Another bright idea from Ritchie

Think about it: if Spain can do this why can’t the UK issue £20 billion of new UK debt to a new National Investment Bank in exchange for equity with the National Investment Bank then using those UK bonds as collateral for ECB cash at 1%.

If the EU can allow this to fund a failed bank to clear bad property debts why not to fund a new bank to create jobs?

Any takers anyone?

Err, yes. Although pendants will note that the UK is not in the eurozone. Thus gilts, bonds issued by the UK, are not on the eligible list of ECB collateral.

There are other problems with the idea as well but this one seems reasonably serious.

26 thoughts on “Another bright idea from Ritchie”

  1. I don’t think this is that bad an idea, actually. It’s certainly a lot better than the bonkers “credit easing” scheme they are proposing and IMF seems to be endorsing, which involves creation of a completely new market in SME-loan-backed securities underwritten by the Treasury and probably in the end purchased by the Bank of England. Oh, and providing commercial banks with Treasury funding at cheap rates in the hope that they will lend it to SMEs. Complete circularity. The only beneficiaries from this ridiculous scheme will be commercial banks.

    The debate we should be having is whether public funds should be used to support SMEs AT ALL. But if they are going to provide public money for SME financing they should do it openly and directly.

  2. Yes, how would this be different to investors providing capital to any new trading entity? Government creates a new debt (because it is broke) – £20bn in bonds – and gives them to the NIB. Which then uses them as collateral for a loan.

    Or, my parents allow me to use the equity in their flat as collateral to enable our business to get a bank loan.

    I’m failing to spot why, apart from Central Bank interest rates being so low, that this is anything other than “duh”?

    Of course, the answer to his question is – they could but as they want to reduce overall government borrowing by as much as possible (even though they are not doing a particularly good job of it at the moment), an extra £20bn gilts issue wouldn’t exactly help.

  3. But this is just saying “why doesn’t the tax payer create a new bank by giving it lots of money, then that bank can borrow more money using that money as collateral” dressed up in more confusing words. Of course is we wished to create a new bank with £20bn of initial funds we could do it.

  4. I would like to see some evidence that there is a general problem with banks being unwilling to lend to SMEs, rather than a specific problem that some SMEs can’t borrow at the rates they’d like to, because commercial banks don’t think much of their risk profile.

    My view is that if we’re going to have a state-funded investment bank (I’d except that not to be a popular proposition on this site) it should be buying equity not debt from SMEs. There’s less risk of its being ripped off that way, because SME owners want the equity to do well too.

  5. I don’t understand collateral. If the Spanish state gives funds (assets, bonds) to a bank because it is insolvent (has uncovered liabilities), then surely those assets are spoken for – they are needed to cover some liabilities. If they are already spoken for, how can they be used a collateral? If you give the ECB first claim on those assets, what’s covering those initial liabilities?

    I have got the impression it’s possible to use the same asset as collateral more than once, but I don’t understand how.

  6. Luis,

    Because the ECB then gives the bank another asset – cash. Which is then used to purchase further assets, debts from SMEs.

    So, the debts from the SMEs cover the uncovered liabilities, the cash has gone, and the bonds cover the loan from the ECB. You just didn’t iterate enough.

    Of course, in the UK context, the extra money given is, by and large, just sitting there improving the banks’ capital adequacy ratios. Because that’s what they were told to do by the government acting as formal regulator, so they have to do it. No matter what the government acting as something between populist agitator and enthusiastic encourager of the nation’s economic growth is telling it to do which they can freely ignore.

  7. SE

    thanks – although I don’t see why that’s preferable to simply holding the bonds to cover the liabilities, or selling them and buying SME debt. What does the extra step get you?

  8. PaulB

    “My view is that if we’re going to have a state-funded investment bank (I’d except that not to be a popular proposition on this site) it should be buying equity not debt from SMEs. There’s less risk of its being ripped off that way, because SME owners want the equity to do well too.”

    Equity holders are the last ones to get their money back. If the SME can’t pay back a loan, then it sure-as-shit isn’t going to be distributing anything to shareholders.

  9. although I don’t see why that’s preferable to simply holding the bonds to cover the liabilities

    SMEs get loans. This is seen as important for the wider community (pretty much across the political spectrum) even if it makes no difference to the bank.

    or selling them and buying SME debt. What does the extra step get you?

    Central bank interest rates are very low at the moment. This distorts the market for those people able to borrow from central banks. I’d also note that Central Banks may be willing (for political reasons) to allow a higher value, as collateral, for government paper than you might get in a current market transaction.

    If the Central Bank loans are for a long enough period, this might even be a reasonable bet.

  10. TTG: Yes I know. But equity holders get the upside when things go well. If you’ve got a portfolio of equity holdings in SMEs, the successful ones may pay for the failures. Whereas if you’ve got a debt portfolio, you have to pay for the defaults in interest rate spread, which means you have to work out what the default risk is on each loan, which is a labour intensive thing to try to do, which is why commercial banks charge interest rates SMEs don’t like.

  11. SE

    ah, think I’m getting there

    so when all’s said and done, you hold an asset (govt bonds) yielding X covering a liability (loan from ECB) costing x, = profit, plus you have an asset (SME debt), yielding whatever, covering your liabilities, costing whatever, possibly also delivering a profit. So the best way to think about it is just like normal leveraging up – if you expand your balance sheet, and all goes well, you make more money. Yes simple really.

    of course you “owe” the government for the bonds it gave you in the first place, but that liability is equity, for whom your making more money manoeuvres is a good thing.

    that said, buying SME debt has to be a risky move doesn’t it? I suppose what matters is the price you buy it at, but still.

