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Monday, 14 April 2014

Wilfred Nagel, CRO of ING: “Small and Medium Enterprises should collect more equity money, instead of borrowing money at the banks”. Nagel has a point, but does not always tell the whole story.

The Chief Risk Officer of ING Bank, Wilfred Nagel, put a column on the corporate website of ING (, in which he advocated that small and medium enterprises (SME) should have more focus on collecting equity capital, instead of borrowing almost all their working capital from the banks.

This is a rather controversial and thought-provoking statement, as the ‘communio opinis’ in The Netherlands is that the banks pinched off the credit supply to these SME companies.

As a matter of fact, I do sympathize with Nagel’s statement, but I also think that this statement does not tell the whole story. That is why I take Nagel’s integral column and add my comments to it.

 “Dutch small and medium-sized enterprises (SMEs) have been facing difficulties for some time. Many, including the CPB Netherlands Bureau for Economic Policy Analysis (in the Central Economic Plan 2014), are pointing at the banks, giving the impression that they have too little capital for lending to SMEs.

My comments: I don’t think that ING and the other Dutch banks have too little capital available to lend to SME companies. I rather think that, among the Dutch banks, there is too litte TRUST in the financial health and robustness of many SME companies.

Where the risk awareness of the banks was virtually non-existent in the prelude to the 2008 crisis, the risk awareness is now extremely high. The banks don’t trust their private and corporate customers sufficiently to give them money nowadays, unless their securities, their reputation and business plans are ironclad. This is definitely a slight overreaction, just as the non-existent risk awareness in 2007 was an overreaction.
Still, it is good to look at the remark about the banks have too little capital…

Since the credit crisis emerged in 2008, there is an ongoing discussion about the amount of capitalization that banks need to survive a crisis, like the one we had over the last six years. 
Roughly, there are two parties in this discussion: 
  • The party that emphasizes the importance of looking at the weighed capital ratio of a bank, in connection with the risk that this particular bank runs on its securities and collateral;
  • The party that thinks that every bank should have an unweighed capital ratio of at least 5% and rather more. 
Although I am personally an advocate of an unweighed capital ratio of at least 5%,  I see the point of the party represented by the first bullet. Most banks belong to this particular party, of course.

Banks that mainly operate in financial environments with limited risks, do not need so much equity capital as banks, which earn their money with very risky trades and investments. 

First and foremost looking at the weighed capital ratio in connection with the risk level of the investments and trades, can therefore be a very sensible thing to do: less risk is less equity capital required, while higher risk is more equity capital required.

However, neither the general public nor the Dutch government know which assets the Dutch banks exactly KEEP on their balance sheets and which specified risks they run by holding these assets:
  • Are there very risky assets on the balance sheet or are most assets virtually risk-free?
  • Are all assets indeed maintained at real market prices nowadays?
  • Did the banks sufficiently write off on their previously overvalued assets, like residential and commercial real estate, sovereign bonds and mortgage backed securities?
  • Or are there still dead bodies everywhere?!
  • How many loans to private and corporate customers run a risk of not being paid back?
  • How many houses and office buildings, carrying a mortgage, are currently underwater?
  • How many of their private and corporate mortgagers are in arrears these days?  
Only the central bank De Nederlandsche Bank should know the answers to these questions, as this belongs to DNB’s prudential supervision tasks (a very important part of this supervision is maintaining and checking the different Basel standards). However, the prelude to the credit crisis of 2008 showed that DNB did a very poor job with their prudential supervision upon the Dutch banks.

At the time, the people in charge of DNB believed in the fairytales of:
  • balance sheet inflation;
  • fractional reserve lending;
  • maximizing shareholder value;
  • ever rising housing prices in The Netherlands.
DNB has only started with its journey to earn back the collective trust of the Dutch people and this journey is not finished yet by a lightyear.

This is the reason that an unweighed capital ratio of 5% or more is a good thing, in my opinion. In this case, we do know at least that the bank is sufficiently solvent to withstand substantial write-offs on its assets, without having to ask the national government and consequently the taxpayers for help.

ING Bank is currently at an unweighed capital ratio of 4.25% (€787 billion in assets vs 33 bln in equity). This unweighed ratio has indeed enormously improved since the crisis started in 2008, but in my opinion the bank is not quite there yet.

Having said that, SME’s are clearly having problems and banks have a responsibility to help solve them. It is sensible to make the right diagnosis and take suitable measures. It then becomes clear that even more additional capital for the banks is not only unnecessary but will also not lead to easier lending to SMEs, which above all need more equity.

My comments: This paragraph emphasizes my point about the lacking trust of the banks in SME companies. Without a doubt, this lack of trust is partially a question of exaggerated risk awareness among the banks. Still, for the main part, it is a consequence of the banks’ clear vision with respect to the problems that many SME companies are in nowadays. SME companies and especially retailers are going through very rough times these days, mainly as a consequence of the ubiquitous consumer strike in The Netherlands.

With the remark about ‘more additional capital for the banks being unnecessary’, Nagel is clearly preaching for his own parish. Most executive bankers will agree with him, but many economists and supervisors probably won’t. At least I don’t agree with him.

Firstly, it is important to point out that the fall in lending to SMEs in the Netherlands is largely a result of lower demand for credit and so what we are now actually seeing is a fairly normal correlation between lending and the state of the economy.

