Smaller banks are key to growth

Central banks remained focussed on consolidation, but encouraging smaller banks may be the way to push economic growth

The International Monetary Fund (IMF) gave out some good news this week. They told us that the crisis was over. Well sort of. The Fund predicted that the strong economic growth in the US and the UK would prevent a global recession. But there the good news stopped. It warned that the world faced “years of slow and subpar growth”. In a world with ultra-low interest rates, why is growth so slow? Where is all that money going?

The answer is rather simple. It is going to speculators. While down playing the risks, the IMF did point out a few danger points. These issues all have a common denominator. They exist because the massive amount of money printed by central banks is going into risky assets. The central banks have been successful in creating “liquidity driven” markets, but failed in creating “growth-driven” markets.

The low interest rates have created an enormous demand for unsafe assets. The indicators are everywhere. Junk bond yields are close to record lows. Equity markets are at all-time highs. Price/ earnings ratios in the US are among the highest decile of reported values since 1881. Nobel Laureate Robert Shiller’s Cyclically Adjusted Price Earnings ratio (CAPE) is at 26. The historic norm is 16.5. Another indicator created by a Nobel Laureate, Tobin’s q, indicates that the US market is 70% over valued. Margin debt in New York is at a historic record of $466 billion.

Meanwhile, the search for yield has created a field day for borrowers. Lending standards are deteriorating. Debtors can now demand money with few strings. New deals have few covenants to protect lenders (cov-lite loans). Repayments can be made in kind (payment in–kind- PIK loans), that is in new debt or preferred shares rather than cash.

The demand for the riskiest assets by speculators reveals the main flaw in the central bank thesis that more stimulus equals more growth and jobs. The reason for the flaw is the central banks are relying on the wrong intermediaries. They provide large bank with huge amounts of cash, which usually goes to speculators or the largest corporations. Lending to individuals and smaller businesses often requires smaller banks and more flexibility, but that is the problem.

In the US, deregulation in the 80’s and 90’s allowed mergers across state lines. This led to a wave of consolidation. In the past 30 years, the number of banks in the US has halved to about 6,000. So now there are fewer small banks. Worse, according to the IMF, large banks have a major competitive advantage. They are too big to fail. Since they have the implicit backing of taxpayers, investors see them as having less risk. So they lend them money at a lower rate. This rate subsidy is estimated globally at $590 billion.

Large banks and small banks have distinctly different business plans. Small banks internalise their risks. They make smaller loans at higher rates for shorter periods. But because they have better knowledge of their customers, they experience only 70% of the defaults that hit larger banks. They also keep their deposits and so are less reliant on interbank loans or even worse, foreign loans.

Even though well-run smaller banks can be safer than large urban ones, they are often punished by banking regulations. In the US, the Dodd Frank bill was supposed to reform abuses perpetrated by large money center banks. Its unintended consequence has been an adverse effect on smaller banks.

The problems of government regulation are not limited to the US. Different countries have different problems. As I wrote last week, the Chinese rural banks issues are not government regulations but their relations with local governments.

In India, the regional rural banks (RRBs) were set up to help channel funds and provide banking services to poor agricultural workers and farmers in the country. But since they are a creature of government regulation, they are subject to restrictions that often make them uncompetitive. They have to follow procedures of scheduled commercial banks when making loans and taking deposits. Their village customers find these complicated, confusing and unnecessary especially considering the amounts involved. The RRBs charge the statutory 14% interest. But borrowers will always prefer the commercial banks if they are available, because they charge only 4%.

Both India and Indonesia have similar problems of regulating smaller rural banks. In India, the National Bank for Agriculture and Rural Development (NABARD) has complained about the Rs100 crore increase in the amount of fraud at the state cooperative banks, district central cooperative banks and RRBs.

In Indonesia, there are 1,641 rural banks, locally known as Bank Perkreditan Rakyat (BPR), operating throughout the archipelago. During its existence, the eight year old Indonesian watchdog, the Insurance Deposit Corporation (LPS) has closed a total of 53 banks, 52 of them have been in rural areas. Rural banks also have non-performing loan ratios of 5.2% well above the national average of 1.9%.

The difficulty of rural access to banks exists in the Philippines. One third of the Philippines 9,000 bank branches are located in the greater Manila area. To address this issue, the government has created rural banks designed to serve the needs of farmers and fishermen far from the cities. Since 2012, 80 of these 560 rural banks could not meet capital requirements and 24 were closed. The Philippines’ solution to this problem was to invite in foreign investors to help increase the banks efficiency and capital.

Small banks in both rural and urban areas can provide enormous social and economic benefits to both their communities and their countries. To function properly, the regulatory environment must encourage and enhance their strengths rather than restrict them. It also must end subsidies to the largest banks. Most of all governments should attempt to restrict their activities to limiting risk rather than using their powers to encourage it.

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and speaks four languages.)

1 decade ago
The big banks are an anchor of stability. The key, as always, is moderation or balance. This is missing in all parts of the world where accountability has been removed from the equation together with integrity, leaving the quest for profits and growth as the sole driver of rulers, Governments and Banks alike.
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