  12. PaulB

    But surely they would also have to take equity stakes that the SMEs wouldn’t like? And, generally, the due-diligence conducted prior to an equity investment should be far more onerous than that done prior to a loan.

    I accept the point that there’s more potential for upside in equity.. but there’s more likelihood of downside too. Far more businesses fail at the equity level than at the preferred creditor level (where the bank would sit). Further, even where there is a success, the asset the banks holds will often not be particularly liquid.

    There’s a pretty well established Privae Equity industry full of people who are good at spotting and nurturing a good SME equity investment opportunity. Not sure I fancy the chances of the government doing a better job.

  13. tory boys never grow up

    If you were to bother to look a little closer you would actually find that bonds issued by Lloyds TSB, Bradford and Bingley and the Yorkshire Building Society and guaranteed by the UK Central Government are all eligible collateral for the ECB scheme – as are bonds issued by many UK banks without the Government Guarantee. So it doesn’t take too much of a leap of imagination to see how the ECB could be used to fund a National Investment Bank, especially since it is already providing billions of cheap funds to other UK banks already!

  14. TTG: to estimate the value of an equity stake in an SME, you have to work out what you expect the business to be worth, on average. Not easy. But to estimate the value of an SME’s debt, you have to work out the distribution of what the business is worth. Much harder. And there is the additional problem that when the going gets tough, the SME’s interests interests are no longer aligned with the lender’s: the SME may choose to follow a risky strategy, with limited liability to protect its downside.

    I sympathize with your scepticism as to the government’s ability to pick winners. But I am equally sceptical about the government’s ability to do a better job of assessing default risk than does the private sector. I’d like the government to flatten the tax treatment of equity versus debt and let the market get on with it.

  15. Offshore Observer

    The really clever part is the ability for the Spanish Government to borrow money from the ECB. The Germans will be doing thier nut at the fact that some spanish banker has worked out how to make the ECB pay for a spanish government bailout. Clever stuff indeed.

  16. PaulB

    “But to estimate the value of an SME’s debt, you have to work out the distribution of what the business is worth. Much harder. And there is the additional problem that when the going gets tough, the SME’s interests interests are no longer aligned with the lender’s: the SME may choose to follow a risky strategy, with limited liability to protect its downside.”

    I’m sorry but this is just plain wrong. All you need to do (and what the banks actually do) is to:
    1) limit how much you are willing to lend to a SME
    2) look at past performance
    3) ask for collateral

    Lending to small businesses in this way is way easier and less risky than it is to buy equity stakes.

  17. Emil: yes, of course the banks take the easy option. And the result is that unless they can come up with collateral from somewhere, SMEs can’t get the funding they want at a price they’re willing to pay.

  18. PaulB,

    yep, and I can’t buy a new car at the price I’d be willing to pay either. Life’s tough …

  19. This is just an accounting trick which is only useful:

    a) because it is expensive for Spain to borrow money.

    b) if the ECB doesn’t mind doing backdoor financing of sovereign governments.

    It would make zero difference to the national accounts vs a conventional borrow and invest. You get zero increase in public sector net debt, an increase in gross debt plus assets. (Before consolidation of “NIB” accounts)

    (a) is certainly not true for the UK, and (b) is probably not true for the UK. The Bank of England would probably refuse to accept specially minted – and untradeable – government paper as collateral, it would rightly tell Osborne to buck up and borrow money if they want money.

    It has moral hazard written all over it, and Mervyn King really hates moral hazard.

    A finer point is maturity matching: if the idea of the scheme is to invest in “infrastructure”, then you should match maturity of assets with liabillities. This scheme is basically borrowing short (form the CB at the overnight rate? 3m rate? I don’t know) and “investing” very long. Very silly. Much better to borrow long in the gilt market and invest long, if you’re going to do this.

  20. The problem with govt investinging in sme’s isn’t picking winners, it’s killing the failures – there’s always an election looming and every constituency is a marginal as far as the incumbent MP is concerned.

  21. tory boys never grow up

    Bradford & Bingley….do you by any chance mean UK Asset Resolution Ltd., who now manage it?

    Yes, UK bank bonds can be repo’d at the ECB. The ECB issues euros, not sterling. Unless our SMEs develop a sudden preference for doing business primarily in euros – which under the current circumstances seems unlikely – please explain how a UK Investment Bank obtaining cash at the ECB would help SMEs? Unless of course it then converted it to sterling on the currency markets. Seems a very convoluted way of obtaining cash when it could also repo those bonds at the BoE for sterling.

    RM’s idea was to issue gilts, not UK bank bonds.

  22. Gareth

    This form of “backdoor financing of governments” is not materially different from the other form I outlined above, which was suggested by the Chancellor at the Conservative Party Conference last Autumn, has been recommended by various parties including the IMF and is being given serious consideration by the Government despite King’s concerns. It’s just simpler and less lucrative for banks.

    I agree that it would be better to match fund directly using long-dated gilts.

  23. The Germans will be doing thier nut at the fact that some spanish banker has worked out how to make the ECB pay for a spanish government bailout.

    Or: everyone in their right mind in Germany will be delighted that finally, a solution has been discovered which allows the most beneficial economic outcome for Germany, without anyone in the German government being able to veto it in order to appease idiot populists.

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