Below is an interesting riposte to the idea, entertained even by pro-market folk such as Kevin Dowd in a recent study of the 2008 banking crash, that a way to make banks more prudent in lending and savings policy would include weakening limited liability of the shareholders and even removing, in whole or in part, banks from listed markets, returning them to more like partnerships, so that we come back to some purer, saner age. It is not quite so simple. The article is from Tim Worstall:
But we can go one level deeper into this as well. It’s common enough to hear that the crash of 2008 was all about the quite despicable idea of shareholder capitalism. That the hunger for profits among the capitalists is what drove us all off the cliff. This is not so. Just as many, if not more, building societies went bust in the crash as did banks. The Derbyshire Building Society, Chesham, Cheshire, Barnsley, Scarborough….
Capitalists have a use. As shareholders, they provide the capital. And if things go kaboom then it’s they who lose their money. Plus, in the case of a banking organisation, what tends to drive it off the cliff is not the capitalist lust for profits: it’s bad banking.
In the US, meanwhile, Donald Trump has won some free market points – for now – by promising to reform, and hopefully roll back, the monstrosity that is the Dodd-Frank legislation of 2011.
Wrong for two reasons:
First, what caused the financial crisis was not banks lending to non-banks (ie, your mortgage, your credit card), but banks lending to other banks via derivatives in a highly oligopolistic market. Specifically, it was the CDSs that did it, with the massive inter-bank CDS market blowing up because those involved never understood that writing another new ‘offsetting’ CDS was not the same as ‘clearing’. Of course, one might have guessed that these things weren’t exactly fungible when you looked at the 90+pg documentation that went with them.
Second, and surely most crucial, is the impossible nature of the ‘deposit contract’ which forms the basis of commercial banks. They are impossible because they make a claim (ie, that deposit money will be returned with interest) which is impossible to keep all the time, and which, history shows, is regularly defaulted upon. In other words, commercial banks make a basically fraudulent claim that they can abolish risk for the depositor. Once again, be clear about this: the entire commercial banking structure is based upon a fraudulent claim. This is why commercial banks should a) not be listed and b) the deposit contract should not really be allowed. Rather, they should be replaced in toto by universally distributed money market mutuals, occupying various specified places on the risk/reward curve. At which point, the problem about oligopolies distorting the savings allocations of global capitalism disappear.
I’ll beg to differ with Michael Taylor here. It’s quite true that if everyone tried to withdraw all their deposits at the same time, banks wouldn’t be able to come up with the cash, and that does indeed happen from time to time. But this sort of thing is not peculiar to banking. If all an insurance company’s customers happened to total their cars on the same day, the insurance company wouldn’t be able to pay the claims. If lightning destroys your new house the day before the builder completes it, he’ll miss the contractual completion date. These are not frauds, they’re just occasions when low probability, but foreseeable, events prevent one contracting party from delivering on his promises. Bank deposits would only be fraudulent if the bank promised to keep your cash in a dark vault. But they don’t, it’s abundantly clear that they’re going to lend it out to someone else. Which is why you (sometimes) get interest on your deposit. Cos the deposit is just a loan to the bank, and like any loan, it can go bad if the creditor turns up his toes.
“It’s common enough to hear that the crash of 2008 was all about the quite despicable idea of shareholder capitalism.”
Common enough, I suppose, but anyone saying that is merely demonstrating his abject ignorance: of history, of the specifics of the 2008 financial meltdown, of banking specifically, and of economics generally. This is a very deep subject, with a lot of moving and interconnected parts, and is far too complex to dig into here. But unlimited shareholder liability isn’t the solution. It isn’t even a partial solution.
As Worstall says, capital (or, specifically, the lack of capital and the inability to raise more) is certainly a problem in some instances. So is “bad banking,” and ignorance and inexperience in the boardroom. I understand the superficial appeal of a return to the old general partnership model in investment/merchant banking, but without a complete overhaul of the global banking system that would be impossible, unworkable and, ultimately, ineffective. The overarching problem is the regulatory scheme and, especially, deposit insurance as presently structured.
