tag:theconversation.com,2011:/global/topics/business-lending-12410/articlesbusiness lending – The Conversation2018-08-15T10:23:53Ztag:theconversation.com,2011:article/1015152018-08-15T10:23:53Z2018-08-15T10:23:53ZSmall business owners are getting a new incentive to sell to their employees<figure><img src="https://images.theconversation.com/files/232006/original/file-20180815-2906-ma5oyy.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">A bartender pours drafts at Harpoon's beer hall in Boston. Harpoon became partially employee-owned in 2014. </span> <span class="attribution"><span class="source">AP Photo/Charles Krupa</span></span></figcaption></figure><p>The federal government <a href="https://nonprofitquarterly.org/2018/08/14/employee-owned-businesses-sba-loans/">just made it a lot easier</a> to form an employee-owned business. </p>
<p>In an increasingly rare example of bipartisan cooperation, President Donald Trump on Aug. 13 <a href="https://www.cnbc.com/2018/08/13/trump-signs-717-billion-defense-bill.html">signed a defense bill</a> into law that included a popular provision that allows the Small Business Administration to straightforwardly loan money to employee-owned businesses that wish to buy out retiring small business owners.</p>
<p>This and other changes in the provisions are significant. Not only could they double or even triple the growth rate of employee-owned companies over the next decade, we expect they will help stabilize jobs in local communities as well as reduce inequality by giving more middle-class families a means of accumulating wealth. </p>
<p>Furthermore, this <a href="https://smlr.rutgers.edu/sites/default/files/documents/ResearchDocs/3-21-18_main_street_employee_ownership_act_summary_5_copy.pdf">measure</a> – which <a href="https://scholar.google.com/citations?user=DWGTo1cAAAAJ&hl=en&oi=ao">we</a> supported with research and analysis – will be a boon to the hundreds of thousands of small businesses owned by retiring baby boomers that are at risk of closing up, putting millions of jobs on the line as well. </p>
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<img alt="" src="https://images.theconversation.com/files/231989/original/file-20180815-2909-vp95cb.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/231989/original/file-20180815-2909-vp95cb.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=388&fit=crop&dpr=1 600w, https://images.theconversation.com/files/231989/original/file-20180815-2909-vp95cb.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=388&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/231989/original/file-20180815-2909-vp95cb.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=388&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/231989/original/file-20180815-2909-vp95cb.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=488&fit=crop&dpr=1 754w, https://images.theconversation.com/files/231989/original/file-20180815-2909-vp95cb.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=488&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/231989/original/file-20180815-2909-vp95cb.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=488&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
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<span class="caption">A wave of baby boomers choosing to retire and perhaps spend more time fishing means millions of small businesses in the U.S. will soon change hands.</span>
<span class="attribution"><span class="source">sirtravelalot/Shutterstock.com</span></span>
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<h2>‘Silver tsunami’</h2>
<p>The impetus behind the latest piece of legislation is a result of what some have dubbed the “<a href="https://bigthink.com/philip-perry/can-the-world-sustain-9-billion-people-by-2050">silver tsunami</a>.” </p>
<p>As baby boomers retire, more than <a href="https://www.project-equity.org/wp-content/uploads/2018/07/Project-Equity-National-Small-Business-Closure-Crisis.pdf">2.3 million closely held businesses</a> that they own are at risk of closing down because of an inability to find someone to take over. These companies employ about 25 million people, spend about US$1 trillion on payroll a year and make about $5 trillion in sales. </p>
<p>While some of these businesses will be passed down to members of the family or others, about <a href="https://www.project-equity.org/wp-content/uploads/2018/07/Project-Equity-National-Small-Business-Closure-Crisis.pdf">6 out of 10 are expected</a> to wind up on the auction block in the next decade because the owners need to sell out in order to retire. </p>
<p>We believe this will represent one of the largest transfers of wealth in American history. </p>
<h2>Workers to the rescue</h2>
<p><a href="https://www.project-equity.org/communities/small-business-closure-crisis/">Surveys show</a> that only a small fraction of retiring owners have a daughter or son who wants to take over the company and is competent to do so, and only a fifth of businesses listed for sale ever sell. </p>
<p>That makes selling their businesses to the workers who helped create all the value in the first place one of the best options available. It not only helps secure the owner’s retirement but also leaves behind a legacy in the local community. It has also slowly become more popular in recent decades. </p>
<p>Small businesses are sold to their managers or workers using one of three methods: an employee stock ownership plan or ESOP, a worker cooperative or an employee trust.</p>
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<figcaption><span class="caption">Experts explain how employees can take some ownership of a business.</span></figcaption>
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<p>The ESOP, <a href="http://kelsoinstitute.org/louiskelso/kelso-paradigm/important-dates/">created in 1956</a> by the late political economist <a href="http://kelsoinstitute.org/louiskelso/">Louis O. Kelso</a>, is currently the most common way to do this because it gives regular workers a way to buy companies and has meaningful federal tax incentives. This allows the new owners to set up a trust, which secures a loan that the company itself will pay back over several years.</p>
<p>A key feature is that the company, not the workers, steps forward to provide the collateral for the loan, and as the loan is paid down, new shares are distributed to employees and managers. The workers do not purchase the shares with their savings.</p>
<p>Worker cooperatives, on the other hand, have traditionally been employee-owned from the beginning, with investments from staff and equal voting rights in many company decisions. Increasingly, the worker coop model <a href="https://institute.coop/workers-owners-conversions">is being used</a> to purchase companies from retiring business owners. </p>
<p>Employee trusts are a new form of ownership, similar to ESOPs in some ways. <a href="https://www.fieldfisher.com/publications/2016/04/watg-employee-owned-through-a-perpetual-trust">Their goal</a> is to ensure a company remains employee-owned in perpetuity by keeping the shares within the trust itself. The employees are beneficiaries of the trust, receiving payouts based on profits. </p>
