News | Wednesday, 08 April 2009

Cash Flow Dilemmas

By a special correspondent

Banks loan out depositors’ money and therefore have the legal and moral obligation to be prudent. They cannot expose themselves to high risks and need to be reasonably sure that they will be able to collect any loaned money back plus interest. Banks, like any other business concern, also have an obligation to their shareholders that translates into the quest for maximisation of profits. Our banks have historically done quite well under both the prudence and profitability criteria.
Ultimately, any bank wishing to prosper must make itself attractive to safe borrowers. Inevitably, the desire for more business will lead a bank to conduct business which does not give the highest assurances of safety. But a bank must be able to manage risk. Bad debts are inevitable and as long as the volume of debts written off is small compared to the overall profits, then the risk is not only worth taking but enables the bank to balance the interests of other stake holders with those of shareholders and depositors.
While no bank is a charity, stakeholders are important. As with any other employer, a bank needs to give its employees security and the possibility of career advancement. This is only possible if the bank grows and prospers. To be able to grow, a bank has to be able to manage risks competently – refusal of all risk is not an option. Borrowers are the bank’s customers that generate revenue. They are vital to the bank’s existence. Not all borrowers are equally competent or honest or even fortunate and it is up to the banks to determine to whom and under what conditions it lends out depositors’ money. This is the bank’s most important function. It feeds momentum to the economy by using cash that otherwise would remain idle and helps bring prosperity to the community at large – and not merely to its customers, employees and shareholders.
A bank that decides to keep only the very top notch customers would soon find that its customer portfolio is too small. In particular, this applies to the present circumstances when the global recession is affecting practically all business entities, when even former high repute, very solid firms are now facing uncertainties and declining future prospects. Banks also advance money to individuals to cover personal requirements – be it through credit cards, personal overdrafts, home loans or similar credit facilities. This credit is important to keep business going. Banks normally assume that there is safety in numbers. Only a small proportion of borrowers are expected to default. Many loans are specific to a purchase and frequently secured. This risk is normally considered tolerable.
In the case of a major recession, the proportion of defaulters could however increase substantially and the realisable value of security, for example property, could become much lower than originally estimated. Small and medium enterprises are a problem. Many small companies rely strongly on credit facilities. In Malta’s specific case many customers expect credit to be a condition of sale and many customers have become used to pay well after the due date. With declining business, those who wish to sell will see their profits decline further unless they offer credit. Cash flow becomes a disaster and with the banks taking a more prudent approach and withholding additional credit facilities, many SMEs are expected to crash. The result is not merely that this will impact investment, employment and other business. The banks themselves are unlikely to be able to collect outstanding dues from bankrupt businesses. Already we have a situation where low demand is causing a drop in property prices and any further loss in demand could lead to the point where the real value of security held by banks is less than what is owed to the banks – as Moody’s have pointed out.
So far, the situation is tolerable. Government has intervened to assist when large industrial employers ran into problems. This is admirable, especially given the financial constraints Malta faces. The Minister of Finance has made it quite clear that Malta cannot afford to handle simultaneous demands from all and sundry. However the problem remains that while Government is doing the right thing in protecting the employment prospects of larger entities, what happens when a shopkeeper fires two sales girls? Malta can live with small job losses but what happens if there is a general trend for several small entities to cut down on their employment? For both the country and the individuals concerned, the situation would be disastrous.
It is easy to say that banks and/or Government must ensure that credit continues to be available at the desired levels. The banks have been largely spared major adverse impacts so far because of the prudence principles applied in years past. Can we expect them now to throw prudence to the winds when risks are higher? Government finances are what they are and the national debt is a huge millstone round our individual and collective necks. If Government were to make available funds to all and sundry, Malta could be bankrupt in a couple of months. The situation will become easier to manage if all concerned try to avoid a situation where credit demand exceeds supply. In an ideal world, Government would guarantee part (not all, as the banks have to accept some responsibility for their judgement) of the additional credit risk taken by the banks and the banks would accept a cut in profit expectations. The ultimate borrower would still accept ultimate responsibility for repayment – credit guarantees may have to be issued to individuals and not limited liability companies. Higher risk credit can also claim higher interest. Can Malta afford such a scheme? This is difficult to answer so we should ask a slightly modified, if rhetorical, question: Can Malta afford a situation where credit becomes difficult to get? The next question is: How bad must the situation get before we do something about it? The answer is that the worse the situation gets, the more difficult it becomes to turn round.
However bad our national finances, Malta needs to avoid above all the situation where we would have to resort to massive external borrowing. The bulk of what we owe is domestic and while the size of the debt is frightening, the one positive aspect is that our international indebtedness is contained. This is a case where we need to manage our collective private wealth in the best national interest. This would be also in the interests of those who hold a greater share of this wealth. After all, we sink or swim together.



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08 April 2009

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