Keep social policy out of credit markets
Banks and financial intermediaries play a crucial role in spreading risk, providing information and reducing transaction costs among investors and borrowers. But when banks follow lending practices that have little to do with commerce but instead focus on social and political objectives, financial markets become distorted. That can lead to higher borrowing costs, lower saving rates and greater default risks. Two types of non- commercial practices have recently crept into U.S. markets.
The first is related to discrimination in lending. With the death of George Floyd, the Black Lives Matter movement has encouraged banks to provide advantageous lending terms to Black and other minority borrowers. The change is based on data showing that minority borrowers are more frequently denied loans or steered to products with higher interest rates, presumably because of discrimination although higher credit risk could also be a concern.
Preferential lending seems contrary to the intent of the Equal Credit Opportunity Act and Fair Housing Act, which prohibits credit decisions based on race. For example, a bank cannot charge different mortgage rates to minority and white borrowers with the same credit risk. On the other hand, neither can it provide advantageous financing to minority borrowers, which is a goal of many social policy advocates.
Banks are getting around the non- discrimination rule with new “supply- chain financing” structures aimed at helping minority- owned businesses. A supplier of goods and services to minority-owned businesses will receive faster reimbursements from the bank than other borrowers will. To compensate the bank, the supplier either pays a fee or receives a discounted payment from the bank. In the end, the minority business has more working capital while the bank makes some profit as compensation. To help fund its supply chain financing, the Bank of America is also using a $ 2- billion “green bond” raised from ESG lenders.
Credit markets become distorted if lending practices favour or disfavour one group of borrowers over another based on factors that go beyond credit risk. Lower-risk borrowers can end up cross-subsidizing higher-risk borrowers if they pay higher interest rates than they otherwise would so the bank can finance its now higher losses from higher-risk lending.
The second example comes from banks excluding some politically sensitive sectors from credit lending. The U. S. Office of the Comptroller recently announced a new regulation prohibiting U. S. banks from refusing to lend to a broad category of businesses, such as firearms manufacturers, family-planning centres, businesses managing prisons and oil/ gas drilling. Brian Brook, the acting Comptroller, argued that credit markets become distorted if bank lending becomes a political tool rather than being based on commercial interests. The banks, though, fear the new regulation could force them to finance companies if they cannot demonstrate that the loan in question represents a credit risk.
This is not the first time that bank lending practices reflecting political pressure have tilted credit markets to support or disfavour classes of borrowers. In the 1990s, the U.S. government promoted easier credit for low- income Americans wanting to buy homes. That easy credit, which the banks heavily promoted over the next decade, was the key factor leading to the 2008 financial crisis, as many mortgagees defaulted after monetary policy was tightened.
In competitive financial markets, a bank’s specific lending practices may not matter much in the end. A bank that provides unprofitable loans will find its stock market value suffers. If an institution decides not to lend to a minority borrower or a specific sector, another lender, seeing the profit opportunity, will step in and take on the credit risk instead. In other words, competitive markets help reduce the scope for discrimination amongst borrowers.
As of 2017, Canada’s five largest banks held over fourfifths of commercial assets in this country. Such high concentration in banking is widely tolerated in the belief that strong banking institutions contribute to financial stability, a claim thought to have been vindicated by the 2008 financial crisis. The cost of concentrated financial markets, however, is that any bank discriminatory practices could be harmful to credit markets as borrowers have fewer lenders to choose from, unlike large companies with access to international markets. Smaller businesses have particularly complained in the past that they have been unfairly treated by banks with high interest rate loans although that may simply reflect credit risk.
The concentrated structure of Canada’s banking system also provides opportunities for the federal government to push its “reset” agenda through credit markets. For example, if the Trudeau government wants to choke off bank lending for certain sectors, it could influence bank lending practices through the Bank of Canada.
The Bank of Canada, holding corporate bonds and enabling credit flow to distress companies, could be instructed to favour or disfavour certain types of borrowers. So far, the bank has wisely avoided discriminatory practices. However, it is not far- fetched that discrimination could set in. With Bank of Canada Governor Tiff Macklem straying into discussions of inequality and climate change and Joe Biden calling last July for the Federal Reserve to fight racial inequality, it is easy to see how the central bank’s role could expand beyond the goal of controlling inflation.
That would be a dreadful mistake, not least for the damage it would do to central bank independence. Social and economic policy interventions are best left to fiscal and regulatory policies, most of which come under parliamentary scrutiny. Playing with credit markets would be playing with fire.
competitive markets help reduce the scope for discrimination amongst borrowers.