<p>A few employee-owned companies include grocery chain Publix Super Markets and staffing firm Penmac – the <a href="https://www.nceo.org/articles/employee-ownership-100">two biggest</a> – as well as food companies King Arthur Flour and Bob’s Red Mill and breweries Harpoon and New Belgium Brewery, maker of Fat Tire beer.</p>
<p>We have spent the last 35 years researching this phenomenon and pulling together all the empirical studies that have been done to assess the impact, which we explore in our books, “<a href="https://yalebooks.yale.edu/book/9780300209334/citizens-share">The Citizen’s Share</a>” and “<a href="https://press.uchicago.edu/ucp/books/book/chicago/S/bo8056093.html">Shared Capitalism at Work</a>.” The <a href="http://papers.nber.org/books/krus08-1">evidence</a> shows that employee ownership tends to make companies more productive and stable. </p>
<p>As for their prevalence, based on our recent calculations of all of the 2014 U.S. Department of Labor data on ESOPs, <a href="https://smlr.rutgers.edu/sites/default/files/documents/ResearchDocs/8-14-18_analysis_of_esop_data_from_2001-2014.docx">we found</a> that about 2 million workers and managers were invested in about 5,800 closely held companies with the total employee ownership valued at $255 billion. While the average ESOP worker in these companies has an ownership stake of $134,000, our calculations are this is close to a quarter of a million dollars for workers who stay with the company for 20 years. </p>
<p>Unfortunately, many business owners aren’t aware this is even an option. </p>
<h2>Raising awareness and guaranteeing loans</h2>
<p>And that’s where the new law comes in. </p>
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<img alt="" src="https://images.theconversation.com/files/231991/original/file-20180815-2921-1dapbuc.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=237&fit=clip" srcset="https://images.theconversation.com/files/231991/original/file-20180815-2921-1dapbuc.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=766&fit=crop&dpr=1 600w, https://images.theconversation.com/files/231991/original/file-20180815-2921-1dapbuc.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=766&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/231991/original/file-20180815-2921-1dapbuc.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=766&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/231991/original/file-20180815-2921-1dapbuc.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=962&fit=crop&dpr=1 754w, https://images.theconversation.com/files/231991/original/file-20180815-2921-1dapbuc.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=962&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/231991/original/file-20180815-2921-1dapbuc.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=962&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
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<span class="caption">Sen. Kirsten Gillibrand wrote the original legislation on employee-owned companies that became law.</span>
<span class="attribution"><span class="source">AP Photo/Seth Wenig</span></span>
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<p>The provision, previously known as the <a href="https://www.gillibrand.senate.gov/news/press/release/after-meeting-with-businesses-throughout-new-york-that-support-workers-through-employee-ownership-and-pushing-for-legislation-to-help-companies-transition-to-esops-or-co-ops-gillibrand-announces-her-bipartisan-employee-ownership-bill-included-in-national-defense-bill">Main Street Employee Ownership Act</a>, was written by Democratic Sen. Kirsten Gillibrand and had co-sponsors on both sides of the political aisle. It is the most far-reaching employee share ownership legislation to pass Congress in over 20 years.</p>
<p>Its most important element involves permitting the SBA to clear away many previous barriers so it can make <a href="https://www.occ.gov/topics/community-affairs/publications/insights/insights-bankers-guide-sba7a-loan-program.pdf">guaranteed loans</a> of up to $5 million to employee-owned businesses, especially ESOPS and worker cooperatives. This will make employee buyouts easier to do by significantly expanding the amount of credit available and will create more flexibility for sellers so that they can transition out of their businesses over a few years. </p>
<p>The law also tasks the SBA with providing more awareness, technical assistance and training both to the small business owners who might be interested in selling to their employees and to the workers themselves. </p>
<p>We’ve observed that past efforts to encourage employee ownership by the federal government led to large growth spurts, such as laws passed <a href="https://www.law.cornell.edu/uscode/text/26/1042">30</a> and <a href="https://www.nceo.org/articles/esops-s-corporations">20</a> years ago that offered tax incentives. That’s why we would estimate the latest measure to double or even triple the growth of employee-owned companies. </p>
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<img alt="" src="https://images.theconversation.com/files/232007/original/file-20180815-2909-172djh1.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/232007/original/file-20180815-2909-172djh1.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=400&fit=crop&dpr=1 600w, https://images.theconversation.com/files/232007/original/file-20180815-2909-172djh1.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=400&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/232007/original/file-20180815-2909-172djh1.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=400&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/232007/original/file-20180815-2909-172djh1.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=503&fit=crop&dpr=1 754w, https://images.theconversation.com/files/232007/original/file-20180815-2909-172djh1.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=503&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/232007/original/file-20180815-2909-172djh1.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=503&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
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<span class="caption">An employee at employee-owned King Arthur Flour Co. in Norwich, Vermont, takes bread from the oven.</span>
<span class="attribution"><span class="source">AP Photo/Toby Talbot</span></span>
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<h2>Measuring the wider impact</h2>
<p>The legislation’s impact could be far-reaching. </p>
<p>If it’s successful in leading more small business owners to sell to employees, it could help reduce economic inequality. That’s because the <a href="https://community-wealth.org/content/cleveland-model-how-evergreen-cooperatives-are-building-community-wealth">primary beneficiaries</a> would be working- and middle-class employees who would suddenly have a new way to build a substantial amount of capital. </p>
