Friday, 23 September 2011

Will twisting cause lending to stick?

Operation twist has been launched and was greeted with universal disdain by the market and had been criticised before its announcement by investors and politicians alike.  The point of the operation is to try and lower the cost of loans by reducing long term market interest rates and the potential reasons  for its poor reception are legion. One of the complaints leveled at it though, was that it could destroy banks’ incentive to lend. Why would that be?

If we cast our minds back to the Walmington-on-Sea bank balance sheet, you may recall that the bank earns profits by borrowing short term and lending long term. Putting this in the context of market interest rates we use a yield curve to demonstrate the difference between interest rates available for different maturities (lengths) of loan.

An upward sloping” yield curve is one where short rates are low and long rates are high, leaving a gaping margin between them (this is the normal state of things). Naysayers believe that by flattening the yield curve there is no margin and therefore no incentive. I don't think this is true.
The reason banks like a steep yield curve is that it implies that short term rates are low, and these determine the cost of the loan to the bank. The income they receive from it, however, will depend upon how much interest they charge. The treasuries yield curve is just one factor, together with the credit risk of the borrower and competition between banks, when determining loan interest charges.

To demonstrate this we use some examples from the UK market.

Two kinds of loans are shown in the charts below: tracker mortgages and fixed rate mortgages. Both are shown relative to the risk free rates for a similar term. You can see that when banks are competing to lend (2005-2007) they price very close to that rate and when they are being more selective they retain a lot more margin for themselves.

At the moment the shape of the yield curve therefore has less to do with banks’ lending rates than risk premia and competition do. It does, however, have a great influence on companies’ borrowing through the bond market. In that sense this policy may be helpful.

By making bond markets more attractive to those who have access to them (big companies) what little lending the banks do offer must increasingly be driven towards households and SMEs (Small and Medium Sized Enterprises).

Whether this will actually happen is debatable. However everyone would agree that the economy will benefit if this is the case. And as banks generally have access to the bond markets the flatter yield curve may give them a golden opportunity to match the terms of their loans and liabilities (reducing the liquidity risk they usually have to suffer).

This is not a silver bullet to kick start the economy but it is not a harmful policy either (as the equity market reaction might suggest). The greatest charge that could be leveled at it would arguably be that it may be inconsequential as medium and long dated yields were very low already.


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