Michael Taylor is correct to lay some of the blame upon credit default swaps (and I appreciate that he didn’t use the idiotic term “derivatives”!), but even that is far from the whole story. And his critique of “deposit contracts” (by which I presume he means fractional-reserve banking) isn’t really accurate because that isn’t really the core problem either (although ignorance on the part of most depositors as to the details of their legal relationship with the bank certainly is a serious issue). But even that ultimately comes back to deposit insurance and inherently ineffective regulation. Regulatory accounting (not to be confused with financial accounting or tax accounting) is a nest of fictions designed to protect bankers from having to expose their mistakes before the capital runs out, and the risk-based capital rules primarily serve to force banks to finance bankrupt governments. It’s government all the way down.
At the end of the day, 90%+ of the problem can be laid at the feet of government presuming to do more than it can while simultaneously making promises it can’t possibly keep. Greedy capitalists doesn’t even make the top 10 of the list of failings.
I’ll also beg to differ, slightly, from JP’s post. Tim Worstall is comparing listed public banks with mutuals, not with private banks like the Rothschilds in days of yore. There’s two different problems here :
1. the problem of managers who are the agents of the owners. The problem is that their incentives may be misaligned with those of the owners. This is a problem shared by listed public banks and by mutuals, but not by the Rothschilds
2. the capital problem – which is how do you get access to extra capital when you need it and the existing owners don’t have it ? This is a problem shared by mutuals and by the Rothschilds, but for which listed public banks have a fairly good solution
Wasn’t another problem for the Co-op bank the rather strange idea of ethical banking? Also known as trying to attract customers who are unlikely in the main to have huge amounts of money by publically stating you will turn down opportunities to increase your revenue of rather arbitrary lines, seemingly determined by the sort of people who are never satisfied if you meet their demands? At the risk of alienating people who want the best deal from their bank (I can’t remember where I saw it, but the Co-op apparently never had any of the best deals on the Martin Lewis type site lists), which is surely most people.
I just can’t believe that helps a bank survive myself, especially if you lack people experienced in making money through banking running the organisation.
I tend to agree with Mr Worstall on most things except banking. There is something deeply flawed about banking which results in a completely intolerable systemic risk. Yes, you can point to particularly bad banks, but a whole load avoid that category by luck rather than design, and all are vulnerable when the dominos start falling.
The fault must surely lie in the fact that we essentially have a centrally planned fiat money system. How could you design anything this way with so few of the features of self correcting market capitalism and not expect it to be so fragile?
The main problem is debt being counted as assets on a humungous scale. If we lent out gold coins – something real – and banks who couldn’t honour their liabilities could get found out. Then we wouldn’t have this global house of cards requiring global government to keep it from killing millions in the event of its inevitable failure.
If you think the claim is fraudulent, presumably you do not believe in interest? And if you do, why do you think the bank pays you interest on the money you have deposited? The goodness of their hearts?
Banks pay interest? Which ones?
The one I bank with does 😛
I’m not sure if it us still the case but the Swiss bank directors are personally liable for the banks they manage (similar to “Names” at Lloyds). They have their “cock on the block” if things go wrong so the Swiss banking system is exceedingly careful and will only lend to safe risks.
Compare this to the Freddy May and Fanny Mac banking situation in the USA where the Government mandated that the banks must lend to poor risks (e.g. people whose only income was welfare checks were permitted mortgages that it was impossible for them to repay) and other deliberate government distortions or allowing bad banking practices (e.g. lending out much, much more than they were taking in deposits).
But, ’tis the way of the modern world where no one in positions of power is held accountable for their actions when TSHTF.
“The main problem is debt being counted as assets” You clearly have at best only a passing familiarity with the concept of “assets” and, for that matter, double-entry accounting.