<p>Furthermore, it’ll help <a href="https://institute.coop/workers-owners-conversions">preserve local jobs</a> and the tax base because as we noted these small businesses often end up closing down because there’s no one to take over. In addition, employee-owned companies <a href="https://www.upjohn.org/research-highlights/how-did-employee-ownership-firms-weather-last-two-recessions">have shown greater resiliency</a> in times of economic stress, leading to fewer layoffs. And <a href="https://www.youtube.com/watch?v=znjEO4TciQI">research shows</a> that these types of companies <a href="https://www.ownershipeconomy.org/wp-content/uploads/2017/05/employee_ownership_and_economic_wellbeing_2017.pdf">offer better pay and benefits than other types of businesses</a>. </p>
<p>With real wages for most Americans flat or declining and most wealth in the hands of the richest Americans, broadening capital ownership to the middle and working classes may be the best – and perhaps the only – bipartisan road left to addressing economic inequality in the U.S.</p><img src="https://counter.theconversation.com/content/101515/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Joseph Blasi is the Director of the Institute for the Study of Employee Ownership and Profit Sharing, which receives funding a range of foundations, including Citi Community Development, the Employee Ownership Foundation, the W.K. Kellogg Foundation, the Open Society Foundation, the Rockefeller Foundation and the Russell Sage Foundation. Other donors are disclosed on its website and in specific conference programs. Professor Blasi's professorship is supported by an endowment set up by the Beyster Foundation for Enterprise Development. Professor Blasi is also a Senior Fellow at the Aspen Institute and assists them in developing dialogues and programs on capital shares for national leaders.</span></em></p><p class="fine-print"><em><span>Douglas L. Kruse is the Associate Director of the Institute for the Study of Employee Ownership and Profit Sharing.</span></em></p>New legislation may boost growth rate of employee-owned companies in the US, easing the impact of one of the largest transfers of wealth in American history.Joseph Blasi, Director of the Institute for the Study of Employee Ownership and Profit Sharing, Rutgers UniversityDouglas L. Kruse, Distinguished Professor and Associate Dean for Academic Affairs, Rutgers UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/866182017-11-02T19:04:11Z2017-11-02T19:04:11ZVital Signs: the US economy is outpacing Australia’s and we should all ask why<figure><img src="https://images.theconversation.com/files/192961/original/file-20171102-26483-ue6zk8.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">
</span> <span class="attribution"><span class="source">Image sourced from shutterstock.com</span></span></figcaption></figure><p><em>Vital Signs is a weekly economic wrap from UNSW economics professor and Harvard PhD Richard Holden (@profholden). Vital Signs aims to contextualise weekly economic events and cut through the noise of the data affecting global economies.</em></p>
<p><em>This week: housing credit is still propping up lending in Australia, while the US economy goes from strength to strength.</em></p>
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<p>Data this week pointed to a continued shakiness in the Australian economy, while the robust US recovery continued.</p>
<p>In Australia, <a href="http://rba.gov.au/statistics/frequency/fin-agg/2017/fin-agg-0917.html">private-sector lending</a> grew at just 0.3%, compared to 0.5% in August. Perhaps more worryingly, business lending dropped 0.1%. It was, again, housing credit growth that propped up the overall figures, growing 0.5% for the month.</p>
<p>Worse still, new home sales fell 6.1% in September, compared to August, according to the Housing Industry Association. So Australians aren’t borrowing much, except to finance the swapping around of each other’s houses at higher and higher prices. Note to picky readers: yes, prices fell a tiny bit in Sydney last month (0.1%), but are still up 10.5% year-on-year.</p>
<p>The US labour market bounced back from the hurricane season, adding 235,000 private sector jobs, according to data from payroll provider ADP. This wasn’t merely a bounce back — it exceeded expectations of a 200,000 gain. This was the biggest gain since March and further evidence of the strong US recovery.</p>
<p>It was not surprising, then, that Conference Board figures showed <a href="https://www.bloomberg.com/news/articles/2017-10-31/u-s-consumer-confidence-index-rises-to-highest-level-since-2000">strong consumer confidence</a>. What was striking, however, was just how strong those figures were. The confidence index rose to 5.3 points to 125.9 – the highest since December 2000. The present conditions measure was also at its highest level since 2001.</p>
<p>The US Federal Reserve kept interest rates on hold at a band of 1.0-1.25% at this week’s meeting, but signalled a fairly high likelihood of a rate rise when they meet in December. As the <a href="https://www.federalreserve.gov/newsevents/pressreleases/monetary20171101a.htm">statement</a> put it:</p>
<blockquote>
<p>The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate.</p>
</blockquote>
<p>Perhaps the only real wrinkle is that inflation remains stubbornly low, despite unemployment being at 4.2%. Some measures of inflation expectations are rising, so the best bet is for a 25 basis point rise in December.</p>
<p>The Fed’s statement made pretty explicit how they think about balance these factors, stating: </p>
<blockquote>
<p>the Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term.</p>
</blockquote>
<p>Of course, current Fed Chair Janet Yellen’s term concludes in February next year, and it is being widely reported that President Trump will not reappoint her. Rather he seems set (to the extent that is possible with him) to <a href="https://www.bloomberg.com/news/articles/2017-11-01/powell-to-be-trump-s-nominee-for-fed-chair-replacing-yellen-wsj">appoint Jay Powell as Chair.</a></p>
<p>I will have more to say about that in future columns, but the main thing to note here is that Powell is extremely likely to continue with the path of monetary policy that Yellen has laid out.</p>
<p>So why is it that the US – which suffered a major downturn – seems to have a stronger economy than Australia – which did not even go into recession in 2008-09?</p>
<p>One view is that the US went through a process of Schumpetarian “creative desctruction”. Homeowners who couldn’t afford their properties got foreclosed on, investment banks that weren’t viable went bust, and the rest of the financial system was recapitalised.</p>
<p>Australian banks, by contrast have made some progress in getting their funding structure to be less short-term and dependent on US capital markets – but only so much. And it seems quite possible that they continue to make questionable loans – particularly interest-only loans – as I wrote about <a href="https://theconversation.com/vital-signs-the-spooky-mortgage-risk-signs-our-bankers-are-ignoring-85591">here</a>, and spoke about <a href="https://thejollyswagmen.com">here</a>. </p>
