Skip to main content
The Actuary: The magazine of the Institute and Faculty of Actuaries - return to the homepage Logo of The Actuary website
  • Search
  • Visit The Actuary Magazine on Facebook
  • Visit The Actuary Magazine on LinkedIn
  • Visit @TheActuaryMag on Twitter
Visit the website of the Institute and Faculty of Actuaries Logo of the Institute and Faculty of Actuaries

Main navigation

  • News
  • Features
    • General Features
    • Interviews
    • Students
    • Opinion
  • Topics
  • Knowledge
    • Business Skills
    • Careers
    • Events
    • Predictions by The Actuary
    • Whitepapers
    • Moody's - Climate Risk Insurers series
    • Webinars
    • Podcasts
  • Jobs
  • IFoA
    • CEO Comment
    • IFoA News
    • People & Social News
    • President Comment
  • Archive
Quick links:
  • Home
  • The Actuary Issues
  • September 2015
09

Losing out on lending

Open-access content Thursday 27th August 2015 — updated 5.50pm, Wednesday 29th April 2020

Shyam Mehta argues that banks should use fat-tailed investment models to more accurately assess the risks involved

2

It is common knowledge that in the UK the amount of bank lending to small and medium-sized enterprises (SMEs) and of mortgage lending to individuals has declined since the financial crisis. The question is why.

A simple answer is that the amount of capital required, by the regulators and under the Basel framework, to support such lending has increased sharply. If capital is scarce and capital requirements have, say, doubled for any given volume of lending, then the volume of lending will halve. I do not believe that this is the answer.

First, I believe that banks were dramatically underestimating the amount of capital needed to do business prior to the financial crisis. The risk of a financial meltdown was being underestimated. 

The use of the normal distribution to represent fluctuations in business conditions is inappropriate, and one needs heavily skewed distributions such as those that underlie the 'Andrew Smith investment model', developed and promoted by Deloitte. 

When building fat tails into an investment model it causes one to quickly reassess the amount of capital needed for risk events. The regulators are merely forcing banks to recognise the fundamental capital that is needed to support lending - even though they do not require the use of fat-tailed distributions to assess bank capital needs.

Second, with a free banking market - in terms of price as distinct from capital requirements, which may or may not bite - it is all a question of price. If banks have had to reassess the amount of capital needed to support a given volume of lending, all that happens is that the price of this given supply increases - capital will be found if it is profitable to use it - and shifts the supply/demand curve. This is a second-order effect and there is no reason for lending to halve. 

If lending was profitable, prices would have risen, lending would have been maintained at broadly pre-crash levels, and the capital needed would have been found.

Unfortunately, not only do banks not know how to assess their fundamental capital needs - because they do not use fat-tailed investment models when assessing this capital - they also do not know how to price their products. Contrary to the thinking of a typical bank, capital is cheap. This is because bank capital earns an investment return corresponding to the riskiness of the underlying assets backing this capital, and so the cost of holding an extra £1 of capital in a world of no taxes is nil. With taxes but low investment returns, such as we see today, there is a small, less than 1% per annum, net cost of holding capital. Against this, although banks assign a high net cost to holding capital, they assign a low cost to doing business. This is again because they do not use fat-tailed investment models when assessing the risks of lending. 

It was this underestimation of risk that led to the financial crisis - aside from regulatory failure in creating a boom/bust credit cycle, in not providing enough liquidity into the system and in not spotting that banks were over-stretching themselves. So, we can say that lending products are now more correctly priced, with too high an assessed capital cost being offset by too low a risk of doing business cost, but that there is opportunity for new entrants to come into the market and more keenly price certain products.

Well, the question therefore remains: Why has lending fallen? I believe one needs to look at the two distinct marketplaces separately. 

In the mortgage market the supply of homes has fallen and there is therefore less need for mortgage finance.

In the SME market, there are two main factors. First, there is increased peer-to-peer lending although it is not clear how much of a factor this is. Second, businesses are cost sensitive. They borrow to invest. Investment returns have declined, but borrowing costs have shot up as discussed above. The supply/demand curve has adjusted and markets now clear at a much lower volume of lending.


