A Recession is on the Horizon – Let’s Talk Challenges and Opportunities

By Cameron Bagrie

A key issue I am looking at are changes in the credit landscape over time. We need financiers to price, take, and manage risk. Credit intermediation is a critical component of economic development.

A five year rise in businesses having difficulty accessing credit from banks is coming to a head with a downturn around the corner, tougher lending standards and excessive demands for security relative to the pricing offered. Gaps are opening for alternate financiers.

The Economic Backdrop

Economic pain will be shared in the battle against inflation. Household wealth has fallen $130 billion in six months ended June and house prices are still falling as interest rates rise. That is against a rise in wealth of $670 billion in the preceding two years though.

The interest rate on banks’ mortgage book is around 4%. Rates on offer are above 6%. There is $160 billion of mortgage debt to refinance in the coming year.

The construction cycle will turn. The profitable cycle after that. Margins will be a compression variable as cost increases are matched by buyer resistance. And then the final cycle to turn will be employment. The lesson from the late 1980s was that it can take time for the pipes to be flushed.

The only real known central banks have at present is inflation, and it is a problem they are dealing with aggressively, worrying the longer inflation remain high, the more it will become entrenched.

So, a downturn is coming but that creates opportunities. Rising interest rates mean taking real risk to make real money. Investors are being reintroduced to Mr and Mrs C Ash. Market share is now the name of the game, not just following the market.

Rather than focusing solely on the economic cycle, or economic reset which will involve some pain, we need to be focused on the bigger picture and rebuilding better.

Credit Intermediation

What can we do to ensure better economic times on a sustained basis down the track?

There is a big wish-list. Improving education outcomes is essential. Infrastructure too. Unlocking New Zealand’s comparative advantages in areas such as renewables. We are a country rich in natural resources.

One that receives insufficient attention is the role of credit intermediation. Financial institutions aggregate and mobilise the savings of people to form larger amounts of capital for investment and lending purposes. This capital formation and effective capital markets play critical roles in the economic development of a country.

This aggregation and mobilisation of capital involves taking and managing risk.

Banks make a lot of money with recent profit announcements receiving attention, but do not take a lot of risk. Banks profits have risen at an average of almost 17% per year.

Bank impairment expenses have averaged less than 0.2% since 1991. For the past ten years the average has been less than 0.1 % of total loans. That is alpha profit returns for little risk. It is notoriously difficult to borrow money from a bank without being heavily asset backed. Banks are pricing for risk through margins but not really taking it

Banks are becoming increasingly cautious lending to business as economic signals flash more red. When they do lend, they typically demand high security across as much as they can get including homes, but still command business margins on a highly secured lend. That is hardly taking risk. Hence, gaps are opening for alternative small business lenders who both price and take risk. Falling house prices are also squeezing the ability to tap into the cash flow bank-of-business, which is often the family home.

The Path Forward

During tough economic times, relationships will be tested. Do not wait until you have a problem to tell the financier as by then it is likely a big problem.

The lending landscape looks set to change enormously over the coming decade. New providers are emerging as banks focus on housing and service levels drop.

High bank profits places pressure on the government to accelerate open banking, a mechanism to drive more competition.

Getting out of this inflation mess is going to take investment in capacity and that needs clever credit writing and businesses to demonstrate the ability to take and manage risk in conjunction with the financier as well. Lending goes two ways, not one way, and resides on trust. Financiers have their magic boxes which score credit applications but at the end of the day you need to look the person in the eye and assess if they are good for it.

Lenders are going to need to be both prudent and courageous over the coming years. This is a time where the right decisions will cement long-term relationships.

Be big or boutique. It is difficult to get the scale of a bank – just look at Kiwibank who still lack the size of the major four. Watch for boutique offerings to cherry pick financing opportunities.

The falling interest rate tailwind we have seen for 30 years is now a headwind. That means a different environment for housing and capital gain. That might help screw the scrum in favour of investing in the real productive part of the economy.

That might be difficult to envisage heading into a downturn, but all major thematic changes start with small steps. It will need boldness from financiers and risk appetites all round including businesses improving their financial acumen.

 

*While Bagrie Economics uses all reasonable endeavours in producing reports to ensure the information is as accurate as practicable, Bagrie Economics shall not be liable for any loss or damage sustained by any person relying on such work whatever the cause of such loss or damage. The content does not constitute advice.

For more information about Apricity Invoice Finance or to find out how an invoice finance facility could help your business adapt to changing conditions by giving you access to the funds from your invoices as soon as they are issued visit apricityfinance.com or call 0800 277 424.

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