Once banks reach a certain size, governments are forced to bail them out when they run in to trouble because of the risks they pose to the wider economy — they are ‘too big to fail’.

UK banks are ‘too big to fail’ — allowing them to collapse would send shockwaves throughout the whole economy // Photo: smemon via flickr

This creates a perverse incentive for such banks to take more risks than they would otherwise, a key cause of the financial crisis of 2008.

Andy Haldane, the Bank of England’s free-thinking Chief Economist, described this relationship between modern banks and the state as a ‘doom loop’.

Haldane pointed to the late nineteenth century creation of limited liability corporate structures as an important driver of banks’ excessive growth.

These structures encouraged risk taking by capping the losses facing banks’ shareholders.

But banks can also limit their losses by securing their loans against land. This means if the borrower defaults, the bank can repossess their home.

This can create a different, but equally dangerous ‘doom loop’.

Banks issue mortgages, housing demand outstrips supply, house prices rise, more people need mortgages and it starts all over again: AKA the ‘doom loop’ // Photo: aotaro via flickr

The cycle works as follows: if the growth of mortgage lending outpaces the supply of new homes, this will inevitably cause a rise in house prices.

As house prices rise, households are forced to take out larger mortgage loans to get on the housing ladder, boosting banks’ profits and capital.

This enables them to issue more loans, which further pushes up prices until such a point that house prices are many times people’s incomes.

In the UK average house prices are now nine times disposable income, a similar level similar to that which they reached before the financial crisis.

The process can continue until there is an economic shock (e.g. a rise in interest rates or fall in salaries) and people’s incomes can no longer keep up with debt repayments. Then the whole process goes in to reverse — there may be mortgage defaults, falls in house prices falls, a contraction of bank lending, recession and, potentially, a financial crisis.

Booms and busts are nothing new, but their effect on the cost of a home is

There have always been booms and busts involving bank lending. But historically they have involved banks’ lending to businesses, not households — the ‘business cycle’. If you read any economics textbook, it will say a bank’s main role is the ‘intermediation of household savings for business investment’ or something similar. This definition is no longer accurate.

In advanced economies, banks’ main activity is now domestic mortgage lending. A recent study of credit in 17 countries found that the share of mortgage loans in banks’ total lending portfolios has roughly doubled over the course of the past century –from about 30% in 1900 to about 60% today.

The UK is a prime example. Figure 1 shows that domestic mortgage lending (green line) has expanded from 40% of GDP in 1990 to over 60% now, while lending to non-financial firms — i.e. ordinary businesses who wish to expand or need working capital — (blue line) has stayed between 20% and 30% of GDP. The UK also saw a huge rise in lending to other non-bank financial corporations (e.g. hedge and asset-management funds) (pink line) but this has contracted considerably since the crisis. In contrast mortgage lending has hardly moved since the crash.

Figure 1: Disaggregated nominal credit stocks as % of GDP in the UK

Source: Bank of England interactive database and authors’ calculations

When banks make loans, they create new money in the form of the deposits that appear in our bank accounts, and increase our purchasing power. Therefore, with the majority of UK loans today funding mortgages, the majority of new money is being pumped in to land and housing.

Given the limited supply of new homes and concentration of economically desirable land in south east England, the result is, inevitably, higher house prices.

For those lucky enough to own homes, rising prices give the feeling of rising wealth and encourage more spending (the ‘wealth effect’). Homeowners can also boost their spending power by borrowing money against the value of their property with home equity loans (the ‘collateral consumption’ effect).

Given that household consumption contributes around two-thirds of GDP growth in the UK, household purchasing power is vitally important for the UK’s wider economic health. It is hardly surprising that the first thing the former coalition government did to try and boost the economy post-crisis was to boost house prices and home ownership by subsidising mortgages via the Help-to-Buy equity loan scheme.

But mortgage debt cannot keep on growing forever relative to incomes, even if it is subsidised by governments. At a certain point, people will begin to cut back as more and more of their wage packets are taken up with mortgage repayments. Is a different path possible?

UK versus Germany

Although the general pattern in advanced economies has been a shift towards mortgage lending, there are some interesting exceptions to the rule. The equivalent breakdown of credit stocks for Germany tells a different story.

Figure 2: Dissaggregated nominal credit stocks as % of GDP in Germany

Source: Bundesbank and authors’ calculations

In Germany, bank lending to non-financial businesses is significantly higher than mortgage lending at 40% of GDP, while mortgage lending has only increased to around 30% of GDP. With both Germany and the UK subject to similar interest rates and other external conditions over the last few decades, it’s clear that there are institutional or country specific effects at work.

There are two major differences between the countries.

Very different banking cultures…

The UK is dominated by four or five very large national or international shareholder owned banks — controlling around 80% of retail deposits.

This is the result of successive waves of deregulation, with banks permitted to engage in mortgage lending in the early 1980s (before then only building societies could do so) and a continued relaxation of mortgage lending regulations through the 1990s.

This led to the eventual swallowing up of much of the mutual sector via mergers and acquisitions.

The UK has a strong ‘transaction’ banking culture. This is characterised by a preference for short-term business loans, centralised and automated credit-scoring techniques to make loan decisions, a need for high quarterly returns on equity and a strong preference for collateral.

As UK banks have become larger and increasingly highly leveraged, they have increasingly sought to lend against existing assets — in particular property or land — which they can claim in case of default. Collateralised loans such as mortgage-backed securities are also quite easy for banks to package up and sell on to other financial corporations — a process called ‘securitization’. This has generated an additional form of income for large banks and they engaged in such activity huge scale in the lead up to the financial crisis.

By contrast, in Germany there is a much stronger culture of ‘relationship banking’. Two-thirds of bank deposits are controlled by either cooperative or public savings banks, most of which are owned by regional or local people and/or businesses.

These ‘stakeholder banks’ are focused on business lending, do not have such stringent collateral requirements and devolve decision making to branches. Rather than always seeking collateral, they de-risk their loans by building up strong and long-lasting relationships and an understanding of the businesses they lend to. It is these banks that have enabled Germany’s famous regional small and medium enterprise sector (the ‘Mittelstand’) to thrive.