The case against a British Investment Bank

Before the PM goes mad and endorses this crazy idea, let’s look at why State-owned banks tend to go horribly wrong

Spain could be bust in two months. It is being ruined by bail outs for state-owned banks.

So what better time for the Labour Party to demand… a new British state owned bank!

This bank could spray taxpayer cash at SMEs, solving the funding gap.

It could also invest in infrastructure projects which the private sector won’t touch with a barge pole.

What could go wrong?

The proposal is made by a new Labour Party report The Case for a British Investment Bank, and being championed by the Labour High Command, led by Chuka Umunna and Ed Miliband.

A little more surprising is that the British Chambers of Commerce is backing the idea. The director general, John Longworth, is raving about it (“companies want nothing less than a new-model economy for Britain” etc etc). The Federation of Small Business is backing it too.

The CBI is emitting sympathetic gurglings.

On Sunday, George Osborne said he too believed there is a place for a new state bank which would lend to small firms and handle major infrastructure projects.

Enough! Before David Cameron goes insane and green-lights a British Investment Bank, the bonkers idea needs blowing to smithereens – believe me, this won’t be a hard job.

Just look at the last time the government had a crack at this sort of thing.

Back in 2002, the Labour government launched Regional Venture Capital Funds. State money matched private-sector cash to invest in cash-hungry young firms. RVCFs were a proto-form of British Investment Bank. Gordon Brown loved the scheme just as much as Chuka Umunna loves the current idea.

What happened?

RVCFs were an utter, utter disaster. They turned £93m of taxpayer cash into £5.9m , a fall of 93 per cent.

Naturally, the new Labour report makes no mention of RVCFs. In fact, it makes no mention of any failure associated with state schemes to meddle with the private sector whatsoever. Decades of failure? Ignore it! The Spanish state-owned banking meltdown? Not mentioned at all.

But the report deserves dismantling on its own merits.

The report was written by Nicholas Tott, a former partner of corporate law-firm Herbert Smith. Tott is an expert on PFI deals. He is a man with serious credentials, and to give him his dues, he spots the obvious problem with a British Investment Bank.

The paradox runs thus: if the bank invests in commercially viable projects it will be competing with the private sector (so called “crowding out”). So it won’t add much.

If it invests in commercially unviable projects which the private sector won’t touch it risks wasting its money on white elephants.

Thus, it will be either redundant or wasteful.

Tott tries to get round this problem by invoking the idea of “market failure”.  The British Investment Bank will focus on a supposed niche where excellent investment opportunities lie, but no market lender will venture.

And where lies this Narnia?

He says: “Market failure is caused by an asymmetry of information between debt provider and business borrower. Lenders find it difficult to distinguish between high and low risk businesses without incurring significant costs. Lenders seek to avoid those costs by basing the decision to lend on evidence provided by the borrower as to its track record and/or the provision of collateral. This obviates the need to assess whether the business is economically viable. This may also be exacerbated by the effects of credit scoring systems which are designed to reduce information costs and improve the quality and consistency of lending decisions but which may increase the likelihood that firms with atypical businesses in higher risk, cutting-edge areas, fail to secure loans.”

The only rational reaction to this is: sorry mate, no deal.

Lenders base their lending decisions on “track record”? Of course they do. Do I need to explain why?

Lenders want collateral? Of course they do. That is because they don’t want to be left with no recourse if the person they lend to goes bust. This is not a market failure. It is how the market manages risk.

Tott is onto something when he says that businesses with unusual or high risk business models often fail to get loans. This is true. But why would a British Investment Bank be any better at sifting out the ones with real merit from the basket cases?

Chuka Umunna has said the British Investment Bank “is not a 1970s concept of picking winners”. Yet this is precisely what Tott is advocating here. He genuinely believes the staff of a British Investment Bank would be able to pioneer an investment strategy which is superior to any used by current market participants.

Part II

A British Investment Bank would have a second remit, also described by the report, namely investing in infrastructure.

Tott notes: “In the area of privately-funded infrastructure projects there may be areas where the risk of delivery is such that the market is unable, or unwilling, to finance the projects and where government intervention is necessary to facilitate the project.”

And how would the British Investment Bank determine which projects are “necessary”? What does Tott have in mind? High Speed Rail 2?  A National Centre for Popular Music in Sheffield (god, remember that epic screw up)?

It’s impossible to know. Tott names no projects. He provides no investment criteria. He merely insists certain projects are “necessary”, and thus merit investment. The only detail is:  “There are over 500 infrastructure projects and programmes over the next decade which will need funding, with an aggregate value of £250bn”.

This segment of the report is so ill-defined as to be worthless.

Yet more problems

State-run banks such as the British Investment Bank have historically gone wrong because of political meddling. The Spanish banks are a case in point – they made politically motivated loans to property deals in politically sensitive locations, and lost tons of money as a result. Parties of all hue understand this. When RBS was nationalised Gordon Brown and Alistair Darling emphasised repeatedly that ownership would be hands off for this very reason.

How would Tott deal with the problem of meddling?

He says: “one possible route would be to establish an Advisory Council which would not have executive authority over the Bank but which would meet with the board to review the effectiveness of its dual bottom line strategy. Members of the Advisory Council could include representatives of key government departments, trades unions, representatives from business, and others.”

The Bank would be crawling in lobbyists. Well, it’s a novel strategy.

There is the problem of how the firm would be run. Would the British Investment Bank offer bonuses and competitive salaries? If not, how will it attract high calibre people? If the staff are paid below the market rate then the risk of commercial failure increases.

There is the problem of incentives – Milton Friedman’s “other people spending money on other people”. The workers at this Bank would be spending other people’s money on other people. There is no incentive for them to do a good job. Will they do an outstanding job in allocating funds through altruism? Tott assumes so.

What if things go wrong? Post-Lehman Brothers we are all agreed that banks must be allowed to fail. Would the British Investment Bank be allowed to keel over and die? Pathetically, unforgivably, Tott fails to mention this
issue.

Perhaps the biggest problem is the mindset. The Cold War gave us decades of data on which economic models work, and which do not. The socialist model of intervention “took a nation of Germans and made them poor” (©PJ O’Rourke). The non-interventionist model allowed third world nations like Taiwan and Malaysia to become first world powerhouses.

The British Investment Bank is a relic of Cold War thinking, when it was naively believed that rational planners armed with taxpayers’ money could allocate resources more efficiently than the market.

It didn’t work then. Labour’s report provides no reason to think it would work now.

If Osborne is seriously thinking of endorsing a British Investment Bank he must be more desperate than any of us realise.