<p>A second view is that the US economy is better able to adapt to the changing nature of the modern economy. It has much more flexible labour markets – although much harsher and less rewarding for average workers.</p>
<p>Perhaps it is neither of these, but presumably both the Reserve Bank and Treasury are trying to understand what looks like a striking different between the US and Australian experiences.</p><img src="https://counter.theconversation.com/content/86618/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Richard Holden is an ARC Future Fellow.</span></em></p>Why is it that the US – which suffered a major downturn – seems to have a stronger economy than Australia , which did not even go into recession in 2008-09?Richard Holden, Professor of Economics and PLuS Alliance Fellow, UNSW SydneyLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/794792017-06-15T10:52:51Z2017-06-15T10:52:51ZAs Fed ‘returns to normal,’ is the risk of recession rising? Experts react<figure><img src="https://images.theconversation.com/files/173911/original/file-20170615-26091-1bokz3.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Fed Chair Janet Yellen speaks at a press conference following the rate-hike decision.</span> <span class="attribution"><span class="source">AP Photo/Susan Walsh</span></span></figcaption></figure><p><em>Editor’s note: The Federal Reserve’s policy-setting committee <a href="https://www.federalreserve.gov/newsevents/pressreleases/monetary20170614a.htm">raised its benchmark interest rate</a> by a quarter-point to a range of 1 to 1.25 percent, the second increase this year. The central bank also indicated that it will likely lift rates once more this year. Given that these developments weren’t exactly a shock, we asked a couple of Fed experts what was noteworthy about the announcement.</em></p>
<h2>What’s the real risk</h2>
<p><strong>Sheila Tschinkel, Emory University</strong></p>
<p>The Fed’s <a href="https://www.federalreserve.gov/newsevents/pressreleases/monetary20170614a.htm">decision</a> to raise the <a href="https://fred.stlouisfed.org/series/FEDFUNDS">federal funds rate</a> was no surprise to financial markets. Nor was its expectation of one more hike this year. </p>
<p>Even though core inflation <a href="https://www.bls.gov/cpi/">has been below its 2 percent target</a>, the economy’s underlying strength suggests little or no risk of recession or deflation. </p>
<p>The Fed also said it is <a href="http://www.businessinsider.com/federal-reserve-rate-hike-plan-to-unwind-45-trillion-balance-sheet-2017-6">ready to begin reducing its holdings</a> of government and other securities later this year. As a result of “quantitative easing” – the purchase of mortgage-backed and government securities to reduce long-term borrowing costs – and other measures aimed at preventing a collapse of the financial system, the value of assets on its balance sheet <a href="https://www.federalreserve.gov/monetarypolicy/files/quarterly_balance_sheet_developments_report_201705.pdf">ballooned to US$4.47 trillion</a> from <a href="https://www.federalreserve.gov/boarddocs/rptcongress/annual07/sec6/c3.htm">$915 billion</a> at the end of 2007. </p>
<p>The Fed seems to believe the bigger risk, actually, is that the economy could overheat, particularly if ultra-low rates are combined with <a href="http://www.marketwatch.com/story/trumps-infrastructure-plan-could-be-a-powerful-economic-stimulus-2017-06-05">government stimulus</a> (which is still up in the air). The upshot is that the Fed seems pretty confident in the economic recovery and thinks it’s time to “begin the return to normal.” </p>
<p>Still, economic growth remains lower than many – including me – would like. It’s <a href="https://tradingeconomics.com/united-states/gdp-growth">ranged</a> from a disappointing 1 percent to 2 percent for the past few years. </p>
<p>The bigger risk facing the Fed might be that the economy is fundamentally not as strong the central bank believes it is. In that case, if the Fed continues to “normalize,” the economy could weaken and even go into recession.</p>
<p>Markets seem to reflect this view. <a href="http://www.macrotrends.net/2016/10-year-treasury-bond-rate-yield-chart">Yields on 10-year U.S. Treasuries</a>, for example, are actually lower than they were in November, even though the Fed has lifted its target interest rate by a quarter-point three times since then. This suggests investors are still anxious about the state of the U.S. and global economies – or something entirely different could be at work.</p>
<p>Without a crystal ball, we don’t know which view is right. While I can’t explain why bond yields have declined, I do believe the U.S. economy is doing all right and the Fed is on a reasonable path to normal.</p>
<h2>The Fed’s balance sheet quandary</h2>
<p><strong>William D. Lastrapes, University of Georgia</strong></p>
<p>Today’s announcement provides the first glimpse into how the Fed hopes to downsize a historically huge balance sheet. In other words, how does it plan to <a href="https://www.federalreserve.gov/monetarypolicy/files/quarterly_balance_sheet_developments_report_201705.pdf">reduce the $4.2 trillion in government bonds</a>, mortgage-backed securities and other assets it holds? </p>
<p>The Fed plans to take a <a href="http://www.businessinsider.com/federal-reserve-rate-hike-plan-to-unwind-45-trillion-balance-sheet-2017-6">gradual approach</a>. Essentially, the securities on the Fed’s balance sheet are continually maturing. As they do, the Fed has been taking the principal it collects and reinvesting it back in new securities. When the bank is ready to begin paring its holdings, it can simply stop reinvesting those proceeds, which will allow its balance to gradually decline. Or, if it would like to speed things up, it could sell some securities on the open market before they mature. </p>
<p>In other words, imagine your teenage self has seven $100 bills and you lend each to a friend in need on a different day of the week, starting on Monday, for a term of seven days. Come the following Monday, when the first bill is repaid, you decide to lend it out to someone else and continue to do so indefinitely. Essentially your balance sheet would always show $700 in assets. Then, if you decided to unwind your little bank, instead of relending the bills you began keeping them as they came due, thereby gradually reducing your assets until they hit zero. </p>
<p>There’s a flip side, however, as for every asset there needs to be a liability. And for every dollar drop in assets on the Fed’s balance sheet there needs to be a corollary decline in its liabilities. For your mini-bank, that liability might be the $700 you borrowed from your parents. And so when you stop relending those bills, you paid them back to your mom and dad, reducing what you owe. </p>
<p>The Fed borrows its money from banks in the form of “reserves” and so reduces these reserves when lending slows. And that’s where it finds itself in a serious quandary that could derail the economic recovery if not handled well. </p>
