“In a market economy such as ours, economic activity or growth is not dictated by Government but rather determined by entrepreneurs and their employees working in their own self-interest. The Government’s job is to create a favourable and fair environment for job makers to thrive, just as a farmer’s job is to provide fertiliser and water for his crops to grow. The farmer knows he can’t make his plants grow — nature has to take its course — but he does what he can to nurture growth. Similarly with the economy, growth will come from innovative people who see the need for a product or service and are free to seize the opportunity to make it happen.” - Finance Minister Bob Richards

The quote above from Mr. Richards is a great one. The concept of the government making a favourable environment and then “getting out of the way” is a key aspect for any chance of success for business in Bermuda. That’s why we need to be careful when we criticise certain sectors or corporations in general within Bermuda. I’ve said this before but it bears repeating: you can’t be for employment and against employers. I won’t debate being a good corporate citizen or ethical banking in this piece but I offer a few comments in defence of capitalism and the business of banking.

Banking is business

In the Minister of Finance’s recent budget speech he suggests banks aren’t lending because loans outstanding are falling and they need to do more. Essentially, the problem with credit is supply. But I don’t think it is that simple. Perhaps there is less demand. In a weak economy many business owners are not expanding so they don’t really need additional financing. Also, in all credit cycles, there comes a point where the debts are repaid. Bermuda is simply on the backside of this cycle (more on this in a future article). Debts are being written off with defaults and many people have become conservative on overall leverage and are simply repaying old balances and not seeking additional financing.

All these factors suggest it is not as simple as making banks lend or that reduced financing is solely the banks fault. Without complete statistics we really don’t know if the demand side is also to blame regardless of the anecdotal evidence of some people suggesting they can’t get a loan. Just because some people can’t get financing, it may be just as much due to the risk of their project and/or the lack of its viability.

That brings us to another point — banks are not in the risk capital game. As a depositor you should hope they never get into it. In fact, I support prudent and boring banking as the security of depositors should be a paramount consideration. But the need to protect depositors leads to less risky lending such as mortgages and loans secured against real assets such as homes and cars. This is where Bermuda has a gap.

There is no real established risk financing source. We do not have much in the way of local private equity, mezzanine financing companies and/or angel investors, except for some individual risk takers. These are areas where marginal risk capital is produced — not banking.

I often hear the comment that if banks just allowed people to refinance at much lower rates a large amount of capital and consumer discretionary income would be released into the local economy. By lowering overall mortgage rates more in line with those in the US, Bermuda’s debt servicing costs would fall dramatically and additional disposable income is instantly created.

This, of course, is very true but probably not realistic. The US housing market (and many other developed markets for that matter) is hugely subsidised by the US federal government. Between Fannie Mae, Freddie Mac and Ginnie Mae the federal government essentially underwrites a large percentage of the US housing market. In fact, in 2009 Fannie Mae and Freddie Mac, the government-controlled companies, issued and guaranteed more than 71 percent of mortgage-backed bonds.

Between those companies and Ginnie Mae, which guarantees loans insured by the Federal Housing Administration, the government backed nearly 97 percent of US mortgages in 2009. Government-backed mortgages have accounted for more than 90 percent of US housing financing since 2008.

The entire US housing market is heavily subsidised and this is one of the major reasons why rates are so low and can be locked in for long periods. However Bermuda banks have no major outlet to securitise loans so all lending is retained on their own balance sheets. One could also argue that due to the size of the market and lack of diversification their risk is much higher and thus the rates they charge are commensurate with this.

This does not even consider that Bermuda’s economy is not extensively diversified and is a higher risk locale than many other developed markets which, in itself, would suggest much higher lending rates than most developed economies. So, unless the Bermuda Government wishes to get involved in the local mortgage market (not recommended) it’s unlikely that local homeowners will be privy to such a luxury.

The last comment I’ll make is on employment. It is unfortunate that the local banks have become, and have been, net job destroyers. At this point in Bermuda’s economic cycle it certainly doesn’t help but I don’t think they are being draconian from a business perspective.

Let us look at a measure called the efficiency ratio. The efficiency ratio essentially measures operating costs to operating earnings and how effectively a bank utilises its assets. The lower the better.

Shareholders want to see that their bank is run effectively and at least in line with peers. According to the Federal Deposit Insurance Corporation (FDIC), banks with between $1 billion and $10 billion in assets (a range for banks in Bermuda) currently on average run at an efficiency ratio near 70 percent, with a range of 58 percent to 72 percent over the past ten years. This compares to Butterfield’s core efficiency ratio of 72 percent, HSBC’s cost efficiency ratio of 53 percent (2012) and Capital G’s efficiency ratio of 82 percent (my calculation).

So as a group they are pretty much on average compared to similar banks. That is now. In recent years, Butterfield’s efficiency ratio was as high as 94 percent (2010) and as low as 66 percent (2007).

A lot of the reduction in staffing is simply a reflection of what has happened in banking around the world. JP Morgan this week, for example, announced an additional 8,000 job layoffs in its mortgage unit. The downsizing in banking is not simply a Bermuda issue, it’s a global one. This is an industry that has become increasingly more automated and computerised while at the same time constrained in growth due to slower growing economies and regulatory oversight. As growth returns to Bermuda’s local economy there may be scope at some local banks to add positions. Banks, however, do not typically offer employment growth ahead of economic development.

The last few years has seen a wave of “banktivism” and anti-banking rhetoric that borders on anti-capitalism throughout the World. It is, in my opinion, a bit worrisome that nations continue to demonise and admonish banking. Banks offer a critical intermediary function in our capitalistic economy. Most situations are not as simple as they first appear. There are often a myriad of risks and structural issues that are not very transparent for many to see when it comes to setting mortgage rates and lending. We need to tread carefully when we criticise any business sector so as not to further discourage their commitment, involvement and investment in Bermuda.