Everybody seems to have grasped that the banks are at the core of our problems today. They are too big and too rich. But most would admit that they do not really understand why.
Banks were always a trusted institution, with the local bank manager a figure of probity and respect. Suddenly, they are the villains of the piece.We need to understand why and to do so we have to look at what banks actually do. And then we can see what they have done.
What are Banks for? The biggest problem banks have is that the stuff they hold and lend, namely money, is the same stuff they need to run their own businesses. All other trading businesses hold stock of goods; food, furniture, carpets or clothes, all are held in stock. That stock is represented by a money value on the balance sheet because it can be bought and sold as needed. But with a bank it is money itself that they hold for depositors which is held in stock. That money may be actual cash but is more likely to be some form of paper representing money. The speed at which that paper can be converted back into cash is what we call liquidity.
A large proportion of the deposits held by banks are virtual cash and can be drawn at any time. These deposits earn no interest for the depositor, but can be profitably used by the banks to earn a return. If a depositor is prepared to leave his money in the bank for longer periods then he is paid interest, and the longer the term of deposit the higher the interest paid. Money held ‘at call’ earns nothing and is highly liquid; deposits with an undertaking not to withdraw for a time earn interest. The longer they are left, the higher the interest.
There are two other components of interest payment. If the deposits are very large, even if made for only a short time, maybe just overnight, they will earn interest which can be really significant if the deposit is large enough. The other element is risk. If there is any question of confidence then the depositor will expect an interest premium. This element is of far greater significance when we consider the lending function of the banks.
Banks are financial service institutions. They not only hold deposits, they operate almost all means of processing transactions.
Banks provide us with all the facilities needed to undertake almost any trade. In doing so, they find themselves holding huge amounts of cash from day to day which is, so to speak, in transit. However, that money can also be used, and form part of, the cash ‘stock’ of the bank, as long as there is always enough to meet the next days service activity. On all these services the bank adds a margin or makes charges, for it has to have an income and make a profit out of the business.
Banks uniquely have another sources of income. They are in the business of lending money.
It is what they do, and what they principally charge for. The interest they charge on money they lend to others is always at a higher rate than the interest they pay when they take in deposits, which are, in effect, borrowings.
It is reasoned that the difference represents the costs of the transactions. But since they lend more than they borrow, this margin was always modest and, for a long time, it was the the principle source of income. However, the banks do indeed levy charges for these services as well. As we shall see, the banks actually lend much more than they borrow and this margin, customary as it is, nevertheless represents a source of pure profit.
So, from managing our transactions, taking care of our deposits, and judiciously lending us money, a bank generates income sufficient to meet its overall running costs and to ensure its future and reward its shareholders. But the banks have gone much further.
Banks began as holders of deposits. Originally gold and other precious minerals were lodged for safe keeping because such stuff was inconvenient for everyday trade. Long ago in China the paper receipts for the lodging of such deposits became themselves traceable, and so the first bank notes appeared. But soon these deposit holders realised they could lend money as well, so long as they provided paper proof of the liability. Furthermore, on the grounds that not all depositors would demand their money at once, they knew that they could actually lend more than they had accepted. At first it was only a modest increase on their deposits that was lent. But then a remarkable feature of this process appeared, and this is crucial to our understanding of what banks do.
Every loan made by a bank is an asset. To the borrower it is a debt, but to the bank the borrower has become a creditor and that means the loan is an asset.
This means that the more a bank lends, the more its assets increase. Obviously, this could go on until all that the bank has is loans, but prudence and experience suggest that about eight times deposits are near the limit. That allows for variations in the rate of deposit and withdrawal. But the whole business rests on the trust of the depositors, that they will each be able to withdraw whenever they wish. The loans that every bank make become assets and part of the stock of money held by the bank. In general it is the most illiquid.
Actual cash in the tills is the most liquid and available money stock at full value. Stocks, shares, bonds, specie and real estate are progressively less immediately available forms of money and, if required quickly, incur penalties because they need time to be sold or otherwise realised. It is this availability to convert into a liquid asset which provides financial institutions with another source of profit, by trading the immediacy of liquidity for future gain from a sale. In other words, they charge for the risk that they may not get the full value of the asset. But that hardly ever happens. Inevitably, this activity means they must participate in financial markets. This provided the opening for financial activities and trading on behalf of the banks themselves. Thus, they were able to use the Banks huge cash reserves to deal in all forms of finance.
