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