Lending Standards: How Commercial Banks fight against the Monetary Policy
Central Banking is Central Planning
Central Banking is Central Planning. It is Command Banking. One institution, called a central bank controls money supply using a variety of tools.
The most popular tool is interest rates. Commercial Banks are fighting against command banking using one resident barbarian known as Lending Standards.
It’s a tug of war. This is an area that has been avoided by economics textbooks. It has not been explored or explained in detail.
Central Banking is Central Planning
When the economy is overheating and in a bad shape, the central bank raises interest rates for the economy to cool off and return to normal growth levels. Raising interest rates makes borrowing expensive and dissuades risk takers from assuming unnecessary risks.
The reduced economy activity allows the economy to breathe normally and avoid a recession caused by an overheated financial sector. It is just similar to that situation when you have a car that is overheating and you reduce speed, park on the road, throw in some water, allow the engine to cool before taking off again.
When the economy is suffering at low levels of growth, and not performing to its desired level, the central bank drops interest rates as a way to boost lending and economic activity. The resulting uptick in borrowing and economic activity closes the output gap and allows the economy to grow at a faster rate and avoid serious depressions.
The act of raising and dropping interest rates is not an exact science but is not an art either. It is a real life balancing act. The central bank attempts to steer the economy through the dangers of recessions and depressions caused by either an under-performing economy or an overheating economy.
The existence of central banking has been largely premised on the need to have a big brother who looks out for the country’s economy in this regard. It is a noble endeavor. This is the conventional viewpoint.
The unconventional viewpoint is that Central Banking is a communist phenomenon that has been branded as a core tenet of a capitalistic economy.
This branding act is a fraud and sham. A lie has been repeated over and over again that with time it has come to approximate the truth. And we have accepted it as the truth.
As with many communist phenomena, the ideology behind is marketed as being for the greater good. The need for collectivism is mistaken as a need for communism. Individualism is misidentified as selfishness.
However, in the end Individualism always triumphs over communism. That is why capitalism has replaced communism in former communist states.
The central banking aspect of capitalism is a fraud. A true capitalistic society would not make use of the central bank in the manner that we use it today.
The current manifestation has one wrong aspect in regard to the control of interest rates and money supply. Fiat Money is a fraud. The gold standard is the real central-banking-based monetary system. Control of interest rates and money supply should have been decentralized.
Regulation and supervision of banks, central clearing systems and other administrative issues should remain in the hands of the central bank.
These are administrative duties. Economic decisions should be left at the individual level (human or juristic person). Aggregated individual level decisions should decide the fate of the economy. There is no need for a big brother.
Most communist policies always end up at the same destination, failure.
Central Banking is failing. Some cannot see the failure because it is not yet at the Dismal Failure Stage, but it will get there. In some countries such as Zimbabwe, central banking has totally failed and some politicians there have called for the total removal of the central bank.
In normal countries, banks, making decisions at the individual entity level are militating against central bank control of money supply. As a response to the corona virus induced recession, central banks dropped interest rates. In response, banks have tightened lending standards so that they do not lend recklessly to anyone that wants debt.
Lending Standards as a Monetary Policy Tool
Interest Rates vs Lending Standards as Monetary Policy Tools
The tightening of lending standards is a counteraction to the dropping of interest rates. Banks are effectively voting against the dropping of interest rates.
The counteract behavior has been observed when interest rates have been raised to levels that are higher than what the banks prefer.
When interest rates are too high for most banking clients, banks have loosen their lending standards so that their desired clientele can access credit.
This counteract behavior reduces the effectiveness of a monetary policy. Banks are making their portfolio decisions based primarily on their preferences and needs.
The interest rate level is a secondary determinant, instead of a primary determinant. It is a morning after.
Actions of individual banks are aggregating into a Monetary Policy Tool. The average lending standard of the banks becomes a main determinant of debt levels.
An interest rate is a price. A price of money. It is a price attached to borrowing and lending of money. The major suppliers in this market are banks. Corporates and individuals are usually on the buy-side. Similar to any market in a capitalistic set up, the price is determined by market forces. Interactions between buyers and sellers of money determine the price.
Central banking distorts the market mechanism by attempting to control the price of borrowing/lending money. At the individual level, Bank A might be willing to supply USD x billion at an average rate of y% per annum.
If the interest rate goes above y%, Bank A can loosen its lending standards so that it continues to lend USD x billion, otherwise there will sit on excess funds that will act as a drag on the portfolio.
Likewise, if interest rates drop below y%, more people want to borrow from the bank than the bank can afford to lend to. Even though the bank has access to more dollars from the central bank, the bank does not necessarily need to fulfill the borrowing needs of all the clients that come looking for money.
Over time, through burning fingers when playing with the fires of Non-Performing Loans (NPLs), banks have learnt the hard way that not all easy money from the central bank should be taken for onward lending to clients.
The problem always comes back to haunt the banks, which have to eventually pay back the low-cost money to the central bank without getting anything from the wave of new borrowers that enter the market when rates are low. Thus, when interest rates go below the natural market interest rate, it is strangely in the best interest of banks not to increase their lending portfolio.
So, if Bank A desires to keep its portfolio at USD x billion dollars, it invokes lending standards as a tool to choke of extra demand.
What does this Mean for the Economy?
The moral of the sad story is that rates should not be artificially controlled by the big brother. Rather leave it to the banks.
The longer the command rate stays below the natural market rate, the worse the economy fares, because of the absence of credit expansion. Without credit expansion, economic growth is stifled.
If the command rate stays above the rate determined by the market, the economy does not suffer much as banks are quick to loosen lending standards. However, loosening lending standards can only go so far in arousing loan interest and keeping the economy going.
Central banks do not need to be totally abolished. The economic command elements of central banking need to be dropped. If that is done, the economy will grow with built-in controls on credit expansion and money supply.
What will total liberalization of Interest Rates do?
If interest rates are liberalized, you might at first get some players who try to manipulate the market, like they did with LIBOR. As more players get into the lending market, the price establishment mechanism will work perfectly.
The exclusive privilege of banks in obtaining lending licenses will have to be dropped.
Banking and lending are two different things. Banking is a trust relationship and lending is a trust-based transaction. Lending can be done by anyone, but banking should be done by banks.
Lending standards reflect the level of credit risk in the market. The level of credit risk determines interest rates. This is how it is supposed to be.
Vengeance against the Resistance
If banks continue sabotaging the Monetary Policy by going against the spirit and intentions of a certain policy direction, the Central Bank might eventually try to force its policies into action by either heavily regulating commercial banks’ lending standards or by partnering with government in undertaking quasi-lending activities such as dishing out loans, grants and stimulus payments.
The move will be retrogressive. It will be more communist than the Soviet Union. Not only will the Central Bank be determining interest rates and money supply, it will be determining who the bank lends to and how much.
Lending Standards and The Stock Market
There has been anecdotal evidence that commercial banks habitually crash the stock market when there is an unfavorable monetary policy regime by raising lending standards.
This is followed by a crash of the stock market. It is difficult to establish an indisputable causal relationship between lending standards and a stock market crash. There are too many variables that can precipitate a stock market crash. Unavailability of borrowed funds is only one of the factors.
Banks sitting on money is not a good thing, especially in the middle of a global pandemic. We have to look at reasons why banks are sitting on money instead of lending. The banking system, to be specific, and the monetary system in general, are broken.
Command banking creates market distortions. Banks sitting on money is an example of a how the market distortions manifest. It is a symptom. The root cause is dysfunctional central banking.
It is time to make a change.
Originally published on medium.
I write creative solutions on business management, business models, macroeconomics, central banking, fintech and financial analysis.