This ratio between the deposits and the amount of lending is known as the liquidity ratio. As a result, if a bank crisis happens caused by over enthusiastic lending or severe economic downturns, the banks could face a run by depositors. For this reason governments gradually intervened and set legal limitations for liquidity. After the upheavals of the nineteen twenties, a ratio of around 12% was set by many regulators, and in some cases as much as 20%. For many years we could all expect there to be no problem with a reasonable rate of withdrawals, and the banks themselves had quite firm lending criteria.
Then in the 1980’s the mood changed.
The big financial institutions, which had been run by prudent and moralistic men who generally had memories of the chaotic times between the wars, looked to be so stable and trustworthy that they could be less regulated by governments.
It was believed that competition between institutions would replace the restrictions of regulation. The political establishments on both sides of the Atlantic, and especially in London, trusted the bankers to behave prudently and honestly. The whole structure of separate markets with many players should be allowed to function competitively, and make quality financial services available to both private individuals and the business community.
Thus the decade of deregulation under Thatcher in Britain and Reagan in America was ushered in and quite quickly the whole financial sector was deregulated. This has proved to be a big mistake.
The first thing that happened was that the big and powerful banks began to eat up all the rest. In every sector and market the major banks began buying up all the finance and trading houses. They quickly moved into all sectors of financial activity. There were some residual regulation but the game was on, and little was attempted to curb these activities.
Not only did all the lending institutions extend their lending beyond reasonable bounds but also, much worse, they began to use their stocks of money to make money for themselves. They gradually invaded all the other financial activities, which until then had been out of their reach, quite correctly and closely regulated. Far from producing an efficient and equitable financial services sector, the whole thing was Father Christmas time for the directors and owners of the big banks and their friends. Because there are so few banks and so much secrecy about their operations, real competition, as economists understand it, was impossible. From day one the markets were fixed by the participants in their favour.
The banks have come to dominate every kind of financial business and either circumvent, or have modified, the rules governing them.
Trades and documents were redesignated as ‘products’. This gave them a certain respectability, and implied that the city was somehow producing something. Whereas all they were doing was moving money around and taking their share in fees. They began to move beyond the traditional money markets by inventing ‘new products’ which were merely the same familiar instruments repackaged to hide the risks and appear to be a one way street with profit but no loss. Perhaps the most reprehensible development was when they started to gamble on market performance without actually making sales and purchases. In all this they were essentially using the funds which derive from deposits to make profits for their shareholders and, of course, their own management.
The proponents of this huge change away from regulation to competition usually quoted Adam Smith as their mentor. However, they conveniently forgot that he also said that markets were inherently imperfect because a few large players will always meet in secret to fix the market in their favour. And so it has proved. At first, the moves into other financial activities was limited to what were called tactical and strategic moves to enhance the banks activities and provide financial strength. This was so much tosh. They were all empire building. The problem was that they were joined in this by some smaller and over ambitious players as we shall see.
Remember the problem: The stock of assets of a bank is money. But they also account for all their running costs and revenue in money, too.
They reasoned that the huge assets they held in trust for their customers could be used by a bank itself, and used in a variety of ways to make more money for that bank.
This was called optimising collateral. What it simply meant was making extra profits for the banks. This would not have been so bad had the banks reduced their other charges and clipped their interest rate margins. In fact they did the reverse, and argued that they had to allow for the risks in what they were doing, and therefore charged more.
Perhaps the most mendacious behaviour was for the banks to argue that they did it all for the shareholders. There is no doubt that the largest beneficiaries of what emerged were the directors and managers of the banks. Of course they wound up the share price in every case. This made banks a good speculative investment for the fund managers (many of whom worked for the banks, too), but at the same time they were handing themselves shares in their own bank as bonuses. This was a great plan for enhancing personal net worth.
Now we have to consider all those things that the other financial institutions had been doing, and which the banks wanted to take over. This will take a little explaining so, reader, be patient, and pay attention. From very early times the banks realised that they could lend money for trade by taking a charge on the goods being traded. This goes back to Roman times and was always predicated on the fact that spices, minerals and cloth could be purchased far away cheaply, and sold at home for much more, and the difference would profit both the trader and the banker. Money was therefore lent to traders with the goods themselves as the surety for the loan. This simple transaction is the basis of all primary trading, and the many subsections of commodity and goods trading.
When most of the world related values to gold and silver, there was little problem with trading in different countries. But as paper documents, notes of one sort or another, represented specie and then replaced it, financial institutions were needed to handle foreign exchange. Through a network of correspondents and markets, all the currencies of the world became more or less tradeable. There was a whole network of these confirming houses, as they were called, which specialised in trade finance.
