Lets leave aside the irony of a bunch of wealthy politicians preaching to a bunch of wealthy bankers at an expensive and exclusive black tie event about how they are going to help “the little people” (I love the pic!),  and focus on the proposal.

“Mervyn King announced plans to flood banks with cheap funds in an attempt to jump-start lending to British households and businesses….”.

Let me tell you a little about how banks work. They are privately held entities. Like other firms listed on the stock market, they do what is best to maximize return for their shareholders. If they have 100 units of capital, they, like any other private firm, will look to allocate the 100 in the most effective way to generate the maximum level of return on that capital.

Banks are not responsible for saving the economy, that is the job of the government through public policy and expenditure and by delivering the right incentives to the private sector to do what is best for the whole while also helping themselves.

So, by providing cheaper loans to banks is the government providing the right incentives to the banks to open up lending to SMEs and households? No – and they know it.

All the government is doing is helping the banks more easily raise capital. How they use that capital is not, and will not, be dictated. Yes, some of it will find its way to you, I and our businesses. However the vast majority will go towards the capital markets functions of the banks and in lending to large corporates. The reason is quite simple; lending to SMEs and households is the most expensive activity for a bank to conduct in terms of capital utilised.

A loan portfolio consisting of SME loans is considerably more expensive to hold then a loan portfolio of large corporate loans.  Obviously the revenue the banks earn also defines the return on capital. Let’s say, on average, a bank earns 8% on SME loans and 5% on large corporate loans. This 3 percent difference in no way compensates the difference in the capital requirement between SME and Large corporate loan portfolios, which can be as large as 20%.  Now also factor in the off balance sheet activities of banks – the complex derivatives they trade in the capital markets division that can reap them considerable revenues but cost the bank nothing in terms of regulatory capital.

So, if a bank has 100 units of capital available, what would it do it with it? Well given the incentive structure, in this case, the capital requirements dictated by regulatory bodies such as the FSA, Bank of England, the EC and the Basel Capital Accord, they would allocate zero of that capital to lending to SMEs in order to maximize their shareholder’s return. This is why Project Merlin, the effort by the Government to tie banks to lending targets, failed – though a token effort was made due to brand necessity, the proportion of loans made to SMEs relative to large corporates fell considerably and continues to fall. This is also why the stimulus package announced at the event covered by the Wall Street Journal will also fail – the incentives are simply not there for banks to lend to SMEs.  Given the current trajectory of regulation, I would even stick my neck out and state that banks will exit the business of lending and generally providing SME services within the next 10-15 years. SMEs should be looking at the new finance/Fin-tech sector for support as it is fundamentally the future for SME finance and banking services.

As a spin on the Government proposal and the general conditions for banking at the moment, why don’t you help me take advantage of the situation? I promise at least 20% Return on Equity for any investor who will help me set up a bank. Here is my high level business plan – any takers? ;)

1. I employ some currently unemployed bankers (adding value to the economy)
2. We raise £1 billion of equity
3. We use the £1 billion to buy as much high-grade securities as we can (minus set up costs), paying maybe 4-5% coupon
4. We use the securities as collateral to borrow £9 billion from the BofE at overnight rate of 0.5%
5. We buy another £9 billion of securities at similar rates as the first batch. At this rate, we are earning at least £400 million per annum
6. We continuously roll the overnight position with the BofE, pledging more of the security pool in collateral if required on margin calls
7. We go public. After costs, the bank is earning at least £200 million a year with a high capital ratio (10% equity-to-debt), and the balance sheet will be clean (all low risk securities). Potential valuation of 20-times earnings: £4 billion. We sell 25% of the company for £1 billion
8. Put the £1 billion raised to good use – go back to Step 3
9. When market cap hits £10 billion, sell another 10% of the company for £1 billion. Go back to Step 3 again
10. Expand to US. Fed is lending at 0.25%. Repeat formula. Start focusing on PR and social issues, buy branch networks from defunct banks and start making actual loans to retail and corporate consumers
11. Exit for a ridiculous valuation. We all win!