FT's Martin Wolf calls for UK to fix it banks, but not its monetary policy

In his Financial Times column, Martin Wolf calls for the UK to fix its banks, but leave its monetary policy unchanged.

Mr. Wolf bases his call on the observation that

The UK is suffering from a combination of the banks’ unwillingness and inability to lend and potential clients’ inability and unwillingness to borrow. 

The BoE’s easing is “pushing on a string”.

This is an interesting observation as it contains a kernel of truth surrounded by a forest of falsehood.

Regular readers know that a bank's lending function is separate from how it funds the loan.  It is separate because banks have many different ways of funding the loan including on-balance sheet, syndicating the loan to other banks or selling the loan to investors.

Banks have the ability to lend, but they are showing an unwillingness to lend.

Why?

Banks are senior secured lenders.  In this role, they require collateral.  When the financial crisis hit, it created doubts about the value of the collateral, particularly the real estate collateral.

These doubts were made worse by the financial regulators adoption of regulatory forbearance.  Under regulatory forbearance, the banks engage in 'extend and pretend' and turn non-performing debt into 'zombie' loans.

The bankers know how much of their portfolio is in 'zombie' loans.  Psychologically, it is difficult to assign a high collateral value to real estate pledged for a new loan when one can see the huge overhang of real estate in the 'zombie' loans.  The result is both the apparent unwillingness to lend and potential clients' inability to borrow (inability reflects a lack of collateral after the bank discounts for 'zombie' loan overhang).

The way to address this problem and restart lending is to have the banks recognize their losses on the excess public and private debt in the financial system.  In recognizing their losses, the banks need to write-down the debt to a level where the borrowers can afford to service the debt.

Debt write-downs should not create equity for the borrower.  Where there is a buyer for the collateral who would pay more than the borrower, the collateral should be sold.

The idea that the BoE's easing, like the other central banks, is "pushing on a string" is totally false.  This policy was known in advance to be good for bankers and bad for the real economy.

It was good for bankers in that it maximized the banks' reported earnings and banker bonuses since the beginning of the financial crisis.  There is nothing like zero cost funds to temporarily boost banks' net interest margin, particularly when the banks are carrying 'zombie' loans.

It was bad for the real economy in that it triggered economic headwinds like the Retirement Plan Death Spiral that crushed current demand.  Under the Retirement Plan Death Spiral, both individuals and companies make up for the shortfall in earnings on their retirement assets by reducing current consumption.

The way to address the problem with monetary policy and support the real economy is to reverse the policy and restore interest rates to a minimum of 2%.