The Impact of LVT on Bank Lending

Introduction

This paper responds to a question posed by officers at HM Treasury regarding the impact that replacing existing taxes on labour, capital, production and trade by the collection of land rental value as public revenue might have on the UK banking system.

The introduction of LVT to replace existing taxes should not be seen as a stand-alone measure of economic reform but rather an essential component of a body of reforms aimed at strengthening the national economy and the welfare of all the nation’s citizens. Its introduction would make all other desirable reforms easier and without it other social and economic reforms would be more difficult and in many cases impossible. As the current banking and debt crises continue to demonstrate there is an urgent need to reform our monetary and banking systems as well as the tax system.

The Credit Crunch

The financial crisis of 2007 to 2009 led to the failure of four major UK banks with the result that they had to be taken into Government ownership to avoid what would otherwise have been a collapse of the banking system. The episode revealed the inherent instability in the banking system in the UK. The overall effect was characterised by Lord Turner as “the biggest collapse of confidence in the money markets which had occurred since 1914”. One of the banking system’s cornerstones, namely trust, was undermined and had to be substituted by trust in the state. This meant that it was felt necessary to guarantee bank deposits through the state UK Bank Deposit Guarantee Scheme.

The crisis could be regarded as international and having its origin with the “sub-prime mortgage crisis” in the United States. There is also a tendency to focus on issues relating to the effect of complex financial products within the financial system. This view gives a sense that somehow the UK banks were passive victims of circumstances. This is to miss the point. The core of the issue lies at what happened at the interface between the financial system and the real economy. To get a clear view of the core issue that led to a number of UK banks failing it is helpful review the actual activities they were following at the time that led to their failure.

Northern Rock[1]

Northern Rock was originally a Building Society. It was founded in 1965 as the result of the merger of a number of smaller societies. In the 1990’s along with many other building societies it de-mutualised, became a bank and floated on the stock exchange.

By the end of 2006 it had become one of the top five UK mortgage lenders. Its business model was based on extending credit to provide mortgages for domestic property. The books were balanced through short term borrowing on the UK and international money markets. After being created the mortgages were not retained by the bank but securitised and sold on in the international capital markets. This supplied funds to repay the loans.

In mid 2007, following a loss of confidence in securitised products the market for these dried up. In August of that year Northern Rock found itself unable to repay its short-term loans. In September it received liquidity support from the Bank of England but the ensuing loss of confidence led to the ignominy of a run on the bank as depositors rushed to rescue their deposits. In February 2008, after the search to find a buyer for the failing bank was unsuccessful, the bank was nationalised with the shareholders receiving no compensation for the disappearance of their investment. It is important to recognise that the lack of wholesale funding was only half the story. Examination of the Bank’s books showed them to contain a large of number of loans for which the value of the property assets used as collateral had decreased well below the value of the loan issued and many instance of arrears in repayments of loans. In January 2010 the bank was split into a “good bank” and “bad bank”, the latter to hold these “bad” loans. At this time Northern Rock remains in public ownership but has resumed its practice of issuing and securitising property loans.

Bradford and Bingley[2]

What was previously the Bradford and Bingley Building Society became a bank when it de-mutualised in 2000. Over the following eight years it set out on a path of significant growth. Its direction was strongly influenced by its acquisition in 1997 of Mortgage Express, a brokerage that focussed on self-certification, buy to let and 100% mortgages. In addition it made a succession of deals with the US company GMAC to buy at regular intervals tranches of the same types of self-certified, buy to let and 100% mortgages.

Before mutualisation Bradford and Bingley had £15.5b of deposits and a loan book of £18.4b. By June 2008 deposits had increased to £24.5b but loans had ballooned to £41.3b. This impressive growth was funded largely by borrowing from wholesale markets. 60% of the loans were buy-to-let mortgages and 20% were self-certified.

In June 2008 the credit crunch caused wholesale funding to dry up. An attempt at a rights issue was not well received and in September, to avoid the bank going bust, it was nationalised. Subsequently the deposits and branches were sold off to Abbey National which later became part of Santander. The mortgage business now contained a large proportion of loans with the value of the collateral less than that of the loan. It was combined with Northern Rock’s bad bank and remains in public ownership.

Lloyds-HBOS[3]

The reason for the downfall and subsequent nationalisation of Lloyds was its acquisition of HBOS. The latter banking group was formed in 2001 on the merger of the Halifax, a former Building Society, with the Bank of Scotland. The former had a tradition of lending to the domestic property market and the latter of lending in the commercial property market. In the years following its formation HBOS undertook rapid expansion largely through loans for the purchase of property with its Corporate Division very active in lending for the purchase of commercial property. In 2003 HBOS lent £112b producing total assets on its balance sheet of £408b. In 2007 it issued £231b of credit taking its assets to £667b. On the other side of its balance sheet retail deposits were only £243b and there was £248b of wholesale funding. In 2009 it had a 20% share of the domestic mortgage market.