I think that we are missing the biggest point here. The thing that would have fixed the banking system is if the fools in government didn’t come up with the idea of “too big to fail”. Were the banks been allowed to fail the assets would have been reassigned to the well run banks as a bonanza, the idiots who did the nonsense would be bankrupt, and the banking public would have learned a very painful lesson to be a little more prudent with their money. The government in the USA (sorry don’t remember the arrangement in Britain) was on the hook for $100k per depositor. That is stupid, but people made choices and banked with that understanding and so they should have fulfilled that in the way they do (by taxing everyone by printing more money.) But certainly the failed banks should have crashed and burned.
So far from fixing the problem, they made it far worst, and guaranteed a repeat. Why should I be careful with my money if there is not risk? In fact, it would be grossly irresponsible in such a climate not to go way out on a high risk credit limb. Instead the FDIC limit was RAISED to $250k. So it was handled in about as bad a way as it could possibly have been. But no surprises there.
As to the OP, I think the idea that this system of bank funding or that should be entirely irrelevant. Let banks organize how they will. Let them convince the public of the soundness of their banking policy, and realize that banking (FDIC aside) is not much different than any other business arrangement. I see no reason for law to demand that banks be organized one way or another. Perhaps the public can be convinced to bank by insurance companies providing depositor insurance, perhaps with unlimited liability, like Lloyds. Perhaps not. Perhaps they are smart enough to not keep massive amounts of money in their checking accounts anyway. Me? I’d like to have a choice unlike the one size fits all market we have now.
But didn’t they also make some very large banks into their friends for life, as well as provide an object lesson to all other banks that having friends in government is far more important than good banking practices?
I suppose it depends on what you think their goals really were when they made the problem worse.
Makes regulation and supervision easier.
Fraser Orr is, of course, exactly correct, and his comments about deposit insurance are essentially the same thing I was saying earlier.
“There is something deeply flawed about banking which results in a completely intolerable systemic risk. ”
Fractional reserve banking does lead to systemic risk, yes. The question is whether it is tolerable or not. Which is a judgement call, no more and no less. I say yes because I think the maturity transformation that FRB does is worth having. Others can differ.
I’m actually a qualified accountant. I understand the limitations of accounting and the difference between it and economics.
But is that effect at its optimum level? It’s not an all or nothing proposition. And is it enhanced by the state essentially mixing capitalism and planning together in a way unlike any other industry?
“systemic risk”
What is this? That a bank will fail? Under the “creative destruction” rules of capitalism, this is a feature not a bug. It is the artificial propping up of the system that leads to real risk.
I was in the clearing business on the day of the Lehmans collapse, and a week later it was as if it had never existed (apart from a few OTC Swaps that hung around like a bad smell, but all the exchange traded stuff was balanced out in a few days).
I saw the system working as it should, once.
Risk and debt are traded commodities like any other, if you undervalue them you disrupt the system.
@james g wrote, February 15, 2017 at 6:48 pm:
And then @Laird wrote, February 15, 2017 at 10:00 pm:
And then, @James g wrote, February 16, 2017 at 8:51 am:
This is priceless stuff. Very droll. One does not often get a real guffaw from reading Samizdata discussion threads, but this was a super exception. Loved it. Thankyou muchly. It knocked all that time spent working on the UK Independent Treasury Economic Model into perspective. Such clarity of thought. Brilliant.
One other problem with banking as a whole – it’s not exactly an easy industry to enter, even if you can assemble the capital requirements. Regulatory hurdles effectively limit the number of banks in a market, and thus as normal processes work to destroy a certain amount of the number of banks, the overall number and the viabiity of the markets fall. And if new entry to the market is limited (and mainly works by buying an existing bank…) then this immediately negates one of the advantages of the capitalist system – that marginal resource can be exploited in innovative ways, but this requires by definition innovation.
It appears to me that one notable effect of this is that it is not possible for a new bank to appear with the aim of getting whatever value they can out of toxic debt, allowing this to be sold off by the holding bank. If you can pick up a load of toxic debt for 1% of the nominal value, and then restructure it to get 2% of the nominal value as a return then that it is a good deal. If the regulatory hurdles mean that you need to get an unrealistic return to make it worthwhile (say 25%), the debt sits in the system and is not innovated with by new entries into the market. The debts are resources in a banking market for which regualtion is effectively destroying the pricing signal.
