The death of small business is a big deal for the EU

Overzealous regulators are working at cross purposes with the ECB. Their efforts are slugging small businesses, fuelling deflation and stalling a much-needed source of growth.

As The Economist recently observed in a piece titled “The world’s biggest economic problem", the threat of deflation remains as likely as the sun coming up. Matters have recently been made much worse as Russian maneuvers in the Crimea have not only drawn military responses, but also a stalling of core EU growth.

A chill wind is blowing over the EU, and it is not just a result of a lack of Russian gas, but a European bureaucracy that is working against itself. While The Economist warns that European leaders are running out of time, the ECB is, once more, trying to hold up the EU with further easing of policy. However, the efforts of the ECB and the bank regulators seem inconsistent; while the ECB eases policy, the regulators are effectively tightening policy. By looking at what banks have realised since the GFC, one can begin to understand why this conflict is apparent.

Banks have realised two things.

First, you can lose money -- a lot of money -- on property, so you need to re-price loans that are made using property as collateral. Banks were always conservative on lending, but recent experience has made them ultra-conservative with regard to the valuation of property. Hence, if a bank lent with a loan to valuation ratio of 75 per cent before the GFC, now it might be at 55 per cent.

Second, more capital has been required by regulators, so as to ‘never again’ allow banks to request official assistance.This effectively means the price of the loan offered needs to rise. Regulators have suddenly woken up from their slumber and are now demanding a final solution to the problem of bank capital at a time of real hardship for many in Europe.

The smaller the business, the bigger the impact of these two changes becomes.

For example, say a business has property valued at €5 million, and the bank used to lend €3.75m, a 75 percent LVR against that asset. Now the bank will only lend €2.75m against that asset, with a 55 per cent LVR. While nominal rates have declined, the risk assessment of small firms has changed dramatically, so that the price of the loan has not declined to where the low nominal rate would normally imply.

In other words, small businesses have less ability to find loans at prices that are still elevated in terms of pricing. While large businesses have professionals who seek and find the lowest possible form of funding, small firms do not have that luxury, and are typically tied to one or maybe two banks. This means that the small firm is understandably paranoid about banks.

Many have only two options. They can sell the same old amount of products at the old margins and wait for the bank to walk in the door and demand partial payment of loans, due to alternations in bank lending policies. Alternatively, they can sell more products at much lower margins and squeeze the living daylights out of the business to stop the bank from demanding partial loan repayments, due to alternations in bank lending policies.

Given such behavior, it is little wonder why prices are falling, as small business struggle to survive in the brave new world of post-GFC bank regulation. Cutting prices is not just a function of external competitive pressure, but effectively emanates from the social engineer in the banking system, who now is demanding a “perfect solution” to the banking crisis regardless of the circumstances. Perfect solutions are the stuff of fairytales, and fairytales can be expensive, especially if the end product is deflation.

Criticism of banking regulation in the EU is not hard to find. Christian Clausen, the President of the European Banking Federation and chief executive of Nordea, has indicated that regulatory demands meant that banks need to charge around 600 to 700 basis point margins on small and medium-sized enterprises, the companies that support EU employment, and who effectively set price levels in the EU. As Clausen indicates:

“Show me an SME that can do a business case on opening a new factory or doing an investment where they can start by absorbing 600-700 basis points on margin. In this environment, it's not possible. We have gone too far” (Nordea chief says bank regulation chokes small-business loans, Financial Times, 16 November 2014).

Importantly, what this piece argues is that, in addition to unemployment, over-zealous regulation is impacting the general level of prices. It is fueling deflation.

A better way

On the one hand, the social engineer wanting a perfect solution to the dilemma of ‘too big to fail’ is very right; big banks need more capital. On the other hand, the spectre of deflation borne by overly zealous banking regulation is very wrong.

As Aristotle would say, “virtue” is a mean and prudent action in the face of naturally limited information. It demands that one should act bearing the extreme situations in mind, yet bearing a course between both of them. This means that in euphoric markets, when GDP is surging, bank capital requirements also soar; when GDP is low, then capital requirements should be eased.

Strong states, therefore, push large demands for capital back onto the banks, who can shoulder them at that time, and weak states, therefore, give banks relief. Bank relief then translates into some relief for small business. It gets the break it needs, so as repair itself, assuming an adequate amount of competition in the banking system.

In other words, using state-dependent banking regulation over the medium term would fix the problem of deficient bank capital over time, yet would allow breathing space for the struggling small business at a time of great need.

By being blind to the plight of the small businessman in Europe, we will wait and watch an ECB that continues to deny the inevitable: the development of widespread and entrenched deflation. Meanwhile, the rest of the EU bureaucracy makes life a living hell for the very sector that is the lifeblood of any free market: small business. Instead of working against the ECB, bank regulators need to work with it.

Unfortunately, the scientists, who argue that the economy can be socially engineered, have now won the day. They are effectively steering the economy off the cliff by frustrating the work of the ECB. It is they who are forcing the EU towards deflation by demanding a “perfect” solution to the problem of bank capital. ‘Perfect’ solutions can be expensive solutions, especially if these solutions are attempted without any consideration to the circumstances that one finds oneself in. It appears that bringing back some of the “art” to policy making has never been more needed, or what Professor Harvey Mansfield Jr. refers to as 'manliness'.

Dr. Stephen Nash is an author and Cambridge Ph.D. graduate with extensive experience in fixed income markets.