<p>Bank reserves – the safe and liquid cash assets that financial institutions hold as deposits at the Fed – <a href="https://www.federalreserve.gov/releases/h41/current/">currently total $2.2 trillion</a>, up from <a href="https://www.federalreserve.gov/releases/h41/20071227/">$5.8 billion in the last week of December 2007</a>. Almost all of these reserve holdings are excess reserves, which means they’re more than the Fed requires banks to hold in order to back up their deposits. </p>
<p>Why would banks keep so much of their portfolios in simple cash assets at the Fed and not in other securities or loans to businesses? One reason is that banks still desire safe and easily redeemable assets because of <a href="https://www.washingtonpost.com/news/wonk/wp/2017/04/21/trump-orders-another-review-of-post-financial-crisis-regulations-on-wall-street/">post-financial crisis regulations</a> and other lingering effects of the crisis. And what’s safer than the Fed, right? </p>
<p>An even bigger factor is that the Fed pays a relatively high yield on those excess reserves, now 1.25 percent, which exceeds what banks could get in comparably safe, short-term investments elsewhere. Why invest in anything else when parking that cash at the Fed is profitable and there is absolutely no default risk? </p>
<p>The problem for Chair Janet Yellen and her colleagues at the Fed is that if they try to pare back its balance sheet, banks may respond by cutting back on their own assets, such as loans to businesses and consumers, which in turn causes checking deposits and the money supply to drastically contract. The consequences are serious and include deflation and even recession. </p>
<p>So why not just reduce the rate it’s paying to the banks so that they don’t want to leave so much of their money at the Fed and instead lend it out? Increasingly, the Fed has been using interest rates on reserves as a way to help it set monetary policy and control its all-important federal funds rate. So if it lowers the interest rate on reserves, that’ll make hitting market interest rate targets that much more difficult.</p>
<p>The Fed now seems to get this and noted in its announcement that it plans to move cautiously on normalization while paying attention to the behavior of banks. The buildup of the Fed’s balance sheet during the financial was unprecedented. And now, so is policy normalization. Fed policymakers are correct to be cautious in their approach.</p><img src="https://counter.theconversation.com/content/79479/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>The authors do not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.</span></em></p>The Federal Reserve lifted rates for the second time this year and expects to do so once more, suggesting it’s fairly confident the economic recovery will continue. Is it overconfident?Sheila Tschinkel, Visiting Faculty in Economics, Emory UniversityWilliam D. Lastrapes, Professor of Economics, University of GeorgiaLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/372202015-02-05T19:36:51Z2015-02-05T19:36:51ZHow to multiply the rate cut impact and unshackle the economy<p>This week’s Reserve Bank interest rate move surprised virtually everyone, bringing the cash rate to 2.25%, yet another historic low.</p>
<p>Despite Australian Treasurer Joe Hockey suggesting the rate cut means “the shackles are off the Australian economy,” the cut is unlikely on its own to kick Australia’s GDP growth rate back to trend level. But with a little help from friends offshore and a light touch from APRA, the rate cut just might work.</p>
<p>Let us review for a moment how a lower cash rate can boost the economy – the so-called “transmission channels” for monetary policy. There are three. First, rate cuts change asset prices, including foreign exchange rates. Second, rate cuts should reduce the cost of capital, all else being equal. Third, rate cuts should increase the availability of credit from banks’ balance sheets. All three elements are important considerations in yesterday’s move.</p>
<p>Asset prices moved according to expectations, with the ASX rallying 1.4% on the news. The main game, however, was the exchange rate.</p>
<h2>Pushing the dollar down</h2>
<p>Many commentators have focused their attention on the AUD-USD exchange rate, which fell by 1.5 cents immediately after the rate cut. Was this the RBA’s main target? The AUD had already depreciated significantly against the US dollar, with the AUD-USD as of 2 February already 15% below its average over the first half of 2014. At AUD/USD0.7769 as of 2 February, the benchmark rate of exchange was very near the level that RBA Governor Glenn Stevens had indicated was desirable.</p>
<p>What had not moved perhaps as much as the RBA might have liked was the trade-weighted index, which measures the AUD against a basket of the exchange rates of our major trading partners. The TWI had declined only 10% relative to its average rate across the first half of 2014, making the AUD the unwilling strong man in a world of “currency wars” depreciation. The ECB’s decision in late January to engage in its own version of quantitative easing - which sent the AUD back up above the AUD-EUR0.70 level, may have been one of the straws that broke the camel’s back and contributed to this early rate decision.</p>
<p>As of Tuesday, the TWI had dropped to below 63 for the first time since July 2009. This is welcome relief. But it can only last so long as other major central banks outside the US co-operate by avoiding further easing of their own.</p>
<p>What is likely to prove more important - and more durable - is a lower cost of capital and the potential to spur investment through greater availability of banking credit to the economy. Here, too, the RBA needs help – from the Abbott government and APRA.</p>
<h2>Getting credit flowing to business</h2>
<p>There is not a great deal of evidence to date that a lower cost of capital – with a historically low 2.5% cash rate already in place for a year – has induced an increase in investment in the Australian economy outside the property sector. Capital expenditure by firms has been largely limited to the resources sector, and is now petering out. </p>
<p>The household savings rate remains high, while the debt-to-asset ratio has fallen. This suggests households are electing to increase their equity in current investments rather than using leverage to expand their investment portfolios.</p>
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<a href="https://images.theconversation.com/files/71164/original/image-20150205-28601-3e6u3t.png?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="" src="https://images.theconversation.com/files/71164/original/image-20150205-28601-3e6u3t.png?ixlib=rb-1.1.0&q=45&auto=format&w=237&fit=clip" srcset="https://images.theconversation.com/files/71164/original/image-20150205-28601-3e6u3t.png?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=553&fit=crop&dpr=1 600w, https://images.theconversation.com/files/71164/original/image-20150205-28601-3e6u3t.png?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=553&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/71164/original/image-20150205-28601-3e6u3t.png?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=553&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/71164/original/image-20150205-28601-3e6u3t.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=695&fit=crop&dpr=1 754w, https://images.theconversation.com/files/71164/original/image-20150205-28601-3e6u3t.png?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=695&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/71164/original/image-20150205-28601-3e6u3t.png?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=695&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
