CFCM CENTRE FOR FINANCE AND CREDIT MARKETS

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1 CFCM CENTRE FOR FINANCE AND CREDIT MARKETS Current Issues Briefing Why Firms Will Feel The Effects Of The Credit Crunch Prof. Paul Mizen Director, CFCM. Produced By: Centre for Finance and Credit Markets School of Economics Sir Clive Granger Building University Park Nottingham NG7 2RD Tel: +44(0) Fax: +44(0)

2 Why firms will feel the effects of the credit crunch The financial crisis has noticeably affected the willingness of banks to lend to each other, increased the cost of interbank borrowing and has deeply affected the operation of short-term asset backed commercial paper markets. Banks have incurred large losses and were facing severe difficulties possibly the closest they had come to a complete collapse since the start of the first world war - before the injection of capital by central banks. Surprisingly, up to this point in the crisis bank lending to companies has not noticeably reduced, in fact, if anything bank lending to firms has increased. Does this mean that firms have been insulated from the crisis affecting financial institutions? To some extent they have been protected from the effects because the private non-financial corporations (PNFC) sector as a whole was financially healthy in the run up to the crisis. Firms had large amounts of cash and these provided a buffer against financial shocks. They also had pre-arranged credit facilities which allowed them to continue to borrow or draw on lines of credit negotiated when banks were more than willing to lend to firms. It is doubtful that these conditions will continue, and below I give several reasons why this is the case. Already the growth rate of UK PNFC holdings of money defined by M4 have turned negative and have been falling since before the onset of the crisis in August 2007 (see Chart 1).

3 Source: Bank of England Also, the growth in PNFC borrowing has been declining steadily from a rate of percent to 10 pre cent in August 2008 (see Chart 2). Source: Bank of England

4 A similar story can be told in the US. According to the International Herald Tribune Commercial and industrial loans by US commercial banks rose nearly 20 percent over the year from May 2007 to May As in the UK, US lending to firms was negotiated under a different regime and banks have been reluctantly honouring these contracts. This will not continue to be the case. The reasons that lending to firms will be affected by the crisis are the following: 1) Firms may have been able to refinance their operations for 2008, and draw on negotiated lines of credit to expand borrowing from banks, but this will not continue for Firms will have to refinance and renegotiate terms of lending when existing facilities expire. Some firms already have to refinance before the expiration of the loans because they have broken the terms associated with borrowing covenants that require certain actions, including repayment of the loan if certain indicators hit threshold levels. In some cases banks have used market disruption clauses to terminate lending contracts early. Eventually, firms will have to determine how much they can borrow and on what terms with the banks. 2) Many firms will not be offered the same scale of lending because banks are deleveraging and will seek to reduce their overall lending. The most risky loans will not be rolled over for the next period and lending will be restricted to higher quality borrowers. Small and medium sized firms are likely to be more affected by reductions in lending than large firms, but even large firms have had difficulty in managing short-term finance. Renault CEO Carlos Ghosn is quoted in October 2008 by the news agency AFP as saying "Short-term issues have to be treated. That is very, very serious. Today, short-term is about managing cash,". Ghosn made the point that for all types of companies, not just the car industry, the need is to consolidate operations and secure funding. 3) Firms may find that the maturity of lending offered will be shortened. This creates different pressures on company financial officers, because although funding is in place it has to be rolled over more often, and this creates rollover risk the possibility that at some point in the process the ability to rollover even short term borrowing will be denied.

5 4) Firms that are able to borrow will find the cost of bank finance has increased. The cost of inter-bank lending has increased with considerable spreads emerging over the implied overnight indexed swap (OIS) rate, a guide to the inferred cost of funds from the central bank adjusted to the same maturity. The funding gap between loans and deposits needs to be met by borrowing on the markets, and since this is more costly the banks customers will be charged higher rates on any new loans. LIBOR is the benchmark for most corporate loans. Central banks have provided a large amount of liquidity at various maturities including overnight, one month and three months, but it is widely accepted that it will take time for the LIBOR-OIS spreads to fall, and when they do they are not expected to fall to pre-crisis levels despite government guarantees extended to banks that are intended to reduce the risk of lending. Mervyn King has said The age of innocence when banks lent to each other unsecured for three months or longer at only a small premium to expected policy rates will not quickly, if ever, return (Leeds, October 2008). 5) Lenders charge a margin over LIBOR to reflect the risk of lending to corporates. A gauge of the degree of the margin can be determined from the cost of insuring against default on the credit default swap (CDS) markets. These figures have adjusted upwards very sharply and instead of margins being 1 per cent plus over LIBOR they are now very often 2 or 3 per cent plus over LIBOR (Financial Times, Corporate Report, October 2008). Some of the increase in the margin will be the pricing in of recession and the associated risks to corporate creditworthiness. Although it is not possible to know how long or deep the recession will be, most observers are now sure a recession will occur. 6) Firms are caught between a rock and a hard place. Alternative funding options are few and far between. The current volatility of equity markets makes new issues of shares a bad option, and few firms would wish to issue more debt in the form of bonds. The reason many firms will want to reduce debt rather than increase it is that higher debt might very well have an adverse effect on the firm s credit rating, especially if it is close to a rating boundary. When ratings are downgraded there are often substantial costs as covenants can be broken, certain types of investors are required by regulators to sell their holdings of bonds (e.g. pension funds, insurers), and the cost of bond finance itself can rise as investors require higher yields to compensate for a lower rating (higher risk). The feedback from a poor

6 rating can also increase the margin over LIBOR charged by banks, some banks will not lend to firms with a rating below a certain cutoff level e.g. AA, and the implication of a poorer long-term rating in the bond market can undermine the rating in the commercial paper market. One option open to firms is refinance using assets in the firm e.g. asset based lending using stock or sales invoices. Typically the asset-based finance industry will buy the assets in exchange for per cent of the value in cash. Many banks have subsidiaries that engage in factoring and invoice discounting, and at the margin banks prefer to lend on these terms because the profits are greater and the risks lower. Asset based finance is one of the few types of financing that rise in a credit crunch or recession. The evidence that firms have been able to borrow or even extend their borrowing using lines of credit should not lead us to the conclusion that they will be able to continue borrowing on the same terms. Times have changes and facilities negotiated before the crisis will not be obtainable in the future.

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