Ironically (hey, this is going to be another ironic outcome of government intervention – who’d have thought it) a lot of the regulation is to protect consumers, but where debt is concerned it may actually harm them – if debts could be easily traded at a huge discount, which requires new entries to the market (or a very well-capitalised organisation in the market already, which clearly does not happen in banking), then they could be restructured with ease.
Reply to Laird,
My criticism about the impossibility of the deposit contract was not specifically a moan about fractional banking. The problem is more fundamental: it is the fraudulent pretence that the bank can actually guarantee that it can return the money because what it does with your money is guaranteed to be risk-free. No bank, and no investor, is ever in the position to make such a claim, and the overt claim that banks make to the contrary will always be, and must always be, false.
On the basis of that basically fraudulent claim, however, banks obtain monies which they then put out at risk in various wise or deranged ways. What is needed, and what would certainly improve the allocation of capital, is for savers to make their own informed choices about the sort of risk/reward they are prepared to tolerate. Hence, if they wanted minimal risk, they could choose a very low-yielding money market mutual investing only in govt paper. If they wanted to have a wild fling, they could invest in, say, credit default swaps or high-risk mortgage debt. There’s nothing implicitly wrong with either of these choices, provided the saver is a) aware that his money is at risk and b) is prepared to wear the loss, as well as take the gain.
A final point: there are two ways a credit system can fail. First, it can take too much risk (ie, go bust). Second, it can take too little risk (ie, refuse credit to a swathe of people or projects which might turn out to be good). When banks mess up, as they always do, and always will, they simply swing from the first fault to the second. Why on earth should anyone tolerate such a system?
On the basis of that basically fraudulent claim, however, banks obtain monies which they then put out at risk in various wise or deranged ways.
One of the problems is not investment per se, but when you hand money over to a retail banking arm of a larger financial corporation, they might p*ss it all up on a loss-making bad insurance product/brand or a dodgy takeover of a fringe institution. Alternatively your returns could come from unwilling taxpayer-funded handouts (theft) or profits from misinformed payment protection insurance (fraud), equally your losses would come from repayment of these (and not necessarily for the same investment or investor).
“And if things go kaboom then it’s they [shareholders] who lose their money.”
But that’s not what happened, is it. The shareholders kept their money and the taxpayers got stuffed.
Accepted that may have been the best response to the problem, but the classical shareholder/capital thingy it was not.
Runcie. See Nassim Taleb re. fragile versus anti-fragile systems. He puts banking (overall) in the fragile category. I take the view that this is because banking only has the veneer of capitalism. If the system works why do central banks exist pumping out trillions in emergencies?
Michael Taylor,
The problem with your view is that to have the money to return the deposit, the bank has to not do anything with the money other than hold onto it. It cannot therefore lend it, thus removing one source of capital from the economy. As the economy depends on capital to allow innovation, we would be forced to rely either on those with existing stocks of capital or the government to provide this.
So whilst complaining about the fraudulant nature of banking sounds good, it does miss the fact that banks play a vital role in providing capital to allow innovation; indeed, it is probably not coincidence that the medieval invention of the bank is a forerunner of the early modern crude versions of capitalism. If you want to see what happens to a country where much of the money is not recycled as investment whilst on account, try India for an example. Low levels of capital availablility, low levels of innovation, domination by large industries and particularly by an overreaching government. If you want a free society, you have to allow money to be recycled through banks (or similiar mechanisms) to allow growth.
Watchman,
I think you misunderstand: I have no problem about credit in general – indeed, the lack of credit is the most common source of preventable poverty – but rather the pretence that it can be done without risk. It cannot, and I think the pretence that it can which underlies commercial banks as a business concept is very damaging.
As for history, I freely acknowledge that in times past there was a very good case for commercial banks because a)as far as money transfer was concerned, it usually involved loading gold onto carts and then transporting them, slowly, through dark forests etc; b) information was difficult to obtain, hence it made sense to aggregate savings in order to minimise those unit costs.
