Angus Armstrong

An Assessment of Bank Lending to UK SMEs in the wake of the crisis

The availability of bank finance to small and medium sized enterprises (SMEs) is important to allow SMEs to start up and finance investment for growth. To assess changes in such availability over 2001–12, we used data from a series of surveys that provide detailed information on the characteristics of a sample of UK SMEs, their owners and experiences of obtaining finance. Using econometric models, which included controls for SME characteristics and risk factors, indicators of changes in the provision of bank lending over the time period abstracting from borrower risk could be obtained. The results suggest ongoing restrictions on the availability of SME bank finance up to 2012 – which appear to have persisted into 2013. Further research using macro data shows an impact of economic uncertainty on such finance. If unresolved, these patterns could imply adverse effects on economic performance in the short and long term.

Restoring Trust in Banking

Trust allows financial transactions to take place when contracts are incomplete and the cost of negotiating too great for the parties involved. Banking covers many different types of transactions in assets with different levels of incomplete contracts. Investment banks have traditionally dealt with assets with incomplete contracts and often traded on informal and opaque markets. The creation of new global banks combined know-how, capital and collateral to generate enormous growth in these markets. While global banks developed trust with counterparties in specific markets, the opacity combined with limited liability structures also created principal-agent problems. The scandals which emerged are a reflection of these agency problems and have left trust in the banks greatly diminished. If levels of trust remain so low, this will be consistent with ongoing bank vulnerability, less lending to finance risky but profitable investment projects, and consequently lower economic activity. Regulation can support private incentives to accept codes of conduct which enhance trust.

Belief in a Just World and Children's Cognitive Scores

Parental beliefs are recognised by psychologists as an important causal influence on child development. A two-period model of human capital accumulation in the framework of Becker and Tomes (1986) is presented. In the first period parents transfer their beliefs, distinct from genes, to children by signalling their ‘belief in a just world’ or their perceived return to effort. Children respond by choosing effort, irrespective of the real world returns, which combines with their genes to create early ability. This determines the rate of return to second-period investment and final attainment. If parents are credit constrained, both beliefs and income determine attainment. Empirical analysis using the second generation of the NCDS shows that beliefs are a strong predictor of early attainment and significantly reduce the importance of parental income. The identifying assumption is that parent beliefs are slow-moving and not conditioned on the child.

COMMENTARY: THE ECONOMIC CONSEQUENCES OF LEAVING THE EU

The phony war is over. We enter a crucial final six weeks before the UK’s referendum on EU membership. A decision by the British people to vote to leave will alter the course of both British and European history. While this is fundamentally a political choice, economic consequences are rightly central to the debate. In this issue of the Review we bring together some of our colleagues from the ESRC’s ‘UK in a Changing Europe’ programme, from a variety of disciplines, to examine the implications of this decision. We also summarise the National Institute’s estimates of the macroeconomic consequences of leaving the EU and compare them to other model based estimates. This exercise is of particular interest since both the wellpublicised HM Treasury and OECD analyses use our global macroeconomic model, the National Institute Global Econometric Model (NiGEM).1

EU Membership, Financial Services and Stability

This paper examines whether EU membership enhances or diminishes the UKs financial sector stability, and therefore its prominence in global finance. The UK is host to the largest share of financial services in the EU, despite being outside of the Eurozone. An important reason is that, as a member of the EU, the UK has direct access to the Eurozones financial infrastructure. If the UK leaves the EU (and EEA) banks and other financial services firms may continue to have access to the Single Market, but they are unlikely to have direct access to the Eurozones infrastructure. Banks in the UK will no longer be direct members the Eurozones payments system. The swap arrangement between the European Central Bank and Bank of England would have no legal enforcement mechanism. Resolution of cross-border banks would be more challenging with less incentive for a cooperative outcome. While some may welcome the reduced size of the financial system, not without reason, this could be achieved more effectively with domestic regulation than by leaving the EU. Given the uncertainty that would follow a vote to leave, there is a risk of capital flight.