Things started to go wrong in 2008 leading to the take over by Lloyds sanctioned by the Government. The reason for HBOS’s failure was summarised by the out-going chairman Andy Hornby as follows:“it was the combination of being property-based on one side of the balance sheet with a significant reliance on wholesale funding on the other.”

Lloyds acquired HBOS in early 2009. In the previous year its commercial property portfolio had made a £24b loss. In the following year there were further losses of £15b. These losses were produced principally by a decrease in the value of the property used as collateral for the loans. The takeover had happened in something of a hurry. When HBOS’s books were examined more carefully on Feb 2008 they found £80b of bad debts. This included £31b of buy to let and sub-prime mortgages and £40b of commercial property loans.

Royal Bank of Scotland (RBS)

The fourth bank to fail was Royal Bank of Scotland. The situation here was rather different from the other three. The full story has yet to appear since there has been a reluctance to publish the report on its downfall. RBS is a large banking group with various activities in financial services. Its demise was triggered by a £5.9b write-down following the folly of the acquisition of the Dutch banking group ABN AMRO in 2007 just as the financial tide was turning. However, RBS was exposed to the UK property market with 15% of the mortgage market and 20% of the commercial loan market. When the UK Government set up the asset protection scheme to support toxic assets, i.e. bad loans, RBS was happy to transfer £325b of assets to the scheme. RBS continues to report losses. A large proportion of these are due to its subsidiary Ulster Bank which so far has made a loss of £8 billion mainly due to the reduction in the value of domestic and commercial property used as collateral for loans.

The Basis of Banking Instability

The ICB interim report on stabilising the banking system published in April 2011[4] gives a description of its view of the basic functions of banks:

"… banks do not take deposits simply to provide safety for the savings of the public. They use funds that are deposited with them1 to provide loans to businesses to allow them to undertake productive economic activities, and also to consumers. The banks pay interest to depositors for the right to use their funds to make loans. They make a profit by charging a higher rate of interest on loans than they pay on deposits. Getting access to loans is advantageous to borrowers – and to the economy in general – because capital is able to circulate, and be used in an efficient manner."

This description bears very little resemblance to what the UK banks that failed were actually doing. Their activity consisted of extending credit for customers to purchase property, either domestic or commercial, and then balancing the books by borrowing from money markets. It had absolutely nothing to do with “productive economic activity” and only incidentally with taking deposits.

The convention is that loans are valued as “assets” on the balance sheet based on the value of the properties they are being used to purchase. There was an expectation of an income stream but not from what the credit was extended for. There was the expectation that the purchaser would repay the loan from some other source.

The practises of these banks supports and encourages a basic business model for the UK economy which consists in a large part of us simply selling houses and commercial property to each other at ever increasing prices.

Bank of England statistics give an indication of the dominance of this process. Table A3.1 give total M4 lending in Feb 2011 as £2,425b. A5.2 gives total secured on dwellings by individuals as £1,241b, very close to half the total. The total lending for commercial property in the UK in that year was approximately £250b[5]. These figures show the extent to which the economy is dominated simply by the buying and selling of property. A little reflection shows this is inherently an unstable process. It is unsustainable. The process produces no new wealth yet a vast quantity of credit is being created to finance it. (New housing is only a few per cent of the total stock). As the prices of property increase the point has to come where they can no longer be supported by the real economy, then the crunch comes.

Meanwhile, the extension of credit to “productive economic activity” is starved. The IBC report noted that in 2009 90% of lending to SME’s (small and medium enterprises) was in the hands of only 5 banking groups. There is an effective monopoly with frequently unaffordable interest rates being charged and frustration that the credit for genuine production is not forthcoming. The situation for large corporations may be different but here the credit is frequently used not to invest in production but to acquire assets. The recent controversial acquisition of Cadburys by Krafts, funded by credit extended by RBS, is an example of this.

Stabilising the Banking System

This analysis suggests that the way not only to stabilise the banking system but to provide the stimulus for real growth in the economy is to get banks to re-direct the extension of credit away from inherently unstable process of financing asset purchase towards productive economic activity. There are a number of approaches that could be taken of which the most obvious relate directly to the banking system itself.

There are issues such as the risk weighting of assets in regard to the new regulations relating to capital reserves. This give much higher risk weighting to business loans than to property-based loans making the latter inherently more profitable.

