Monday, 25 June 2012

The absurdity at the heart of banking.

The Basle Committee on Banking Supervision and the UK’s Vickers Commission on Banking have the same aim: to make banks have enough loss absorbing buffers in the form of shareholders and bond holders to ensure that the risks involved in banking are reduced to acceptable levels.

That basic idea is flawed for the following reasons.

But first, please note that it’s the BASIC or TRADITIONAL activity performed by banks that I’ll consider here: taking deposits and lending money deposited on to borrowers. Of course banks do more than that, but the latter, to repeat is the basic activity of banks and it’s the one considered here.


There is always a finite possibility that EVERY LOAN made by a bank goes wrong. Thus to make a bank 100% safe, it must have loss absorbing buffers EQUAL IN VALUE to loans (or equal to deposits). But that would mean a miserable return on capital for shareholders, bond holders and depositors – or a standard return on capital for share and bond holders and zero or worse return for depositors. And that is a nonsense.

So what those designing Basle or Vickers type regulations do is to go for a compromise. That is, they aim to ensure that buffers are large enough to reduce risks to an acceptable level. But that still leaves a finite risk in place: a risk that is carried by taxpayers. In other words, if depositors are to be sure of getting their money back, then banks ABSOLUTELY MUST BE underwritten or subsidised by taxpayers.

Now what do you call an entity that claims to be commercially viable (normally headed by a self-styled swash buckling proponent of capitalism) but which in reality absolutely has to be underwritten by taxpayers? The words “farce”, “nonsense” and “hogwash” spring to mind.

And this taxpayer subsidy is ASTRONOMIC. According to this study by Andrew Haldane of the Bank of England, the value of the TBTF subsidy over recent decades has amounted to more than bank profits!!!! See 3rd paragraph under the heading “Implicit subsidies” here.

I argued above on purely theoretical grounds that the basic banking activity in its present form is fundamentally a farce. It seems from Haldane’s evidence that the numbers backs this up.

What do we get from banks in exchange for the TBTF subsidy and occasional credit crunches?

The cost of the crunch has been ASTRONOMIC: GDP of countries affected is now five to ten percent below trend. We are talking hundreds of billions or trillions.

Now if this astronomic cost is matched by some equally astronomic benefit, then OK. But it’s not.

Basically the only benefit that banks can point to is that the risk they run “improves liquidity”. Or put it another way, banks claim that if regulations are too restrictive, economic growth will be impaired.

Whichever way banks put it, half the economics profession and nine out of ten politicians are fooled. As to the word “liquidity”, that’s an important technical sounding word, so that impresses the gullible. As to threats that economic growth might be impaired, well every politician wants economic growth: it wins votes. So banks only have to mention economic growth, and politicians jump to attention, salute bank CEOs, and give banks a more or less free rein.

So do restraints on bank activity ACTUALLY impair economic growth? Well OF COURSE THEY DO ALL ELSE EQUAL!!! But all else does not have to be equal. That is, given a deflationary effect of tighter bank regulation, the government / central bank machine can easily make good with some stimulus. The result is less bank funded economic activity and more equity funded activity (in the case of industries where it is difficult to cut capital intensivity). As the rest of the economy, the result is more activity based on plain simple old consumer demand, rather than based on bank loans.

Thus the central argument put by banks against tighter regulation is HOGWASH.

As this Financial Times front page lead story pointed out, banks use any old fraudulent or dishonest argument to water down bank regulations.

Conclusion: banking in its present form is a farce.

Banks don’t need to be 100% safe?

Banks could point out that having the value of buffers equal to the value of a bank’s loans is an unnecessarily high level of safety, and involves large amounts of share and bond holder capital lying idle in exchange for a very small improvement in safety (as compared to the size of buffers and levels of safety contemplated by Basle and Vickers).

Put another way, cutting the size of buffers from say 100% of the value of loans to say 50% involves a big increase in lending in exchange for very little increased risk. And that additional lending brings a large economic boost or stimulus.

True, but banks would not be doing anything there that cannot be done at zero cost and no additional bank riskiness whatever by the government / central bank machine. That is, “economic boost” or “stimulus” can be implemented by any monetarily sovereign government anytime and at no real cost and no additional risk of banks going under.

When it comes to the question as to which is the best of the above two options, there is no contest.

An arcane point – skip if you like.

