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Balance Sheets Viewpoints

Mend the Balance Sheet

by Sir Howard Davies

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The New Rules of the Game

This is a remarkably challenging time to be a chief financial officer (CFO). All the comfortable assumptions of the last decade or more have been overturned in a very short time; the credit crunch is rapidly rewriting the rules of the game.

For years, banks have been almost embarrassingly keen to lend. That has been particularly true in the case of lending to individuals. We have all received credit card cheques through the mail, and regular encouragements to take out larger and larger loans. As a result household debt in the United Kingdom is even higher than in the United States, as a percentage of GDP. It has been reasonably easy to secure credit for companies too, even those without a great story to tell. In a booming economy, the rising tide lifted all boats. Now all that has changed. Banks are not at all keen to lend, and the terms on which they do so have been deteriorating rapidly.

Why is that the case? Well, the simplest answer is that they need to repair their balance sheets to cope with the effects of the lending binge and the associated hangover. The losses on mortgage and other lending are massive. In its Financial Stability Report of October 2008, the Bank of England assessed the write-offs for British banks at around £130 billion. That is reflected in banks share prices, and their need to rebuild their reserves. Until that process is complete, and it may well take some time, their appetite for new exposures will be extremely limited.

While many of us may understand, intellectually, why banks are behaving in this way it does not make the consequences for companies any easier to manage. Now good credits are finding it hard to raise finance. Suddenly, cash is king, in a way it has not been in some time.

Of course, the simple point is that we are entering a recession. That is a novel experience for many. We have not experienced a downturn in the United Kingdom since the spring of 1992. The British economy enjoyed 64 consecutive quarters of growth. In fact, the economy began to pick up at exactly the same time I was appointed director general of the Confederation of British Industry. Not even I would claim a direct connection, but my point is that the last downturn was so long ago that most of those in senior management positions in British companies have little memory of how recessions affect corporate life.

Companies were slow to react. Indeed, I think this is one of the reasons why the recession took some time to hit us, but it hit us with some force in the second half of 2008. In the 1970s and 1980s, when downturns were more frequent, companies knew how to react. At the first sign of trouble a hiring freeze would be put into place, followed by a memo from the CFO saying that every order for a pencil should be signed by him personally. This time, there was a delayed action response, as people tried to pretend for a while that it wasn’t really happening. Now they know that it is for real, and it is likely to be painful.

But this recession may be unlike those we used to know. There is a famous sentence at the beginning of Tolstoy’s Anna Karenina to the effect that all happy families are happy in the same way, while all unhappy families have their own particular sadness. I suspect that this is true of the economy as well, and that each recession has its own particular characteristics. This time, the most marked feature is availability of credit. We know that, for households, the borrowing boom of the last decade is over, and that our saving rates will need to rise. Something similar will be true for companies also. For the moment, I imagine that many investment projects have been put on hold. That will not last forever, of course. But when it is time to invest again, there will be a premium on the use of retained earnings as far as possible. Just as banks will be looking for larger deposits from borrowers in the mortgage markets, and lower income multiples, so they will also be looking for companies to fund more of their investment projects themselves. This mechanism will, of course, reduce the speed of the upturn when it comes, but I fear that is an inevitable consequence of the type of recession we will see this time. Regulation will have an impact on borrowing costs too. I hope we avoid overreaction, but it is inevitable that capital requirements on banks will be tightened, which will increase the cost of borrowing. If banks are required to hold larger reserves, their ability to lend is constrained.

We can also expect some of the more imaginative and complex funding schemes, which banks and investment banks have been promoting in recent years, to be less in evidence for a while at least. The credit default swap market will certainly decline, and other derivatives markets will suffer as well. Financial regulators will be keeping a much closer eye on this kind of financial engineering than they have done in the past. It is clear that credit expanded more rapidly than the authorities foresaw, through the use of derivatives and off-balance-sheet vehicles. Regulators will try to prevent that happening in future.

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Further reading


  • Bank of England. “Financial stability report.” Issue 26 (December 18, 2009). Online at:

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