There is also the accounting convention in which the doubtful debt provisions for bank loans relate to the value of the collateral behind the loan rather than the income stream that provides the repayments. This greatly disguises the risk. For example supposing a customer takes out a mortgage of £200,000 on a house valued at £220,000. They have a regular job and so are able to make regular repayments. Supposing there is a dip in the housing market and the house is valued at £180,000. The bank now is regarded as having a bad loan on its books but what is the real significance of this? It is the same house and more importantly the mortgagee is still in the position of being able to make the repayments. The bank’s income stream is unaffected. The real problem for the bank comes not when the value of the property changes but when the customer is ill or injured and cannot work or loses his job because these are the times when the flow of income stops. Basing the evaluation of bank assets on the income stream that is used to repay them rather than on the collateral gives a more realistic view of their real value and better assists in evaluating the relative merits of loaning for the purchase of property against loaning for production.

Bank Stability and the Incidence of taxation

There are also factors outside the banking system itself that can help to bring stability to it. The main one of these is the incidence of taxation. In economies such as ours, where Government Revenue constitutes almost half of GDP, taxation becomes one of the major determinants of the direction of business activity. As the large banks have been keen to point out recently even companies that manage to avoid paying corporation tax make a considerable contribution to the exchequer through PAYE, national insurance and other taxes. For productive businesses the tax burden is a significant influence on whether the business is viable. Often it is the demands of HMRC that send a company over the edge. To look at it another way, if workers were happy to have the same take home pay as they do now how many more businesses, particularly SME’s with high labour costs, would be viable if there was less income tax or national insurance to pay?

By comparison the increase in the price of property, particularly domestic property, comes tax-free. Commercial property gains may carry capital gains tax liability but the registering of subsidiaries offshore provides the means of avoiding this. Those who claim they bought a house ten years ago for £200,000 and that now it is worth £500,000 could be viewed as having made gains of £300,000 for which no tax is liable on a continuing basis.

Under present circumstances lending for productive activity is very unattractive to banks. It no longer makes business sense for them. At the same time creating credit for property purchase is attractive. The incidence of taxation has a significant influence on this. Hence changing the incidence of taxation from production to property would affect the behaviour of banks and thus help bring stability to the banking system. (A recent OECD report[6] on taxation gave similar general recommendations in relation to encouraging growth in the economy). For this shift to be effective it is necessary to recognise that “property”, both domestic and commercial, has two components; the buildings which are technically “capital” and the site on which the building is erected which in economic terms is “land.” The two respond very differently to changes in demand. On their own, buildings can be produced in component form in factories. The supply could be increased to meet increased demand with rival producers competing to keep prices to a minimum. This is what happens in the automobile industry. The problem with buildings is finding somewhere to put them. Land in suitable location is in short supply and since locations cannot be manufactured the supply curve is inelastic. Moreover, whereas buildings depreciate with time land does not deteriorate. Hence it is the land factor in property that increases during booms and it is the return from increased land prices that investors hope to capture. Hence, when designing a tax shift to stabilise the economy and promote useful economic activity it is important to focus it on land rather than property in general.

A first step in this change in tax incidence would be to adapt business rates by transferring its incidence to the owner, exempting the building component and extended them to unoccupied land with a corresponding increase in the rate so that it had an impact on the land market. This was recently strongly recommended by the IFS in their Mirrlees Review of taxation[7]. For domestic property, a corresponding reform of the Council Tax would bring similar benefits.

Responding to possible negative effects of taxing land values on bank balance sheets.

A major concern of the banks which have already issued loans against property, both commercial and domestic, is that shifting tax onto land would decrease the value of the assets used as collateral in these loans. As was pointed out earlier this is not a real problem but one of following the rules of the balance sheet. What is of real significance to the lender is the income stream coming from the borrower to produce the repayments. This is not affected. Indeed, if corresponding reductions in taxation on production was introduced the reliability of these income streams should actually increase.

In January 2009, as part of the Government response to the crisis, an Asset Protection Scheme was set up to allow failing banks to take out insurance against their failing assets. The understanding was that the banks would absorb a certain amount of the loss but if they became severe then Government support would step in. An alternative strategy that was used for Northern Rock and Bradford and Bingley was the setting up of a “bad bank” to take non-performing assets off the bank balance sheet. Thus a strong precedent has been set for Government support of loans made against property where the value of the asset has deteriorated. Compared with the losses which occurred during the financial crisis which required a provision of over £500b any further losses due to a tax shift would be modest by comparison and therefore could, if necessary, be managed by a suitable Government backed scheme. In addition, at this time since a considerable section of the banking industry is in public ownership the shareholder and national interest coincide. Consolidation in the short term could be tolerated if it produced stability and genuine growth in the long term.