My comments: This remark only contains half the truth. I am convinced that there is indeed a lesser demand for credit among Small and Medium Enterprises; when your sales are way down and your business runs on a lower level than before, you just need less credit. 

Nevertheless, it is futile to deny that the banks also pinched off the credit supply to SME companies; partially by raising the conditions for acquiring a loan and by setting the approval standards to a much higher level than before. And, of course, also by asking for higher risk premiums on their loans, thus effectively increasing the interest rates that the borrowers should pay. The latter has also scared away many borrowers. In 2007, lending money was too cheap and perhaps it is too expensive nowadays.

Secondly, Dutch SME’s are already more dependent on bank credit than those in other comparable countries. It is, therefore, sensible to move to a healthier financing model for SMEs and not to give a new boost to increasing debt positions. For this reason, ING is working very actively promoting initiatives in this area, such as the Stimuleringsfonds Ondernemend Oranje Kapitaal.

My comments: This remark about ‘not giving a new boost to increasing debt positions’ makes sense. I do indeed think that too often only borrowed capital from the banks is seen as the lubricant for doing business.  It seems that many companies don’t try hard enough to collect sufficient equity capital and/or subordinated loans from friends and family.

And perhaps on many occasions, companies don’t choose for a path of cautious and autonomous growth, but instead for rapid expansion. This is a certain way to create enormous debt, which ought to be paid back; even when business is bad.

Thirdly, banks do not lack lending capacity. Dutch banks have significantly improved their capital positions since the financial crisis. For example, ING amply meets all current standards and so is in a position to grant just under €4 billion of credit each week worldwide without putting pressure on its capital ratios. Furthermore, the fact is that both customers and credit providers benefit if banks do not stash their capital away but lend it to creditworthy customers.

My comments: It is definitely true that the Dutch banks enormously increased their capital ratios. Still, I refer to my first comments in this article about the capital ratios.

This particular paragraph has a high “You must believe that our assets and capital ratios are good, because we tell you so” level. We – the Dutch public and politicians – must believe that ING’s asset quality and capital ratio are good, because we can’t know it and prove it. I hope, however, that De Nederlandsche Bank is taking its prudential supervisory role more seriously today than the bank did in the years before 2008.

This does not of course detract from banks, and certainly also ING, applying a prudent risk policy. Many factors determine the customers that a bank lends to within the scope of its balance sheet, including the nature and duration of the relationship with the customer, the risk profile of the proposed loan, the price the bank receives for taking on risk, the extent to which the loan contributes to the creation of concentration risk on the balance sheet and the requirements of the sustainability policy being pursued. The importance of proceeding carefully in this respect, is underlined by recent experiences with lending to SMEs. Dutch SMEs made up 5% of ING’s total credit portfolio in 2013 but contributed 22% of the total addition to the reserve for loan losses.

Against this background, the question is what actual public interest is served by loosening credit standards applied to SMEs? And how does this relate to the aim of safer banks? In fact, banks are now being told to stretch their approval criteria, which is the same as calling for more financing (often of losses) and expansion instead of reducing SMEs’ dependence on debt.

My comments: I fully agree with what Wilfred Nagel states here. Investing in and borrowing to SME companies is extremely risky business in the current economic conundrum and it is very hard to make this a profitable one, even for such professional and experienced organizations as banks.
No investor or customer of a bank should accept that his bank takes too much risk with his equity capital and with the money that the bank borrowed from its customers. Banks should lend to SME companies , when the risk/reward ratio and the opportunities for success are favourable; not because the politics and the general public ‘demand’ that they do so.

This is undesirable from the perspective of both the bank and its providers of capital and of the financing structure of our economy. If we assume 4% leverage, every euro of capital put into the balance is €25 less available for businesses which are creditworthy.

My comments: This is financial mumbo-jumbo of Nagel and definitely not the strongest paragraph in this column. Or in other words: I don’t understand one bit of what he exactly wants to say with it.

On top of this, a further strengthening of the capital positions of large Dutch banks will not lead to more lending to SMEs as this only works if both the bank and potential providers of capital are convinced that the investment will be used for profitable economic activity. In other words, granting capital to creditworthy parties at a reasonable return. Gathering capital only to jeopardise it by lending to parties that do not meet the minimum requirements is not a very productive strategy.

Those calling for a relaxation of bank lending to SMEs are, therefore, promulgating a sort of industrial policy at the cost of banks’ savers and providers of capital. This is not appropriate to a market economy and is particularly unwise given the need to increase not debt but equity of SMEs.”

My comments: Nagel is totally right with these paragraphs. It is useless for banks to increase the unweighed capital ratio, if they use it to squander money, by lending it to not creditworthy (SME) companies.

Politicians, the employer’s associations and the general public can of course say as often as they want, that the banks should borrow more money to SME companies; these people are all entitled to their opinions. Nevertheless, as long as the banks run a much more than average risk of not getting this lended money back in the end, they should not lend it at all.

The only thing that I don’t agree with, is that Nagel connects increasing ING’s unweighted capital ratio solely with increased lending to SME companies. 

In my humble opinion, ING Bank should definitely increase its unweighed capital ratio to 5% or more, even if they use that money for investments in only the safest of companies and assets. As this crisis has proven one thing, it is that even the safest of assets and companies can one day prove to be not safe anymore. And then it should not be the taxpayer again, who should foot the bill for this discovery.


A rectification with respect to some of the contents of this article has been printed in the following article

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