As deregulation progressed, the banks moved in, and specialised confirming has disappeared. The banks argued that combining trade finance with foreign exchange trading would be more efficient and cheaper. That has proved wrong in every respect. The banks, meanwhile, have other agendas, and gradually more and more of trade transactions have become speculative. The whole process of supplying trade finance has become intertwined with the operation of commodity markets, which the banks have entered as well.
All kinds of commodities, from pork bellies to diamonds, are traded in organised markets. There are also markets in shipping space and capital goods. All these markets needed the banks to facilitate such sales and purchases by providing almost instant credit and well-organised settlement procedures. In general, the participants jealously guarded such markets and the banks were the servants of the markets.
Here too the banks have bought and bullied their way in. There are hardly any commodity markets that are not dominated by banking subsidiaries. The excuse for this is that the commodities themselves have formed substantial proportions of the banks’ collateral. Above all it is the sheer size of the banks’ financial resources which has enabled them to dominate these markets. The obvious danger here, as in all markets, is that where there are fewer and fewer players, the opportunities to exact maximum profit are increased.
Perhaps the most important and, in the end, crucial role of the banks has been the establishment of values for all forms of assets.
This is, in the first instance, entirely legitimate. After all, they exist to protect their depositors and to profit their shareholders. The single most significant asset, without argument, is real estate. Land and buildings have been the fundamental source of collateral for bank loans for all of their history. The term collateral is widely misused in the present situation. It simply means the consequential substitution of one form of value for another; literally ‘by the side of’ and thus a substitute. For most of us our houses stand as the collateral for our major borrowing. But banks will take any tradeable asset as collateral, including all forms of shares in business, and even businesses themselves.
A pawnbroker will take any valuable item, which may be sold to realise its value as security for a loan. Of course only a proportion of the expected value will be lent, sometimes as little as ten percent. This is accepted as a charge for the risk that the real value cannot be realised. In addition, the pawnbroker will make a charge when the loan is paid and the goods redeemed. At their most cautious, like in the 1960’s, banks behaved much like this. It was almost impossible to get a loan without putting up physical assets to a substantially greater value than the loan. Typically seventy per cent of the net value of a house could stand as collateral for a loan
Gradually the banks have changed. They appreciated that the benefits to be gained from lending and charging interest could offset the risks that an asset would not achieve its full value in disposal. They also saw that property values were rising from year-to-year, and therefore expected to recoup any undervaluing from such increases. They saw incomes increasing, and expected families to be able to repay more substantial loans. They saw the economy expanding, and expected businesses to repay larger loans with added interest. They began to lend higher and higher proportions of value.
While such a development may be understandable when granting business and private loans, when transferred to the house purchase market, it eventually brought the whole edifice down.
The banks have always accepted other forms of collateral such as stocks, shares, and any other form of documentary credit instrument. Again, these have been steadily increasing over the recent past. These have always been traded in usually specialised institutions. The banks moved in here, too, and began to trade themselves using their own and their depositors’ assets. As a result they formed an over optimistic view of value again.
Then there is the whole business of ‘personal loans’ to buy cars and other consumer durables.
This was a highly specialised business because little surety was required other than the particular car or machine purchased, and the incidence of default was frequent. Consequently, the lenders had to become directly involved with sales, and also disposals. All this, and they had a pretty extensive debt collection operation as well. To finance this, a very high interest rate was charged for these services. This business was so widely distributed and of such significance in the consumer driven post war economies, that governments regulated the business very tightly.
At first the banks simply bought the finance houses which had been very profitable. But, as regulation was eased, they incorporated such activities within their main businesses. While finance companies still exist, few are independent. One of the last and biggest, Lombard Finance, went to RBS during its spending spree. The high interest rates are still charged, even though the banks have access to some very sophisticated debt management and bad debts were less frequent.
As well as limits to their cash ratios, banks were forbidden, or actively discouraged, from participating in other financial activities.
With deregulation, however, and given the almost limitless financial resources, the banks could at last enter every kind of financial activity.
They could use the huge stock of assets to engage in any activity they chose. Above all they could ignore the former limits to lending and reduce their liquidity in some cases to only four percent.
The first target was the building societies. Although the banks had been active in providing mortgages, that activity was dominated by mutual building societies. These institutions had been strictly regulated, and had been the repository of huge amounts of small savings, which were then recycled and multiplied as private house mortgages. Being mutual they were relatively cheap, and the profits were handed back to the savers. The system was generally beneficial. Occasionally there were shortages of mortgage funds because liquidity ratios had to be protected but, in general, the huge housing booms of the nineteen thirties and the fifties were successfully financed outside the banking sector.