Implementing a tax shift onto land values will not necessarily produce a decrease in land values which are essentially capitalised rents. Given the scarcity of land, particularly in favourable locations such as city centres, rents generally rise to the most tenants can afford to pay. With a decrease on taxation on labour and capital, location rents could well increase sustaining land values. This was the experience in Denmark in the 1950’s[8] where, following the introduction of LVT at a modest rate, increases in productivity outweighed the speculative losses and land values actually increased.

A second concern would come from financial institutions such as insurance companies and pension schemes that have property as a component of their portfolio. For them a decrease in capital values would correspond to a reduction in their returns with knock-on effects for their customers. Such institutions are the main investors with 23% of the market share. However, commercial property only constitutes 5% of their portfolio so if this particular investment category no longer provided sufficient returns a transition to other types, preferably those which actually lead to genuine wealth production could be managed without undue disruption.

Conclusion

In the context of this essay the utility of Land Value Tax needs to be seen as a tool in the much needed shift in the balance of the economy. At the core of the present situation of instability and weak growth is the use of land as an object of speculation rather than an essential pre-requisite for production. This has diverted the banks from their socially useful function of providing credit for wealth creation to an alternative which inevitably leads to cycles of boom and bust. The shift in the incidence of taxation onto land values would provide a stimulus for such a change

As part of the transition there could be a situation where mortgagees fall into negative equity due the reduction in land values when the speculative element is removed. This is a practical problem which can be overcome with practical solutions. The credit crisis has provided much experience, expertise and innovation in dealing with supporting bank balance sheets which could be utilised. There is already a UK Bank Deposit Guarantee Scheme whereby the Government has undertaken to back deposits and support for bank loans in the form of the Asset Protection Scheme which is already in place. Given that the changes anticipated would be much less than those that occurred on the crisis it should be possible to adapt these for this new purpose. It should also be recognised that the negative equity problem would be a transitional issue which would only be necessary for the short term. Once the economy is on a more stable basis and the restrictions on genuine growth have been reduced, the income flows that are what is really necessary for healthy bank balance sheets would become more reliable. Restoring the health of the economy should be given precedence over conforming to accounting conventions.

Executive Summary

Of the four UK banks that failed in the 2008 financial crisis and had to be taken into public ownership, for three, Bradford and Bingley, Northern Rock and HBOS (now part of Lloyds group) the specific reason for the failure was the same.

Each of the banks had a business model which consisted of extending credit to customers for the purpose of purchasing property rather than for productive business enterprise and then making their books balance by borrowing money from wholesale markets rather than taking deposits.

The basis for this imprudence was the expectation of ever increasing property prices producing a preference to fuel speculation rather than sound lending to business for productive economic activity.

The obvious reason for the bank’s preference to speculative lending compared with lending for productive purposes is the perceived greater profitability and lower risk! Perversely, it is also encouraged by regulatory requirements. The incidence of taxation plays a significant underlying role in this. Whereas productive economic activity is heavily taxed, particularly through taxes on labour but also through business rates and corporation tax, by contrast the increase in domestic property values is untaxed.

The basis of property price inflation has to be the land component rather than the capital (i.e. building) component since it is this that has the scarcity value and is not subject to depreciation.

Shifting taxation off productive activity and onto land would provide a change of conditions which would work to alter the balance of what the banks’ extend credit for. Reducing taxation on productive activity would make it more profitable and so less risky to extend credit for productive activity and taxing land values would reduce the attractiveness of extending credit for property speculation. Thus a tax shift from labour and capital and onto land would provide an incentive for banks to move from inherently unstable practices to more stable and economically and socially useful ones.

The adverse effect of the reduction of land values on the assets on bank balance sheets and provision for negative equity is a practical problem that would need to be managed. It is essentially an accounting problem and not an economic one. It could be tackled by adapting the techniques established in the credit crisis for dealing with the much greater asset reductions that the crisis precipitated.

[1] House of Commons Treasury Committee, Banking Crisis: Dealing with the failure of the UK Banks, p45

[2] ibid. p14

[3] ibid. p42

[4] Independent Commission of Banking, Interim Report: Consultation on Reform Options, April 2011 section 2.8

[5] Maxted, B. & Porter, T. UK Commercial Property Lending Market Research Findings, Department of Corporate Development, De Montfort University, 2010.

[6] OECD Tax Policy Brief, Tax Policy Reform and Fiscal Consolidation, December, 2010.

[7] Dimensions of Tax Design: the Mirrlees Review, J. Mirrlees, S. Adam, T. Besley, R. Blundell, S. Bond, R. Chote, M. Gammie, P. Johnson, G. Myles and J. Poterba (eds), Oxford University Press 2011.

[8] Robert Andelson, Land Value Taxation around the world, 3rd Edition, Blackwells, 2000.