Will the Government’s credit review system really make a difference to cash-strapped businesses?

THE GOVERNMENT’S declaration in the Budget that it would set up a credit review system to monitor lending decisions by Irish banks has thrown the issue of access to credit into sharp focus once more.

But will the measure make a real difference to cash-strapped businesses, or is it just the latest sop? And, in any case, should the Government be taking a position on banks’ lending practices?

Since the problems in the Irish banking sector intensified, small and medium-sized enterprises (SMEs) have repeatedly complained that banks are freezing them out. Banks have responded by saying they are in fact lending in high volumes, while the Government has declared that, as part of the National Asset Management Agency (Nama) process, banks will be “encouraged” to lend.

In principle, it should be a neat solution. You inject large amounts of equity as part of a recapitalisation process into the Irish banks to bring up their capital ratios and they, in return, commit to lending again. In practice, however, encouraging banks to lend by setting up credit review committees or otherwise is far from simple, while some would say directly intervening in banking is the last thing a government should do, given the outcomes of previous crises.

Chastened by the difficulties in which they now find themselves following their lending exuberance during the boom, banks are seeking to hoard much of the capital they have managed to raise. This is leading to a “liquidity trap”, whereby banks are not filtering their capital out to the wider economy, potentially deepening and prolonging the recession.

Mark Fielding, chief executive of the Irish Small and Medium Enterprise Association (Isme), says credit remains tight, pointing out that 42 per cent of his association’s members are finding it difficult to get bank funding.

“It’s a total joke when I hear banks saying they’re lending to over 80 per cent of applications,” he says, adding that most lending discussions do not get to the formal application stage as they are turned down before this.

Of the credit review committee, Fielding says it is “not going to make a whole pile of difference”, and expresses concern that it will create a false sense of hope that SMEs will be given money.

But for banks, it is something of a catch-22 situation. If they don’t lend, more companies will go to the wall, driving up unemployment and prolonging economic recovery. If, however, they lend across the board to SMEs, they risk increasing their bad loans.

Brian Lucey, associate professor of finance at Trinity College Dublin, is adamant that the Government should have no role in banking. “The Government shouldn’t force the banks to lend.”

He says there is a contradiction in the Government’s avowal not to nationalise the banks on the grounds that it does not want to politicise lending, and the fact that this is what it would be doing by encouraging the banks to lend to certain sectors.

In the past, the Government has alluded to prioritising certain sectors of the economy, and the credit review committee will pay attention to sectors “where particular stresses have been reported”, such as retail, tourism and agriculture.

But while there may good reasons for closing the liquidity trap by forcing banks to lend and helping businesses in trouble, history shows this may not be the best solution.

In Japan, after its massive property bubble collapsed in the early 1990s, the banks, terrified of further losses, held on tightly to capital. The government stepped in, however, and persistently bailed out the banks, requiring them to lend to SMEs.

But by lending to “zombie” firms that were otherwise insolvent, the strategy led to further losses among the banks and a prolonging of Japanese economic stagnation.

A better way to get activity back in the “real economy” and keep unemployment down would be to let the Government intervene through the tax code, says Lucey, or by getting State agencies such as the IDA to offer incentives such as grants.

However, John Cotter, director of the Centre for Financial Markets and associate professor of finance at UCD, says the perception that the Japanese intervention was not very successful is “exaggerated”.

According to Cotter, “responding to a crisis situation doesn’t mean the best solutions”.

“When you have a solution in a crisis, it isn’t optimal. However, it will solve some of the problems,” he says. In this respect, he believes that the Government exerting pressure on banks to make them lend to good companies is to be welcomed.

But can you actually force banks to lend? No, it seems.

“You can’t force banks to lend, if there aren’t profitable opportunities then they will have to return money to shareholders,” says Lucey.

Stephen Kinsella, a lecturer in economics at the University of Limerick, describes the Government’s iterations that it will get credit moving as “bluster”. “The Government can’t force banks to lend, but it can put pressure on banks to act like they’re going to expand their lending.”

As part of the Government’s guarantee of the banks last September, banks committed to increasing their lending to first-time buyers and SMEs.

Bank of Ireland launched a €250 million fund to provide Irish businesses with short- to medium-term financing, and soon after signed a €100 million loan facility with the European Investment Bank (EIB) to provide funding support to SMEs. In February, it launched an additional €100 million fund to support the financing of Irish- based renewable energy projects.

On recent evidence, however, it is in no rush to lend. As of the end of October, €39 million of the business support fund had been drawn down, just €4.3 million of the EIB facility had been lent out, and €600,000 of the green fund had been drawn down.

Is there anything else that can be done to free up credit?

Sweden, itself no stranger to banking crises, has imposed negative interest rates designed to penalise banks for keeping excess reserves. In August, the Riksbank became the world’s first central bank to introduce negative rates on bank deposits, in effect imposing a fine of 0.0036 per cent on banks that refused to lend.

While such a move is not an option for Ireland given its membership of the euro zone, Lucey says the European Central Bank should consider it, as he believes a negative interest rate would increase liquidity in the wider European banking sector, including Ireland. However, this is unlikely given that Irish banks are struggling more than their European peers.

In the meantime, the Government will keep its pressure up on the banks and, pending the outcome of the credit review committee’s findings, may take further action. But whether this will translate into real liquidity remains to be seen.