Can banks survive?

There's one question that's been sharpened by the Libor scandal which hasn't had the attention it deserves - namely, could banks as we know them survive in a proper, honest, market economy?

I ask for three reasons:

1.Banks are supported by a massive implicit subsidy - the fact that their borrowing costs are kept artificially low by the belief that the government will bail them out if they fail.The Bank of England estimates this subsidy to be worth up to £120bn. This is more than all the profits banks made between 2004 and 2011 (table B3.2 here).

2. Banking, in its present form, creates a large negative externality in the form of risk pollution: all of us suffer when a banking crisis leads to economic crisis. This externality might be so large as to swamp the profits that banks do make. As Andy Haldane of the Bank said (pdf):

Fully internalising the output costs of financial crises would risk putting banks on the same trajectory as the dinosaurs.

3. The Libor affair suggests that some of the profits that banks do make are thanks to, ahem, sharp practice. If we heed Warren Buffett's maxim that there's never just one cockroach in the kitchen, we must ask what else are banks up to? How far are profits boosted by mis-selling, or front-running, or insider trading or other dubious deeds?

These facts raise an uncomfortable possibility - that if we were to ever have an idealish market economy - in which businesses don't get state subsidies, behave honestly and do not impose externalities upon others -  then banks as we know them couldn't exist.

Banks as they presently exist are not exemplars of a free market economy but rather means whereby a few oligarchs can enrich themselves at the expense of the rest of us. 

Those who rightly rail against crony capitalism - as Sam Brittan does - fail to see that a genuine market economy requires very radical change in the banking system indeed - much more so than the Vickers report envisages.

Comments

[Nick Rowe]

Is that a subsidy of L120bn *per year*? (I'm too lazy to download and read the BoE pdf.)

[nino]

lets hope you're right.

[Zorblog]

What's uncomfortable here? Banks can exist, but they have to be state-owned.

In Switzerland, a significant size of the banking sector is state-owned, as most cantons ("states") fully or partly own a local bank, and some of them explicitly provide a guarantee of deposits. Those banks work fine. They may not be as sophisticated or innovative as UBS or Credit Suisse, but in the end, it does not make a significant difference for the client.

UBS and Credit Suisse used to complain about unfair competition, but since the Swiss National Bank had to take over CHF 65 billion of toxic assets from UBS, that's an argument we don't hear much often.

[Account Deleted]

Nationalisation of retail banking (remember Girobank?) would probably be popular. Most of us consider our bank a utility, not an expression of utility maximisation.

A focus on necessary services (and having a proper IT contingency plan) rather than selling unnecessary insurance and other "products" would be a killer USP.

Though state banks have their problems (ultra-cautious investment etc), a more diverse banking landscape would be more resilient and less prone to excessive leverage. Misbehaving banks could then be allowed to fail.

Probably the best legislative move would be to ban banks from issuing household mortgages (leave this to sole-purpose mutuals). This might make retail sufficiently unattractive that the banks themselves engineer a proper break-up.

[Blissex]

As Steve Waldman and others show the "prime rate" in the USA has been "managed" by USA banks and the Fed/regulators to greatly boost bank lending profits to individuals, to allow them a cushion when they have trading losses:

http://www.interfluidity.com/posts/1160447599.shtml
"the spread between the Federal funds (and Treasury bill) rate and the prime rate widened from 1 1/2% to 3% in 1991. That was Greenspan's gift to the banking sector to insure that major banks would not fail. You may recall at the time that rumors were rife — including some repeaed on the floor of the House — that Citibank was about to go under. By doubling the margin between the prime and the funds rate — and essentially increasing the profitability fourfold after taking into consideration the costs of processing loans"

The conclusion here is that the finance industry, like the oil and arms industries, are thinly veiled arms of state policy, and of elite domination within states.

As to finance/banks profitability and subsidies Nassim Taleb (and others) have pointed out that over the cycle they accumulate net losses, thus the need for periodic bailouts.

The real business model of banks/finance is:

* Underprice risk, especially tail risk, to boost booked profits by underreserving against that risk.

* Distribute a large chunk of the booked profits as "compensation" to traders and management.

* Hold hostage the payment and credit systems for a bailout when the tail risk inevitably happens, and wipes out al booked profits and more.

[Luke]

Following up on A to E above, what would an ultra- cautious utility bank do with the money deposited in it? I'm thinking of something with current accounts with no or minimal interest, maybe a savings account.

Would it hold as a trustee? In which case if it put the money in something that failed, that's the depositor's problem, but it can't go bust.

Whether it was a normal bank or a trust, what would it lend to/invest in? I'm guessing all property lending and business lending is out. Overdrafts? Are they too risky? Not a rhetorical question - I don't really understand how these supersafe banks are meant to work, though I like the sound of them.

[Luis Enrique]

Break'em up!

[Account Deleted]

@Luke, ultra-cautious banks have a couple of strategies they can adopt.

First, they can lend to the same people who make the deposits, i.e. make lots of relatively small loans to individuals and SMEs. The advantage of this is that you spread your exposure across a lot of liabilities, so you are more resilient. The disadvantage is that your margin (i.e. the interest) will be modest, because you're not chasing high risk / high return business. This is the Bailey Building & Loan ("It's a Wonderful Life") model.