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<p>Within the property sector, credit continues to grow at a relatively rapid pace, with <a href="https://theconversation.com/infographic-how-exposed-are-australian-banks-30272">credit growth</a> for investment properties far outpacing the expansion of credit for other purposes - whether household or business. In 2014, credit to purchase investment properties appears to have accounted for about 35% of all new credit creation in the economy. No wonder critics worry that the RBA’s rate cut has the potential to stoke excessive leverage in the property market.</p>
<p>The question becomes whether there are other triggers that can be pulled to encourage more credit to flow into other types of investment in the Australian economy. Ideally, that would be a renewed expansion of business credit to support increased capital expenditure, and eventually business activity and employment.</p>
<figure class="align-left zoomable">
<a href="https://images.theconversation.com/files/71165/original/image-20150205-28578-egik59.png?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="" src="https://images.theconversation.com/files/71165/original/image-20150205-28578-egik59.png?ixlib=rb-1.1.0&q=45&auto=format&w=237&fit=clip" srcset="https://images.theconversation.com/files/71165/original/image-20150205-28578-egik59.png?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=523&fit=crop&dpr=1 600w, https://images.theconversation.com/files/71165/original/image-20150205-28578-egik59.png?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=523&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/71165/original/image-20150205-28578-egik59.png?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=523&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/71165/original/image-20150205-28578-egik59.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=658&fit=crop&dpr=1 754w, https://images.theconversation.com/files/71165/original/image-20150205-28578-egik59.png?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=658&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/71165/original/image-20150205-28578-egik59.png?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=658&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
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<p>The RBA cannot dictate that looser monetary policy be directed toward the business sector. But the Abbott government and APRA have in hand the tool to provide a not-so-gentle nudge.</p>
<h2>Will the government act on Murray’s advice?</h2>
<p>We are merely weeks away from the deadline for final feedback to the <a href="http://fsi.gov.au/">Financial System Inquiry</a>, led by David Murray. A key recommendation of the inquiry was to raise banks’ average internal ratings-based risk weights on mortgages to narrow the difference between the mortgage risk weights used by authorised deposit-taking institutions and the “standard” risk weights used by other institutions.</p>
<p>In shorthand, this recommendation would force the Big 4 banks to hold more capital against their mortgage books, making the mortgage-writing business relatively more expensive (and less attractive) from a capital perspective.</p>
<p>This recommendation makes sense. The post-2008 boom in investment property has been driven in part by investor demand – but also in part by the Big 4 banks being willing underwriters of residential real estate. This willingness has in turn been driven, at least in part, by the regulatory setting that makes mortgages one of the least capital-intensive – and therefore cheapest to produce – lending products in the Australian market.</p>
<p>Reducing this regulatory incentive to lend into the property market holds the potential to increase the appetite among the Big 4 for other types of lending, including business credit. It is a reform that the Abbott government and APRA can hang their hat on in 2015.</p><img src="https://counter.theconversation.com/content/37220/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Amy Auster does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>This week’s Reserve Bank interest rate move surprised virtually everyone, bringing the cash rate to 2.25%, yet another historic low. Despite Australian Treasurer Joe Hockey suggesting the rate cut means…Amy Auster, Deputy Director, Australian Centre for Financial Studies Licensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/346232014-12-02T16:08:05Z2014-12-02T16:08:05ZChina’s interest rate cut is mixed blessing for the world economy<p>China’s central bank surprised most observers last month when it <a href="http://online.wsj.com/articles/china-central-bank-pboc-cuts-interest-rates-1416567408">announced</a> its first interest rate cut in more than two years. The move is intended to bolster growth in the world’s second-largest economy, following stimulus measures by central banks in Europe and Japan. </p>
<p>The People’s Bank of China cut its one-year lending rate by 0.4 percentage point to 5.6%, reducing the cost for businesses to hire and invest. It also lowered its deposit rate by a quarter point to 2.75%, while giving banks a more liberal hand in how to pass that on to consumers. </p>
<p>But the PBOC <a href="http://www.pbc.gov.cn/image_public/UserFiles/english/upload/File/PBCDecidestoCutRMBBenchmarkLoanandDepositrates.pdf">emphasized</a> that the cut was neither a change in China’s monetary policy nor a move geared towards boosting the economy – which is growing at the slowest pace in more than five years. Most China watchers, however, interpreted this to mean exactly the opposite. They saw it as a moment of awakening for China’s leaders to the need to show their commitment to preventing the economy from slowing any further.</p>
<p>The economy was in desperate need for more liquidity to avoid slipping into deflation. Growth in both consumer and producer prices has been slowing for much of the year. And the leadership felt it had to do this even if it meant offsetting efforts to fight spiraling debt loads among local governments and the growth of a shadow banking industry that operates beyond the reach of regulators. Both groups will get a boost from a lower interest rate. </p>
<h2>Investment and consumption: a balancing act</h2>
<p>But will the stimulus work or is it the wrong medicine for what ails the Chinese economy? And does it signal any change in how China’s leaders oversee monetary policy? To answer these questions, we have to go back to a fundamental issue of how China manages demand for its goods and services. </p>