Neither of those conditions apply today: money transfers are near-instantaneous and near-risk free; and information costs have fallen to near-zero. Consequently, the case for aggregating savings into commercial banks and accepting/ignoring the costs involved no longer stands. Hence I suggest a set of universally-distributed money market funds, with the individual saver able to choose his/her own position on the risk/reward curve. You’d get better savings allocation, hence better economic performance, and you’d drop the oligopolistic structures in finance which have proved so distorting both to the economy (ie, London house prices) and to the distribution of income. What’s not to like?
Perhaps as mentioned before, it is fiat money that puts the spanner in the works for the entire system. What would make the system “work” again is a return to an era when banknotes were actually issued by banks and backed by commodity? Perhaps bank backed digital currency is one solution?
Michael,
Happy enough with that on an academic level, but the issue is that removing the bank as a safe deposit organisaton for a pure investment distribution requires a level of risk taking which will not appeal to everyone (even now many people prefer almost non-existant interest to investment remember). So if the choice is investment or the matress, a lot of money will go out of circulation. We will in fact hit another of India’s problems – an appreciable proportion of its money supply was being cached rather than invested because people were keeping it out of banks and in their own possession (one reason for the delegitimisation of their high-denomination notes was to deal with this by requiring the existing stocks of cached money to enter the banking system). So I think the effect of what you propose would be the same.
I agree that risk should be acknowledged, but deposit insurance to protect savers rather than investors should not be a problem (after all, it is paid from the same money that is put in by the savers), so long as people ensure there is a clear indication where the cost of this will fall (so not the 2008 situation which seems to have been characterised by lack of clarity). So up to a certain value I have no issue with risk-free saving, as the other choice is that that money is not available to produce credit at all. Obviously the level is a matter of debate, and should probably be determined by the organisation concerned (but won’t be, because banking is tightly controlled by government and the small number of big players who are not threatened by the risk of disruptors in the sector).
Michael Taylor, I think you mischaracterize banks’ claims that deposits are “risk-free”; it is not the bank which is actually making that claim but rather the government, by offering deposit insurance. No bank has ever guaranteed that what it does with your money is risk-free (that’s why banks carry loss reserves); all they promise is that your money will be returned (thanks to the miracle of deposit insurance). I’m fine with your idea of a series of funds having varying risk tolerances. But it is the existence of government-sponsored (and -mandated) deposit insurance which inserts a significant element of risk into the system. (I could write a long post on the inherent flaws of the current deposit insurance system and how I would change it, but I’ll forbear.)
Watchman, you are certainly correct that there are significant barriers to entry into the banking industry. But you are mistaken as to the matter of buying distressed debt at a discount. I have been in that business for nearly two decades, and it is active and thriving. There is no shortage of investors, very few of which are banks, and the only real requirement is access to the necessary cash to buy the loans. The industry is essentially unregulated except for the servicing of consumer loans (which means receiving and processing payments, communicating with borrowers, handling collection activity, etc.). Indeed, the only reason the industry isn’t even larger is that most banks carry distressed loans on their books at inflated values (thanks to regulatory accounting; see my comment way above) and they don’t choose to recognize the loss. The banking system is full of toxic debt; it’s not being sold and liquidated because banks don’t want to acknowledge just how precarious their capital position really is. The pricing system is working; it’s just being ignored.
Slarti, I’m pleased that I can contribute to your entertainment! My condolences at having to work on the UK Independent Treasury Economic Model.
Worstall. You might actually have mentioned the one Building Society that did fail – the Dunfermline, appropriately based in Gordon Brown’s constituency and yet another example of abandoned Scotch financial prudence – rather than those with problems where the ‘traditional’ mutual solution of amalgamation with another, larger mutual provided a way out. (Just as the Bank of England, long ago, managed banking problems with a lot more discretion than in 2008 thanks to that Moral Hazard merchant King – somewhat improved in retirement.)