could do to help right now. Indeed, with credit conditions so tight, it
has been asked whether the FPC should be easing regulatory constraints on banks. The aim
would be to encourage them to loosen lending conditions, helping recovery. And, it is
suggested, that would be consistent with the FPC's remit because it could reduce threats to
stability from the risk of borrowers defaulting.
At its September 2011 meeting, the FPC concluded that such a step would in fact be
counterproductive - endangering stability and jeopardising recovery. Given the precarious
starting position of UK banks when the crisis broke, their capital adequacy is still being
rebuilt. And banks are still operating in an extraordinarily risky international environment. It
would not be sensible to relax capital requirements when the unusual hazards persist.
Today, gradually strengthening capital adequacy, and so building resilience, is best not only
for stability but also for sustaining the recovery through what might lie ahead.
Monetary policy
With government needing to set fiscal policy in order to repair the public finances, that means
that the burden of stimulating our economic recovery falls mainly to monetary policy. Bank
Rate is at, effectively, zero. And the Bank has provided further stimulus, via quantitative
easing, in order to underpin demand, and so guard against inflation being persistently below
our 2% target further down the road.
For the economy as a whole, that has bought time to smooth the adjustment. For firms, it has
reduced the cost of capital and the weight of debt burdens. The equity prices of leveraged
firms have generally risen more than the market as a whole. Easy monetary conditions no
doubt go some way to explain why more firms haven't failed; and why the Bank has received
few approaches, under what is still known as the London Approach, to help banks and firms
keep talking when a co-operative solution is within reach.
In all this, the Monetary Policy Committee faces a delicate and unavoidable balancing act.
As I have said before, easily the Committee's biggest judgment in recent years has been that
inflation will gradually fall back to the 2% target - initially as the effects of higher VAT, energy
and import prices diminish; and then as slack in the economy bears down on wages and
prices. Though it has fallen significantly over the past six months, from over 5% to 3.5% on
yesterday's reading, it remains uncomfortably above target. The MPC will guide inflation
back to target in the medium term, but in the near term there is considerable uncertainty
about the path that it will follow.
In its February forecasts on the outlook for growth and inflation, the MPC saw a gradual
pickup in activity as the headwinds from weakness in the world economy and tight credit
conditions receded and as the squeeze on household incomes is ameliorated through lower
inflation.
Big picture, that view on the growth outlook still looks broadly on track, but it is not always
going to seem like that over the next few weeks and months as the ONS data for the first half
of the year are published.
Two temporary factors look likely to muddy the waters, leaving the headline ONS figures for
GDP growth well short of what has been suggested by surveys.
First, data for construction output over the turn of the year were extremely weak. That looks
likely to be a substantial drag on recorded growth in the first quarter of the year, possibly
leaving the headline figure for activity close to flat. But surveys point to much more modest
falls in construction output. And growth in the sector is estimated by the ONS to have
resumed in February. Also, construction was very weak in the first quarter of 2011, only to
bounce back on the ONS measure in Q2. Mismeasurement, in what is still a fairly new
monthly statistical series, can't be ruled out. Those straws in the wind suggest that the drag
on growth may prove to be temporary, so long as the global environment does not
deteriorate.
Second, the additional bank holiday for the Queen's Diamond Jubilee in June will reduce the
number of days worked. Taken together, all this means that you will probably see weak
headline ONS numbers for growth in the first two quarters.
The MPC will be focused mainly not on headline growth but rather on indicators of
underlying activity. Surveys of UK companies' output have, in fact, continued to tick up, with
the most recent CIPS readings, taken as a whole, at the highest level for over a year. Survey
measures of private sector employment have begun to edge up too. Overall, surveys point to
growth in underlying activity over the first half of 2012 - not stellar growth, indeed modest
growth, but growth nonetheless.
But if the overall story of recovery in underlying growth still looks broadly intact, there has
been bad news on the inflation front.
The recent inflation data, particularly for goods prices, has come in a little stronger than
expected. Sterling oil prices and wholesale gas prices have risen by more than 5% since
February. Together with duty changes announced in the March Budget, that seems likely to
leave the short-term outlook for inflation on a path a little higher than incorporated into the
central projection described in the MPC's February Inflation Report. I think inflation might
remain above 3% throughout the second quarter of this year, and possibly into the second
half of the year.
Already in February, there was a risk that inflation might fall back towards target less quickly
than incorporated into our "most likely" central outlook. Not only was there a prospect of
supply disruptions to oil production, there was also a possibility that firms might seek to
rebuild margins faster than assumed as and when economic recovery becomes more
secure.
So one possibility is that companies have begun to rebuild or protect their profit margins
more quickly than expected. According to the latest ONS data, by the end of last year the
profits of mainstream businesses (excluding oil and finance) had fallen to their lowest share
of GDP for a couple of decades. Companies' willingness to tolerate a further squeeze, in the
face of rising import prices, might be limited. We need, therefore, to assess the extent to
which spare capacity is dragging down on prices. In this particular context, we can take some
comfort from the growth of earnings (wages and staff bonuses etc) being subdued, below
2%. But with productivity growth having been incredibly low for a while now, it is possible that
the rate of earnings growth consistent with achieving the 2% inflation target has been below
the 4-4.5% we typically used as a rough benchmark in more normal conditions before the
financial crisis and subsequent recession. How and when businesses in aggregate will again
generate productivity improvements will be at the heart of the Committee's deliberations.
To be clear, this is about the path inflation takes back to target, not whether it will return to
target. The MPC will ensure that it does return to target and that medium-term inflation
expectations are anchored to the target.
Conclusion
To conclude, UK companies are having to adjust to a different pattern of demand, to
profound shifts in world trade and prices, and you are having to cope with this while the
financial system both recovers itself and adapts to new "rules of the game". Given some
threats to stability linger, the Financial Policy Committee's primary focus has to be on
encouraging continued progress in building resilience in the banking sector. That will pay
dividends in the longer run.
I hope that that time can also be used, by bankers working with your community of corporate
treasurers, to richen the options for working-capital finance and longer-term funding available
across the business community. Such has been the call during similar periods in the past,
going back more than a century. But it also offers opportunities. Innovation, which we must
not make a dirty word, might help.
Meanwhile, monetary policy will underpin the recovery so long as that remains consistent
with anchoring inflation expectations in line with achieving the 2% target over the medium
run. We shall not let that slip.