Second, they can invest in low-risk securities such as government bonds. While that might appear questionable in current circumstances, public debt is generally safer than houses (literally). Again, returns are relatively low, but that is not a problem per se.

The point is that a bank can operate safely so long as depositors accept minimal interest (near zero in real terms), i.e. they want service (money security and payment convenience) rather than a return on investment.

Yoking retail and investment banking together is an exercise in financial leverage. It makes no sense in terms of customer service, risk management or operational efficiency. They are chalk and cheese.

[Frances Coppola]

Our current TBTF banks ARE dinosaurs. The future of banking doesn't lie in megaliths wallowing in the warm waters of State subsidy. My post today showed how small businesses act as banks when they extend lines of credit to customers. There are other forms of non-bank banking that many of us use without thinking about it - airmiles, for example, or NECTAR points. Even payments are not necessarily conducted through banks: in Africa, where something like two-thirds of the population doesn't have a bank account, they use mobile phones to make payments. We do not need these monstrosities. Like the dinosaurs, they should be allowed to fail so that the new breeds of small, fast-moving, adventurous creatures that are hiding in the undergrowth can come out into the light.

[Ralph Musgrave]

Chris gives three reasons for doubting that banks could exist in a genuine free market in the above post. I’ll take them in turn.

1. The fact that an industry is currently subsidised is normally not a reason for supposing it would not survive at all without a subsidy. For reasons given in the economics text books, removing a subsidy normally just reduces the size of the relevant industry: it doesn’t destroy it. Removing agricultural subsidies would not stop people growing food.

2. I have no quarrel with Chris’s suggestion that banking IN ITS PRESENT FORM involves large externalities and that the latter might exceed profits. That would be an argument for disposing of the industry if the externalities cannot be disentangled from the rest of the industry. But I think the two CAN BE disentangled, as follows.

The basic risk run by banks IN THEIR PRESENT FORM is extremely simple: they, 1, accept deposits, 2, promise to return those deposits, and 3, lend the relevant money on to borrower WHO ARE NOT GUARANTEED to return the money. Crazy.

There is a very simple solution, as advocated by Lawrence Kotlikoff, Prof.Richard Werner and others. That’s to force depositors who want their money used in a commercial fashion to accept the risks normally associated with commerce: the possibility of losing some or all their money. As to depositors who want 100% safety, that’s OK, but their money should NOT BE invested. It should be lodged in a 100% safe manner, e.g. at the central bank.

3. The fact that banks derive SOME PROFIT from sharp practice does not mean that the BASIC function performed by banks is not useful / profitable. Accepting deposits, i.e. looking after peoples’ spare cash and lending that cash to borrowers is a perfectly legitimate activity, and will yield a profit if done competently. We just need to remove the “have your cake and eat it” promise that banks (thanks to the taxpayer) currently extend to depositors.

[Frances Coppola]

Ralph,

I didn't expect you of all people to get the banking sequence wrong. Banks do not "lend out" depositors' money. They lend, then seek funds to settle drawdown of the loan. Those funds may come from customer deposits (which may themselves be generated through lending), or from wholesale borrowing, or from bond issuance, or from interest receipts, or from loan redemption. To say banks "lend out" depositors' money is simply wrong. Depositors' money is at risk because banks use it to settle claims.

[Jim]

Anyone who thinks State owned/locally run/mutual banks are intrinsically less risky hasn't been watching whats happening in Spain.

The biggest creator of systemic risk in the banking system is the State guarantee to depositors. Why put your money in a safe bank at a low rate of interest when you can put it in the State Bank of Nigeria, get a nice return for zero risk (as long as you deposit less than the cut-off amount)?

In a purely free market banking system, with no deposit guarantee (as it happens was the case in Its a Wonderful Life) the biggest driver towards bank risk management is the fear of depositors taking fright and pulling money out of the bank. It is that market force that makes a bank honest. Without it you get all the swindles and sharp practices that we are seeing now. Make people be responsible for their own money and they will force the banks to be less risky.

[Thomas]

Wrong question! The question must be: Are financial markets markets in an economic sense?

When we look at them and see, how they behave, the answer seems to be "no".

On real markets it would be impossible, to create the Ponzi schemes we have seen in the past at the financial markets. And the reason is dead simple: money is not a commodity. Money has a total different role than products and services, which you can buy and sell.

As long as we reduce market economy to competition, do not understand, what money really is and how people deal with it, we will never have a true market economy or capitalism, since we overestimate "finacial markets" to the disadvantage of the true markets which should the wealth of a society.

[Guano]

"Are financial markets markets in an economic sense? ... When we look at them and see, how they behave, the answer seems to be "no".

Indeed, even though when someone on TV says "Now let's see what's happening in the markets" they are referring to the financial markets.

[exchange ukash]

You completely duplication our mean and the difference of our information.

[aged loan modification leads]

I'm pretty sure the big banks will be pretty safe. It is the smaller ones that should be worried.