<p>First, China’s growth has long been driven by investment rather than consumption, in contrast to most Western economies. Since 2010, private domestic consumption <a href="http://data.worldbank.org/indicator/NE.CON.PETC.ZS">has accounted for only about 35% of China’s GDP</a>, significantly lower than 60% in Japan and 70% in the US. In other words, China produces a lot more than what its own market can consume, which is why it has been so dependent on exports and foreign demand to absorb this surplus. </p>
<p>Second, when the world economy falters, this imbalance between investment and consumption gives rise to a serious problem of excess capacity. In other words, China may have produced more computers, jeans and other goods than consumers at home and abroad are willing to buy. This was exactly what happened during the financial crisis five years ago when global demand dried up, prompting China to shore up domestic consumption by <a href="http://www.economist.com/node/12585407">implementing</a> a 4-trillion-yuan stimulus program – about US$650 billion in today’s dollars. </p>
<h2>Too much stimulation</h2>
<p>But it didn’t really work. While it might have added a few percentage points to GDP growth, it actually worsened the overcapacity issue it was trying to remedy by overstimulating the manufacturing sector. Much of the liquidity injected into the market was disproportionately distributed to state-owned enterprises and investment companies created and endorsed by local governments.</p>
<p>This newly injected credit allowed the state sector to maintain or even expand its capacity, even as market demand remained subdued. Since the state sector is concentrated predominantly in capital-intensive industries, this has led to excess capacity accumulating mainly in industries such as cement, coal, petrochemicals and steel.</p>
<p>In light of what happened during the crisis, is the recent rate cut going to do much good? This mostly depends on whether local politicians are allowed to distort how the additional bank credit gets allocated, as was the case in 2008 and 2009. From this perspective, China’s banking system remains pretty much the same as it was then. The cut will not only give the deeply indebted state-owned enterprises and investment companies a new lease on life, but it will also leave the overcapacity issue unresolved, or even worse than before.</p>
<h2>China’s Marshall plan</h2>
<p>Global <a href="http://www.businessweek.com/news/2014-11-23/china-stock-index-futures-rally-after-first-rate-cut-since-2012">investors</a> reacted to the rate cut with great enthusiasm, especially in commodity markets. But it’s a different plan that they should be paying more attention to, one that could actually solve China’s overcapacity problem and have a more measurable impact on the world economy, if not an entirely favorable one. </p>
<p>Two weeks before the cut was announced, Chinese President Xi Jinping <a href="http://news.xinhuanet.com/english/china/2014-11/06/c_133770684.htm">proposed</a> a new initiative for regional economic integration labeled “One Belt, One Road.” Dubbed China’s Marshall plan, this grand project would establish a so-called Silk Road Fund with US$40 billion to invest in infrastructure within certain countries in Central and Southeast Asia. This plan offers a better solution to the overcapacity problem than cutting interest rates as it promises to develop a large external market for Chinese products. </p>
<p>Piecing together these two policies gives us a clear picture of how China’s economic governance might affect the global economy. Given the absence of more fundamental reforms in China’s political economy, the issue of misallocation of resources and overcapacity in China will still linger. But, at the same time, the country is about to take advantage of its growing influence in the region to solve its domestic economic issues. </p>
<p>The stimulus should help some parts of the world that will benefit from any increase in Chinese growth, but it will also mean more competition for others as the country throws more of its increasing economic weight around. Especially within the neighboring regions where China holds more sway, countries competing with China in the sectors plagued by overcapacity such as petrochemicals and steel will face strong pressure to restructure. </p>
<p>In regions where China enjoys less of a presence, by contrast, more trade conflicts between China and her partners in these markets will loom large.</p><img src="https://counter.theconversation.com/content/34623/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Hans H. Tung does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>China’s central bank surprised most observers last month when it announced its first interest rate cut in more than two years. The move is intended to bolster growth in the world’s second-largest economy…Hans H. Tung, Assistant Professor of Political Science, National Taiwan UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/317712014-09-21T20:32:03Z2014-09-21T20:32:03ZSmall business feeling the lending crunch – and three ways to help<figure><img src="https://images.theconversation.com/files/59481/original/p274hmzb-1411089659.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">With banks pulling back on lending to small business, the sector has had to look elsewhere for funding.</span> <span class="attribution"><span class="source">Shutterstock</span></span></figcaption></figure><p>Since the global financial crisis, credit growth in Australia has returned. But while growth in home lending between 2008 and 2014 was relatively strong (0.49% per month), it was actually negative for business lending (-0.04% per month).</p>
<p>This pattern of weaker business credit for corporates and small to medium enterprises is <a href="http://www.theguardian.com/business/2014/aug/28/business-lending-falls-for-second-quarter-smes">not unique to Australia</a> but has been reflected around the globe due to long-term factors, such as the consolidation of banks and the centralisation of credit assessment. The issue has been accelerated by shorter term cyclical factors, such as increased business risk since the GFC and reduced demand for business credit.</p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/59376/original/jr6x8mm8-1411016277.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/59376/original/jr6x8mm8-1411016277.png?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=265&fit=crop&dpr=1 600w, https://images.theconversation.com/files/59376/original/jr6x8mm8-1411016277.png?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=265&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/59376/original/jr6x8mm8-1411016277.png?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=265&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/59376/original/jr6x8mm8-1411016277.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=333&fit=crop&dpr=1 754w, https://images.theconversation.com/files/59376/original/jr6x8mm8-1411016277.png?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=333&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/59376/original/jr6x8mm8-1411016277.png?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=333&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