Shyam Mehta is a former investment banker and insurance risk practitioner

This article appeared in our September 2015 issue of The Actuary .
Click here to view this issue

You may also be interested in...

2

Letters to the editor: Teaching grandmas on nest eggs

03 SEPTEMBER 2015 | NEIL HILARY AND PATRICK CLEARY, PRESENTERS AT THE MAY 18 SESSION
Thursday 27th August 2015
Open-access content
2

Letters to the editor: Youngest person on the planet

Thursday 27th August 2015
Open-access content
2

Letters to the editor: Winning numbers

Thursday 27th August 2015
Open-access content
2

Letters to the editor: Public-sector finances - a step too far?

Thursday 27th August 2015
Open-access content
2

Letters to the editor: Members' incentive

Thursday 27th August 2015
Open-access content
2

Letters to the editor: No need for another 'discount'

Thursday 27th August 2015
Open-access content

Latest from September 2015

2

Political animals in the workplace

Bonnie Marcus offers nine top reasons why women find office politics frustrating
Wednesday 30th September 2015
Open-access content
Joanne Segars, chief executive NAPF © NAPF

Actuaries and pension industry oppose pension tax changes

Responses from the pension industry and actuaries to a public consultation have shown no support for changes to the pension tax system.
Wednesday 30th September 2015
Open-access content
ta filler

One in 10 parents 'fronting' car insurance for children

One in 10 parents of young drivers admit to fronting car insurance for their offspring at some point, according to research.
Wednesday 30th September 2015
Open-access content

Latest from 09

2

FRC endorses quality scheme

Derek Cribb outlines the scheme that has boosted the IFoA’s reputation for innovation
Tuesday 1st September 2015
Open-access content
2

The future in focus

President of the IFoA Fiona Morrison believes uncluttered thought can produce better results for actuaries
Thursday 27th August 2015
Open-access content
2

Growing pains

Drawing on childhood memories, Kelvin Chamunorwa looks at how actuaries can inform on emerging environmental risks
Thursday 27th August 2015
Open-access content
Share
  • Twitter
  • Facebook
  • Linked in
  • Mail
  • Print

Latest Jobs

BPA Transition Manager

London, England / Edinburgh, Scotland
£45000 - £65000 per annum + market leading bonus and benefits
Reference
148878

London Market Pricing Contracts - Inside & Outside IR35

London (Central)
£1000 - £1300 per day
Reference
148877

SME Pricing Director

London (Central), London (Greater)
£225K + bonus + benefits
Reference
148872
See all jobs »
 
 
 
 

Sign up to our newsletter

News, jobs and updates

Sign up

Subscribe to The Actuary

Receive the print edition straight to your door

Subscribe
Spread-iPad-slantB-june.png

Topics

  • Data Science
  • Investment
  • Risk & ERM
  • Pensions
  • Environment
  • Soft skills
  • General Insurance
  • Regulation Standards
  • Health care
  • Technology
  • Reinsurance
  • Global
  • Life insurance
​
FOLLOW US
The Actuary on LinkedIn
@TheActuaryMag on Twitter
Facebook: The Actuary Magazine
CONTACT US
The Actuary
Tel: (+44) 020 7880 6200
​

IFoA

About IFoA
Become an actuary
IFoA Events
About membership

Information

Privacy Policy
Terms & Conditions
Cookie Policy
Think Green

Get in touch

Contact us
Advertise with us
Subscribe to The Actuary Magazine
Contribute

The Actuary Jobs

Actuarial job search
Pensions jobs
General insurance jobs
Solvency II jobs

© 2023 The Actuary. The Actuary is published on behalf of the Institute and Faculty of Actuaries by Redactive Publishing Limited. All rights reserved. Reproduction of any part is not allowed without written permission.

Redactive Media Group Ltd, 71-75 Shelton Street, London WC2H 9JQ