Expert Commentary

Deflation Mindset Setting In

The Bank of England is concerned that lenders are not going to lend.

As European banks release results over the coming days, there is increasing uneasiness that they might be showing signs of an unwillingness or, indeed, inability to lend to businesses desperately in need of bridging loans to get them through this crisis. According to the Financial Times, the Bank of England's Prudential Regulation Authority is advising banks not to go overboard in setting loan-loss provisions, fearing that such action will limit the capital available for banks to use in fresh lending. Rather ironically, the Prudential Regulation Authority is telling banks not to be prudential! U.S. banks have increased their loan-loss provisions by hundreds of percent, and the fear is that this behavior will hinder any recovery.

The problem is that banks are commercial enterprises, and they take lending decisions based on the circumstances of the moment. They see the economy imploding and are acting as one might expect during deflation. A deflationary crash is emerging whereby defaults are rising, making lenders less willing to lend, leading to further bankruptcies. As this develops, borrowers will also become less willing to borrow, and the whole house-of-cards will collapse. Unless governments are planning to nationalize banks and force them to lend, banks will do what they think is best for them to survive. The increasingly conservative behavior that categorizes deflation looks set to continue. As the chart below shows, yield spreads (and defaults) are probably on a rising trend.

Bloomberg Barclays Pan-European High Yield Index (EUR) Option-Adjusted Yield Spread