Comparing Housing Booms and Mortgage Supply in the Major OECD Countries

The house price and lending boom of the 2000s is widely considered to be the main cause of the financial crisis that began in 2007. However, looking to the past, we find a similar boom in the late 1980s which did not lead directly to a global systemic banking crisis – there were widespread banking difficulties in the early 1990s but these were linked mainly to commercial property exposures. This raises the question whether the received wisdom is incorrect, and other factors than the housing boom caused the crisis, while macroprudential policy is overly targeted at the control of house prices and lending per se. Accordingly, in this paper we compare and contrast the cycles in house prices over 1985–94 with 2002–11. There are more similarities than contrasts between the booms. Stylised facts include a similar rise in real house prices where booms took place, and a marked rise in the real mortgage stock along with real incomes. The aftermath periods are also comparable in terms of house price changes. Econometrically, determinants of house prices are similar in size and sign from the 1980s to date. There remain some contrasts. Leverage rose far more in the later episode and did not contract in the aftermath. Mean reversion of house prices is greater in the earlier period. The earlier boom period showed differences with average house price behaviour which was not mirrored in the most recent boom and inflation was higher. Despite the contrasts, on balance we reject the idea that the recent boom was in some way unique and hence the key cause of the crisis. There is a need for further research to capture distinctive structural and conjunctural factors underlying the recent crisis which differ from the earlier boom and some suggestions are made.

An Assessment of the Independent Commission on Banking's Recommendations

The government set up the Independent Commission on Banking (ICB) to consider structural and non-structural measures to promote stability and competition in the UK banking system. They have produced a comprehensive assessment covering some of the key issues facing the banking industry. The ICB’s three core recommendations are: a ring-fence to separate retail and wholesale banking activities; banks are required to have more lossabsorbing capital; and greater competition in retail banking markets. In some respects, the recommendations are a step back towards an earlier time of compartmentalised banking.1 The litmus test is whether they deliver a similar period of financial stability and economic growth. In our view, the ICB’s recommendations do not take enough consideration of the unique characteristics of banking and only address the proximate cause of the crisis. We contend that the recommendations are likely to reduce the probability of individual bank failures, but unlikely to significantly reduce the probability of another systemic crisis. The predicament which the Chancellor Mr Osborne calls the ‘British dilemma’ remains unsolved; the UK is one of the biggest financial centres in the world but cannot afford to carry large contingent fiscal risks.2 A more advantageous trade-off may be possible, but this requires deeper reform of the governance of banks and key funding markets to address some fundamental agency issues.

Financial Regulation: Are We Reaching an Efficient Outcome?

This issue of the National Institute Economic Review includes articles by six renowned financial economists who each investigate one key aspect of the Global Financial Crisis (GFC) and the regulatory response. The authors, who will also present at the National Institute’s Annual Finance Conference at the Bank of England in March, were asked to have in mind the following guidance in preparing their articles:

Commentary: UK Housing Market: Problems and Policies

There is mounting evidence that we are failing to deliver decent housing, especially for the younger generation. First, more and more houses are being bought for investment purposes which raises the cost of housing. Second, older generations appear to be ‘under occupying’ and even hoarding houses while younger generations are struggling to move into homes. Third, the number of new homes continues to fall below the number of new families. Fourth, the re-reclassification of housing associations may leave this essential source of housing for lower income families less able to access long-term stable funding.

Unconventional Monetary Policy: Introduction

The world’s four major central banks have turned to new forms of monetary policy to support demand during the Global Financial Crisis.1 The conventional policy instrument of overnight interest rates was reduced to close to zero per cent within eighteen months of the crisis.2 This presents a problem of providing further stimulus by lowering interest rates; if rates turn negative then depositors always have the option of holding wealth in cash at a zero interest rate. The option of holding cash is thought to create an effective floor on interest rates known as the zero lower bound (ZLB). Central banks have had to find new ways of deploying monetary policy, popularly known as ‘unconventional’ monetary policy, to provide further stimulus subject to the ZLB.