However the fact that X is a better option than Y does not mean X is the BEST POSSIBLE option. Indeed, there is still a defect in a banking system that involved buffers equal to the value of bank loans (the “X” option, so to speak). And it’s not the above point about share and bond holders’ money lying idle: money is just numbers in computers. The real defect is thus.

Depositing money in a bank knowing full well that the bank will loan that money on to businesses or for mortgages, etc is a COMMERCIAL TRANSACTION. Now if buffers are equal in value to loans, there is nothing left for depositors, as pointed out above. I.e. the latter “commercial transaction” brings a zero or worse return – which makes a mockery of the allegedly commercial nature of the transaction.

Alternatively, if buffers are much smaller, the taxpayer inevitably carries the risk. But a transaction where the taxpayer carries the risk is not a commercial transaction.

This all smells of “check mate” or “false logic”. The way out of this is set out a few paragraphs hence under the heading “A simple rule”.


Glass-Steagall is widely seen as a cure for banking problems. Unfortunately it is not. It DOES prevent banks making INVESTMENTS which are taxpayer backed. But it does not stop them making taxpayer backed loans that are less than 100% safe. So Glass-Steagall does not solve the basic problem dealt with here.

The complexity of Glass-Steagall, Basle, Vickers, etc.

The next flaw in regulation of the Glass-Steagall / Basle / Vickers type is its complexity.

As Martin Jacomb (Chancellor of the University of Buckingham) put it in an article about Vickers in the Financial Times, “The ring-fencing proposal involves much detailed regulation.” Or to put it more bluntly, Vickers means plenty of lucrative work for lawyers.

A second problem with complexity is that it makes it easy for banks to nibble away at the regulations a bit at a time, AND THEY SUCCEED. It is a HISTORICAL FACT that Spanish banks between around 2000 and 2005 managed to get regulations watered down. Now the disastrous results are plain for all to see.

And as distinct from “nibbling”, sometimes banks manage to have large chunks of regulation removed: Glass –Steagall.

And a THIRD result of the complexity is the authorities are quite clearly incapable of distinguishing between safe and unsafe banks. See for example here and the above article on Spanish banks. See also p.5 onwards of John Kay's paper "Narrow Banking".

IN CONTRAST, if we had relatively few and simple regulations, the merits of which everyone, especially politicians, can be made to understand, banks would have much less chance of acting as parasites on the community as a whole.

Well there is a beautifully simple rule or set of rules! Read on.

A simple rule.

Depositing money in a bank, knowing full well that the bank will loan your money on and get you a better rate of interest than if the money was not loaned on is a COMMERCIAL TRANSACTION, as mentioned above. And it is not the job of taxpayers to subsidise commerce.

Ergo, there is no justification for any taxpayer backing for the latter activity.

In contrast, there are two VERY GOOD arguments for everyone having access to a 100% safe account, if that’s what they want or need. First, it can well be argued that access to a 100% safe account is a fundamental human right. Second, there are numerous firms or other entities which would be breaking the law if they took any sort of risk with various sums of money. For example, lawyers handling clients’ money have no right to take a risk with that money, absent permission from clients.

There is thus a very simple rule that can replace Glass-Steagall, Basle, Vickers, etc., and it is this.

Depositors have to choose between, first, safe accounts, money in which IS NOT INVESTED OR LOANED ON, and which thus earn little or no interest. Second, depositors can go for what might be called “investment” accounts. Here, money IS LOANED ON, or invested. But that is a COMMERCIAL transaction, and like all commercial transactions, it offers potential rewards and potential losses. That is, the money is doing something, so a significant rate of interest is earned, but if the bank goes belly up, the taxpayer does not come to the rescue.

Laurence Kotlikoff.

The latter system is pretty much the one advocated by Laurence Kotlikoff (once described as Mervyn King’s “guru”).

Kotlikoff, in Ch 5 of his book “Jimmy Steward is Dead” suggests that all money deposited in banks should be put into mutual funds (“unit trusts” in the U.K.). Depositors would be able to choose funds of varying degrees of risk, with the least risky being what he calls “cash mutual funds”. He says “These cash mutual funds would thus represent the demand deposits (checking accounts)…”

He goes on: “In requiring that cash mutual funds hold just cash, limited purpose banking effectively provides for 100 percent reserve requirements on checking accounts.”

And the latter idea in turn amounts to much the same thing as the system advocated in the first few pages of this submission to the U.K.’s Vickers Commission.

Irving Fisher also advocated 100% reserve on checking accounts.

So there is plenty of brain power behind the idea!!!!!

No comments:

Post a Comment

Post a comment.