Once deregulated, under the Lawson chancellorship, the directors of the mutual building societies, actively encouraged by the banks, set out to demutualise and become banks. They argued that such a move would enable them to increase funds for building more houses by using the ‘wholesale’ money markets. This was entirely spurious. There was, at that time, no shortage of funds, and the wholesale market would expect higher returns than the local savers would accept.
One has to ask why, then, did they rush to ‘demutualise’. The answer was that converting to bank liquidity ratios, combined with all the other devices open to banks, this process would release huge funds, some of which were used to bribe the ‘members’, that is, savers and borrowers, who all received generous bonuses. But the real beneficiaries were the directors and their advisers, who took huge ‘fees’ to arrange the process. And guess who owned many of the advising firms? The building societies were stripped.
Once these new banks had been set up, they began to borrow in the money markets, and engage in increasingly reckless lending on the back of a house price boom which their apparently cheap funds were instrumental in causing. They became very profitable and so the proper banks moved in, quickly bought them up, and incorporated them in their businesses. It soon became apparent that these were poisoned medicine with a large number of unsustainable mortgages.
In the expectation of continued rises in the price of houses, mortgage loans of well over one hundred per cent of the house value were granted.
Often, it might be added, to families who had no chance of repaying out of conceivable future income. The whole process was encouraged by governments throughout the eighties and nineties in pursuit of home ownership of ‘affordable’ houses.
The truth is that there is an irreducible proportion of the population that can never afford to buy a house. In Europe this is accepted and humane and financially sensible law and regulation makes renting the preferred option for a large proportion of the population. In Britain we are obsessed with home ownership; an impossible aspiration for many. We also have a tradition of mean landlords and feckless tenants to contend with.
Once absorbed into the banking system, the mortgage business has added to the pollution of banking probity.
To deal with all the problems of insecure loans, banks were encouraged to ‘collateralise’ loans – a practice invented in the U.S. This meant combining bundles of mortgages, good and bad, and then ‘trading’ these mortgages to other financial institutions, usually owned by banks. This not only meant that each bundle had bad debts built in, but the costs of such trading were deducted from the loans. In the end everybody had a party on the proceeds, and the assets lay on the balance sheets at much more than their actual value. This was one major cause of the banking crisis.
In addition to these devices used to provide a basis for trading in the wholesale market money, the new ‘banks’ also indulged in a range of devices, such as off shore trusts, to hide the more risky mortgages. The whole process was founded on the belief that the rise in house prices would go on for ever.
It is a truth seldom acknowledged that most of the embedded wealth of the Western world is there for all of us to see in our buildings.
These are valued far beyond their reasonable worth but they stand as collateral for all our savings. Even now, three years into the banking crisis, their balance sheets have on them a very substantial amount of this dubious debt.
A word here about the Nationwide, which was the only significant mutual building society to survive in Britain: this has gone on from strength to strength in spite of repeated attacks from asset strippers. There is no doubt that the loss of the building societies caused by the deregulation, and then greed of the financial community, has been a great disadvantage to Britain, and is one of the causes of the present housing crisis.
The rules on granting mortgages have now had to be readopted. Borrowers are, once again, required to provide substantial equity, and the investigation of ability to repay has been much increased. One result has been to depress the housing market itself, and that has meant less houses being built, the pathetic measures recently announced by the government notwithstanding. It has also aggravated the problem of toxic debt (bundles of dubious mortgages which will never achieve their cost) the value of which refuses to rise.
Worse was to come from the unregulated bankers. Having realised that they could use their assets in all kinds of interesting and profitable ways, they set about doing so with gusto. The first target was the foreign exchange market. This is the necessary and important function of supporting trade and travel between countries. Trading businesses can settle accounts across the foreign exchanges on a day to day basis but, in many cases, where trade is seasonal or rates are fluctuating, there is a need to buy currency in advance, or at least insure against losses. Of course, many times in history, governments have intervened in such trade by fixing rates and limiting supply. In the end this does not work, as the Chinese are about to discover. But the existence of a world electronic network making it a single market provided endless possibilities for instant profit.
At first, large holders of currency like, for example, airlines, were encouraged by the banks to move money between currencies to gain the best rate of return overnight or week by week. But with the advent of computer driven instant settlement they discovered that they could shift money around at will at any time of night and day. It is now the case that 96% of all foreign currency transactions are purely speculative and has nothing to do with trade. Far from helping to give stability to the exchanges, such activities have meant a market almost permanently in flux. And every transaction means profit for the trader, usually a bank or its subsidiary.
