Regional banks for a regional industrial policy

Article first published on Shifting Grounds

According to George Osborne, the strength of an economy is reflected in its bond yields. Textbook theory tells us that if a sovereign state can borrow cheaply on the open market, it is considered less of a risk for investors.

This idea has come to the fore recently as a result of the problems faced in Greece and the wider Eurozone, where the possibility of default on domestic loans has increased sovereign risk and caused yields on southern European bonds to explode.

So far, this logic has seemed to hold up: the larger the risk, the larger the expected return. But George Osborne would also have us believe that low bond yields show that investors feel secure in our economy and want to put down roots – apparently, we are a ‘safe haven’. Unfortunately, he has conflated sovereign risk (the type seen in Greece) with willingness to invest in the real economy.

Imagine you are an investment manager controlling hundreds of millions of pounds. Your task is to invest this money in order to make a large enough return to be able to make pay outs, cover running costs and generate profit. The options you have in front of you are to employ complex financial instruments via investment banks, to invest in companies via shares or to lend money to the government by buying bonds.

The first of these is currently out of vogue given the level of risk it can entail. The second is less attractive because of firms’ anxiety about their potential to grow and generate profits. They are cutting back in order to stay afloat as they see demand in the economy drop, inflation stay high, and household incomes shrink. Furthermore, with the Eurozone (our largest trading partner) having difficulties, the potential in the short term for an export-led recovery is severely hampered.

The only option which is certain to generate a return (albeit a very low one for an investment) is lending to the state. So lower bond yields, inspired by increased demand from equity-shy investors, do not point to healthy domestic businesses: quite the opposite.

This myopic focus on maintaining our credit-worthiness is disproportionately hurting those industries – outside London and the City – which struggled to get investment during the good times, let alone now. There should be a coordinated approach to boosting these regions’ profiles by local authorities, Mayors and UKTI using links the region has to other parts of the world: through immigration and universities, for instance.

But securing funding for these industries is not merely a matter of publicity. Returns on investment within small scale manufacturing or research, for example, are much lower than in the financial sector and so, unsurprisingly, capital flows to the City. To ensure capital flows outside the M25, we need an institutional structure that supports change.

A regional bank is a financial institution which only lends to businesses and entrepreneurs within a defined, geographical area. Its objective is to invest and lend to businesses to create long term, sustainable growth. As a result, it has a natural bias towards human and skills development, research and innovation. Initially funded by the state, it is self-sustaining in the long-term as a result of earning a margin on its loans, and spreads risk by diversifying its portfolio.

The first plank of a workable regional banking policy is that any future quantitative easing through these institutions and use them on regional/city industrial policy. This would stop new capital sitting as reserves in private banks or as corporate bonds but would get transferred into the real economy.

The second is to make state loan facilities available – or indeed open up the Public Works Loans Board – at preferential rates to small-medium enterprises. This would boost local growth and help create resilient domestic supply chains.

Finally, regional banks must be linked with private investment banks  and pension funds, both in order to understand what private investors are looking for, and to champion a range of potential investment opportunities in their region. If the risk (or return) is too high (or too low) then incentivising private capital with regional bank guarantees should provide the necessary momentum.

Of course, as with any investment institutions, there will be poor results and even defaults. And we must be aware that for some sectors – in particular high-tech manufacturing, research and innovation – there may need to be sustained investment which is loss making over a period of time before the market will take interest on its own.

But the price of inaction is continued under-investment outside financial services and the south east. For now, the UK is only a ‘safe haven’ for sovereign risk. If regional banks can utilise their employees’ local knowledge and expertise, as well as root their decisions on the basis of first-hand economic research, the investments they make will help to draw attention to safe havens that currently fall outside the radar, and to achieve that much-discussed goal of ‘rebalancing the economy’.

Joe Sarling is an economist. He blogs at www.commenttoday.org and tweets from @joesarling.

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