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<p>Small and large business borrowers are relying more heavily on internal funding sources, such as retained earnings, and in the corporate sector there has been an evident diversification towards more market-based funding. But it is the “bank dependent” SME sector, with limited access to alternative markets that is feeling the pinch.</p>
<h2>Small business: the engine of the economy</h2>
<p>While it’s recognised businesses should not be funded unless they can generate an adequate return of capital, restricting the flow of funds to the SME sector can have a significant impact on the economy. </p>
<p>In Australia, for example around two million SMEs account for 68% of all industry employment and 56% of <a href="http://www.abs.gov.au/ausstats/abs@.nsf/mf/8155.0">industry gross value added</a>. Starving these businesses of funding will impact on employment growth and growth in GDP.</p>
<p>Negative credit growth for business has its roots in both demand and supply factors. In terms of the demand for credit there has been:</p>
<ul>
<li>reduced business leverage:</li>
<li>business diversifying funding sources post GFC</li>
<li>increased price of SME credit</li>
<li>stricter lending covenants and increased cost of eligible collateral.</li>
</ul>
<p>On the supply side, factors that have led Australian banks to have a preference for housing over business lending include:</p>
<ul>
<li>regulatory capital requirements</li>
<li>consolidation in the banking sector, and</li>
<li>costs of credit assessment for SMEs.</li>
</ul>
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<p>The ratio of business credit to total credit has been declining since the late 1980s. This longer-term trend is driven by concerns about increased credit risk arising from the business loan failures that occurred at that time, and the introduction of risk weighted capital ratios under the Basel I accord in 1988.</p>
<p>Under the Basel II Accord (2004) a new framework was introduced, leading to a greater differential in capital requirements for home and business lending.</p>
<p>This differential has had a major impact on bank balance sheets. Australian banks, with almost 63% of assets in residential property loans, have the largest proportion of residential real estate loans to total loans on bank balance sheets of all countries surveyed by the IMF. Although, the extent to which this focus on property “crowds out” business lending, and especially lending to higher risk SMEs, is difficult to determine.</p>
<p>The potential for capital requirements to adversely impact SME lenders was noted by the Financial Stability Board and Basel Committee’s Macroeconomic Assessment Group which <a href="http://www.financialstabilityboard.org/publications/r_100818b.htm">stated</a> in 2010 that as a result of tighter regulatory standards “bank-dependent small and medium-sized firms may find it disproportionately difficult to obtain financing.”</p>
<p>Regulations that provide disincentives for banks to engage in lending to SMEs have particularly grave implications for Australian business as approximately 90% of all intermediated credit in Australia is provided by banks.</p>
<h2>Assessing SME credit risk</h2>
<p>Increased consolidation in the banking sector has led to greater economies of scale in business lending. Where SMEs are concerned reliance on low cost credit scoring models, rather than traditional relationship banking can have adverse consequences. First, where young, high-growth SMEs are concerned, there is a high probability that such businesses will be denied credit, as their financial profile approximates that of a bankrupt firm with few assets, low liquidity and a low solvency ratio. </p>
<p>Second, given the importance of the capability of the business owner, credit assessment models that ignore this aspect are also more likely to make a Type 2 error, that is approve a loan which subsequently defaults. Third, individual banks may view SMEs as a segment rather than as heterogeneous businesses with varying risk profiles, leading to <a href="http://www.accaglobal.com/content/dam/acca/global/PDF-technical/small-business/pol-af-ftd.pdf">reduced business lending</a> to SMEs in the aggregate.</p>
<h2>Options for Australia</h2>
<p>*<em>A national SME database
*</em></p>
<p>Banks have special access to the financial information of small firms that are not subject to the disclosure requirements of equity markets, or have a publicly available risk rating. Therefore developing a national database on SME information, as is <a href="https://www.gov.uk/government/consultations/competition-in-banking-improving-access-to-sme-credit-data/competition-in-banking-improving-access-to-sme-credit-data">proposed in the UK</a>, could make significant inroads into the current level of information asymmetry that exists between the large Australian banks and other potential lenders, and would be well received by both financiers and borrowers.</p>
<p><strong>Lowering barriers to entry for non-bank lenders</strong></p>
<p>Two major categories of non-bank lenders have been targeted by international regulators – non-bank online lenders and securitisers. This segment is still embryonic in the Australian SME lending market.</p>
<p>The technology introduced by online lenders in terms of credit assessment and SME loan monitoring offers the potential for bank lenders to provide a more cost-effective technological solution to reduce the transaction costs of SME lending. Not only would online solutions reduce costs, but an effective regular monitoring process may overcome the need for non-monetary covenants being imposed on SME borrowers.</p>
<p><strong>Regulatory options</strong></p>
<p>The capital impost of SME lending may be slightly ameliorated by expanding the definition of “retail” SME loans to A$1.5 million in line with the Basel II framework. </p>
<p>Second, given the more homogeneous nature of housing lending, the concentration of such lending on bank balance sheets, and the potential for such lending to “crowd out” business loans, there is an argument to reduce the differential in capital requirements between home loans and SME loans by imposing the standardised Basel II risk weight on all home loans.</p><img src="https://counter.theconversation.com/content/31771/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>The authors do not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Since the global financial crisis, credit growth in Australia has returned. But while growth in home lending between 2008 and 2014 was relatively strong (0.49% per month), it was actually negative for…Deborah Ralston, Professor of Finance and Director, Australian Centre for Financial Studies Martin Jenkinson, Research Officer, Australian Centre for Financial Studies Licensed as Creative Commons – attribution, no derivatives.