Introduction
Sir Howard Davies is director of the London School of Economics and Political Science. Prior to his current appointment, he was chairman of the Financial Services Authority.
He served for two years as deputy governor of the Bank of England. Prior to that, he spent three years as director general of the Confederation of British Industry. From 1987 to 1992 he was controller of the Audit Commission. From 1982 to 1987 he worked for McKinsey & Company in London, and during 1985–1986 was seconded to the Treasury as special adviser to the Chancellor of the Exchequer. He has also worked at the Treasury and the Foreign and Commonwealth Office, including two years as private secretary to the British ambassador in Paris.
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.
Slow Road to Recovery
All this sounds rather pessimistic, and I fear that does reflect my state of mind at present. The latest economic data in the United Kingdom is very bad, worse than the market expected. The recession is likely to be deeper than those we experienced a couple of decades ago. The recovery process may be slower too, as banks engage in defensive behavior. When you have been through a near-death experience, survival is the top priority, ahead of expanding into new business opportunities.
But there will be some upsides. I suspect that we may experience quite a lengthy period of low interest rates. Inflationary pressures are likely to be weak, which will give the Bank of England’s monetary policy committee more flexibility with interest rates than it has had for some time. The commodity and oil price spike, which was boosting UK inflation, appears to be behind us. I also expect that the exchange rate will be quite weak, especially against the dollar. This will be part of the rebalancing of the British economy which we need to see. Our balance of payments has been in structural deficit for some time. While it is possible to run a trade deficit for a long period if the rest of the world is prepared to invest in your country, as has been the case in the United Kingdom for a while, it not possible to run a deficit indefinitely, without having some impact on the real exchange rate. There are already some signs that overseas investors are less ready to buy British government debt. That is depressing the pound.
The period from 1997 to 2008 when sterling was relatively high has altered the shape of the British economy, with a smaller exporting sector. My hunch, and it is no more than that, is that it will become somewhat easier to export goods and services from the United Kingdom than it has been in the recent past. So there will be an upside for some businesses. The impact on manufacturing is often discussed, but manufacturers will not be the only people to benefit. I write as the chief executive of a university with a lot of overseas students, which is in effect a service export business at the center of London. 70% of students at the LSE come from other countries. In the recent past, with the pound at two dollars and housing costs in London extravagantly high, we have been an expensive option for students from Asia and North America. At the beginning of 2009 we are already looking significantly more competitive, which is a positive development for us, and for other British universities, training companies, and the like.
Overall, though, there is no hiding the fact that these will be testing times for CFOs. In many cases, funding for 2008 was already in place, with undrawn facilities. 2009 will be tougher, and companies will need to explore alternative sources of funding wherever they can find them. Conserving resources, especially cash, will be at the top of the agenda in many companies for some time. CFOs may become rather unpopular with their colleagues in the process. But if their company survives, while others fail, that unpopularity will have been worth it.
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