ECONOMICS:How do you get bank credit flowing at a pace that sustains a decent recovery?

BEN BERNANKE, chairman of the US Federal Reserve, is a student of history. His study of why the Great Depression lasted so long noted that “deposits did not flow back into the banks in great quantities until 1934”. Meanwhile, “the government had to continue to pump large sums into the banks”.

Even more important was the change in attitude among lenders, who emerged from the depression chastened and conservative. There was a shift away from lending towards holding safe and liquid investments.

Bernanke concluded that the US financial system operated under handicap for about five years.

The challenges today are of a lesser magnitude, but similar in many other respects.

By the mid-1930s there was a large accumulation of bank reserves and the Fed began to fret that the banks would reverse course and lend recklessly again. So they tightened policy, thereby driving the economy into renewed recession. Policy mistakes are an ever-present threat.

All this is relevant to the recent debate about the National Asset Management Agency (Nama) and credit flows. But for Bernanke we might not have had Nama at all. His earlier work showed the importance of early and radical policy action in a crisis, and the US is the exemplar in this regard.

However, Nama does not guarantee the resumption of adequate credit flows, a point made by the International Monetary Fund (IMF) during its mission to Ireland last year. Contrary to much hysterical speculation, the IMF was fully in favour of Nama, but a team member, Steven Seelig, who is shortly to join the Nama board, noted that he did not believe it would result in a significant increase in bank lending in Ireland.

The Minister for Finance and the Taoiseach subsequently sought to correct the record, pointing out that without Nama credit would contract sharply so Nama, by definition, increases the supply of credit. This debate also had echoes of the 1930s experience, with the Minister saying the IMF was really talking about a possible future surge in lending, which was not going to happen.

It’s an important and sensitive matter about which there can be no certainty.

Previously I have confined my comments on this to the economists’ jargon that Nama is a necessary but not a sufficient condition to restore adequate credit flows.

I remain of this view. It does not guarantee a result, but without Nama or some similar solution we would be infinitely worse off.

The key point is that economic growth is likely to stay weak as long as banks choose to sit on cash, cut leverage and stick to safe and liquid investments.

Banks face pressures from all sides: transactions and balance sheet taxes, bonus taxes, Basel II etc, as well as their natural inclination to regroup and the deterioration in credit quality of prospective borrowers.

Left to their own devices, both banks and households are likely to sit on cash for years – long after the worst of the crisis has passed.

In fairness to them, policymakers seem to recognise this much better than markets. That is why official growth forecasts from governments and central banks are noticeably more conservative than those of the market economists and why low interest rates will probably continue for longer than is generally supposed.

However, it does leave us with a conundrum – how to get credit flowing at a pace that sustains a decent recovery.

In Ireland there is a natural focus on small and medium-sized enterprises (SMEs) given their economic importance. Last week in this column, John Kelly listed the measures taken by the Government so far to try to ensure an adequate flow of credit to them. Inevitably, they were largely exhortatory, though there is now talk of a guarantee scheme. This will necessarily be limited given the constraints on the public purse.

In addition, two reports by consultants Mazars were undertaken in 2009. The picture that emerged was reasonably positive, with new credit of €2.6 billion advanced between February and September 2009.

The problem with this is that there is no way of telling whether €2.6 billion is sufficient, adequate or, indeed, excessive. By the same token, it is impossible for the Government to dictate to the banks what the amount of credit extended should be. Political interference would almost certainly guarantee a sub-optimal result, which is why the recent decision to delegate more powers to the National Treasury Management Agency is welcome.

Irish banks have even more reason to be conservative. Their starting point is weaker, their boards and senior management have been shaken up and, as pointed out last week, we now have “heavy-touch regulation” with staff from the Financial Regulator on site and attending credit, risk and other committees and copying the documentation. In addition, the guarantee scheme provides that executive bonuses shall be linked to reductions in guarantee charges, reductions in excessive risk-taking and encouraging the long-term sustainability of the covered institution.

All this results in an environment that is loaded against risk-taking. It is unlikely that this is a major problem at the moment given the lack of demand but it could easily become one when economic activity picks up.

In the final analysis, the board of directors is responsible for the affairs of a company. This puts Government appointees to bank boards in a potentially difficult position.

As Prof Niamh Brennan has pointed out, it is not the duty of any director, regardless of how he or she was appointed, to “represent the public interest”. Directors have a duty to be independent and to act in the interest of the company as a whole, ie in the best interest of all shareholders.

Conflicts of interest could easily arise. The Government might wish to see more credit extended to SMEs but it might not be in the banks’ best interest to do so if, for example, the applicants were not sufficiently creditworthy or the return was too low.

There is no easy solution to this dilemma, which is not amenable to Government diktat.

The situation may, however, be alleviated by the upcoming bank recapitalisation process.

If the average discount on the loans transferred to Nama is more than the 30 per cent estimate, the required recapitalisation of the banks will be greater than earlier envisaged.

In the absence of significant private capital, it is possible that the Government may end up as a majority shareholder in the banks.

Presumably, the Minister would then have a majority of “public interest” directors on bank boards. There would be less potential for conflict but the situation would still not be ideal as the possibility of the oppression of minority interests could still arise as long as the Government shareholding was less than 100 per cent.

The Government should continue to appoint high-calibre candidates to bank boards, give them their marching orders and let them get on with it.

Their task is unlikely to be an easy one.