A funny thing happened to business lending on the way from the GFC.
Australia’s banks turned into giant building societies, lending almost exclusively against residential property and rarely, if ever, making unsecured loans to businesses or people any more.
If someone asks for a business or personal loan these days, the banker asks for the house.
The result is that traditional small business lending has dried up, and with it business investment, while Australia has the highest ratio of household debt to GDP (134 per cent) in the world, since business owners have to borrow against their houses.
And, by the way, the upward pressure on values from banks has probably contributed to the over-pricing of Australian real estate.
As a result of a combination of the “risk-weighted assets” system and the credit crisis, banks have basically withdrawn from the thing they were set up to do: facilitate commerce.
For the big four banks, only 16 per cent, on average, of a real estate mortgage is counted when measuring the bank’s capital ratio. This is rising to 25 per cent next year.
But every dollar of an unsecured personal and business loans counts against capital and in some cases the risk weighting is 150 per cent.
Capital -- that is, the bank owners’ money -- has to be 8 per cent of assets, although mostly it’s around 10 per cent. That is, the ratio of owners money to other peoples’ money has to be no greater than 12.5 to 1 and is usually 10 to 1. The result is that for every dollar of capital, the big four banks can choose to lend $62.50 secured against real estate or $10 unsecured.
Guess what happens? It’s only natural and totally understandable. It’s true that interest rates on personal and business loans can be three times what the banks make on residential mortgages, but that still doesn’t make up the revenue.
And in any case, these days the banks are all about volume and market share.
In a way, the increase in the risk weightings of residential mortgages next year, from 16 to 25 per cent (of the asset counted against capital), imposed by the Australian Prudential Regulatory Authority and due to start from July 1 next year, will only exacerbate the problem.
That’s because analysts reckon the banks will need to raise about $24 billion in precious, expensive, new capital, which they have already started doing -- including Thursday’s sale by ANZ of Esanda for $8 billion.
They will be loath to waste it on loans that count dollar for dollar against that new capital, and will be even more inclined to focus on real estate.
And by the way, the big banks might have to increase the risk weighting of their real estate mortgages to 25 per cent, but the smaller banks and non-bank authorised deposit-taking institutions are at 35 per cent for the same assets.
Why are the big ones favoured like that? Because they practice something called 'advanced modelling', which APRA says involves superior risk management systems.
But that represents a built-in regulatory bias towards the banking oligopoly in Australia, and makes it much harder for the smaller players to take market share off them because their interest rates have to be higher to pay for the capital.
But leaving aside that little glitch, the system of risk-weighting assets was a wonderful development for the banks when the Basel Committee invented it in 1988 -- for the simple reason that it increased the assets that banks were allowed to hold for the same amount of capital.
You see, the Basel Committee didn’t decide that the weighting of secured loans should kept at a dollar for dollar and unsecured loans’ weightings increased, so banks had to cut back on them.
Oh no, secured loan weightings were reduced to less than a sixth of their real value, and unsecured loans were kept at 100 per cent, as all loans always had been.
It was just another step in the centuries long march of banks from lending only their owners’ capital to merchants on the security of nothing more than promissory notes to being highly geared (effectively lending $60 for every $1 of capital), highly profitable lenders of others peoples’ money against real estate.
Banking developed in Italy in the 13th century from the practice of issuing bills of exchange to facilitate trade.
The merchants of Venice had begun to deposit their surplus cash from doing deals with the moneychangers, who lent it on to those who were temporarily short.
Around 1800, bank capital was down to 50 per cent of assets because of the pressure on bankers to finance the wars of their sovereigns. By the end of the 19th century, bank capital, after another 100 years of wars, it was 20 per cent. There was, of course, no such thing as risk weightings; a loan was a loan.
Following the invention of central banking after the 1907 Knickerbocker Trust collapse, banks were allowed to hold less and less capital until, in the late 1980s, they hit more or less rock bottom at less than 5 per cent.
That’s when someone hit on the brilliant idea of letting them notionally reduce the value of secured loans when measuring the capital: the result was continued the process of lowering the capital – in other words increasing the gearing and therefore profits – but this time without seeming to.
The ratio of capital to assets stayed the same! It’s just that credit assets magically shrank if they were secured against land.
Fast forward to 2015, and the banks are under pressure to increase their capital because … well, they lost it all in 2008. Sorry everyone. The Australian banks didn’t lose theirs, but the rules are global now so one in, all in.
The pressure to increase capital, combined with the system of risk weightings, has fundamentally changed the nature of banking.
No longer is the credit risk assessor paramount within the bank; now the real estate valuer is king or queen. All that matters to a bank’s solvency is the LVR (loan to value ratio) not the credit score of the borrower, and the key unknown is the value.
Banks are no longer very interested in credit-worthiness, or in establishing the sustainability of small business’s cash flow. They just want the security of the entrepreneur’s house.
The result, apart from the well-documented dearth of business investment in Australia, is that two new industries are now beginning to flourish in Australia: non-bank lenders focusing on the personal loan and small business sector and venture capital.
Increasingly, entrepreneurs are being forced to raise equity capital to fund their working capital, in the absence of either a business loan or an overdraft, which means selling part of their businesses.
And that is expensive capital, both in the returns that the venture capitalists expect and in the emotional wrench of equity dilution.
So the shifts in bank regulation -- more capital and the risk weighting of assets -- is actually having a profound effect on the way business itself is conducted.
And the growth of peer to peer lenders like Society One, Ratesetters and ThinCats (in which I am a small investor) is a direct consequence of the banks withdrawal from unsecured lending.
There are others, like the listed DirectMoney which uses a unit trust structure, and Investors Central, which issues preference shares to fund car loans through a subsidiary, Finance One.
Perhaps at some point the banks will decide to get back into personal and business lending, and mop these new smaller players up, but for moment they’re munching on the banks’ unsecured lunch.