Monday, 17 December 2012

The great liquidity crunch is starting to bite – Liberalise contract law and the financial market now!

 Until recently it was thought that the crisis in southern Europe largely affected only small and medium size enterprises: yet as the deadline for bank capitalisation of the ECB moves ever closer, the economy is feeling the crunch of the resulting restriction of credit. In Greece several medium enterprises, thought by many to be viable concerns, could not find the short term finance to survive. In Cyprus the largest supermarket chain (in terms of stores) is in dire straits as banks seem unwilling to bankroll it.

Economics warns that money supply is really created by the banks and not so much by the central bank: Banks receive deposits or capital, which does not receive any interest and hence it needs to be loaned out. In their efforts to make a profit they lend most of that to others, essentially expanding the money supply. As the money supply is linked directly with the GDP an expansion of the money supply can lead to an increase in income; a reduction will always certainly lead to a decrease in the nominal GDP and increase unemployment further.

The economist seems to be relatively optimistic that the retraction of banking will provide alternative ways for large and small businesses to receive financing. It argues that large and solvent companies can issue their own paper that would be eagerly bought by investors eager for safe interest bearing assets, while small companies can trade their invoices in a secondary invoice market in order to receive more liquidity.

Sadly neither of the two is possible in Southern Europe. The first obstacle is physiological. As the economic depression in the Southern Europe deepens, investors will be unwilling to raise debt for profitable and respectable large companies, as the companies’ future is certainly going to be affected by further decline in sales in southern Europe, and the general increase in taxation.

More worryingly the idea of lending in Europe was tied to the idea of banking. As a result contact law and bidding law has centred on banks and their specific provision of auxiliary banking services. For example companies are frequently asked for a bank guarantee (that proves the company’s solvency) as part of the bidding process, effectively tying up the company’s financing with the banking sector. However as banks seek to restrict their exposures there have been cases were they request that amount that the guarantee suggests should be tied in the bank until the results of the bidding process have been completed, which could take six to twelve months. The bank effectively holds your money without you having access to it until you have won the contract, effectively starving small companies the ability to compete in an EU wide level to survive.

How can this change? the legal framework is outdated and prevents innovation in financing. It is not clear if a third party has the right to claim an invoice without having significant restrictions and regulation that make the whole process too costly. The answer is clear: a liquidity shortage is inevitable: yet quickly deregulating the financial market and the laws relating to everyday business finance could help alleviate the gap. Sadly this is so far off the agenda it is not even discussed in the southern Europe. 

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