The banks next target was a real winner. We come now to asset management.
In the Western world the largest repository of savings are the pension funds. Almost everyone in the private sector and large proportion of those in public activities contributes to a pension.
This means that every week many billions of pounds of savings go into the pension funds. The pension business is still regulated, but mostly from a taxation and legal point of view, rather than operationally. However, the funds cannot be held in cash but must be invested to realise value and yield a return.
Trustees hold most funds. In many cases these are professional financial managers but, in many cases, they are elected amateurs. So these huge funds are entrusted to asset management companies and, what a surprise, these are often owned by a bank, though sometimes by the pension funds themselves. In many cases these management companies behave honourably and do well for the members, but they still demand and get very substantial fees. More importantly they are given much discretion about how the assets are managed and what is bought and sold.
Where they become major shareholders they have great influence on the direct management of large corporations as well as all kinds of other businesses. And, of course, they are very active in mergers and takeovers, all of which produce eye-watering fees once more for banks, and little profit for shareholders or employees. Given the close involvement with the stock market and the property market, these arms of the banking industry are also able to trade on behalf of the banks themselves very profitably.
There is much more to be said about the involvement of the banks in foreign currency, international trade, and asset management, but enough here to make it clear that all such activity produces no benefit for the general population, and all profits extracted from these financial transactions have to be paid for by either users or savers within the financial system.
Banks were reliable protectors of our money, be it savings or current. They were also providers of loans for business and private consumption. They have been the traditional creators of liquidity, and that means the cash we need to undertake our everyday economic activity. They were prevented from reckless profiteering by strict regulation. Once that was removed on the spurious grounds that the ‘market’ would provide constraints and discipline, the bankers have enriched themselves at our expense. They have become so large and can command such assets that they have not only industrial power, but now even political. They have become too big to fail so that all the usual commercial constraints, which govern the behaviour and policies of companies, no longer apply. They are truly ‘out of control’.
And that brings us to our present crisis, namely the potential default of sovereign debt.
While there are good arguments for blaming the politicians of Europe for the Euro mess, on top of our own domestic debt crisis, there is no doubt that the bankers are also to blame.
It should have been quite clear to all those involved with national finance, as well as the politicians, that the Euro was set up without sufficient discipline and enforcement. It was all the more necessary, given the widely disparate economic performance and stability of the countries concerned.
In the British case, where a central bank exists, the debt crisis in the banking sector was tackled by ‘lending’ them huge amounts of money on top of an already extensive public debt. Instead of simply protecting the depositors, the banks were financed in their entirety. In the end they passed into ineffective public ownership. The government all but owns the two concerned, but exercises no control over their management.
In the case of the poorer members of the Euro family the bankers all took a stance, which would have been familiar to seventeenth century princes. They simply lent the money and pocketed the interest on the assumption that countries do not go bust. The problem is that the money they have lent is ours not theirs. Furthermore, they are not dealing with sovereign countries that control their own currency. The Euro depends on a reliable independent banking system to fund the debts of the seventeen countries. The bankers should have raised interest rates for less reliable governments long ago.
The Euro is probably doomed and all efforts will have to be turned to finding the least damaging way of dismantling it.
In this the bankers owe us all a high degree of cooperation and compensation. Since they have contributed to the mess they must at least protect depositors and savers.
In the meantime the whole business of ‘the markets’ must be ended. The idea that there is a free market in money is nonsense. In the absence of strict national government regulation the bankers cannot be trusted. They are simply too big and powerful to be allowed to continue. A root and branch reconstruction of the whole sector is necessary right now.
I am not a great one at making prescriptions but I would suggest that something along these lines is necessary. Setting up departmental boundaries within banks will not work. We are dealing with a very intelligent and determined community and anything other than strict separation will not work. In the nineteen thirties the American government did not shrink from breaking up the great companies and cartels in America. We should not shrink either.
The five big banks should be broken up and their retail businesses restricted to taking deposits and making business and private loans. Also, their size should be limited. Any new or existing retail bankers must be strictly limited and regulated.
Secondly, new mutual building societies should be established by recreating the specialised regulatory structure of former times. In the meantime the mortgage activities of the big banks must be hived off, sold, mutualised and made subject to tight regulation.
Thirdly, the banks should be forced to sell their asset management operations, which in future should be subject to close regulation. Lastly, all the trading activities of the banks should be hived off or sold to independent trading houses specialising in shares, commodities, transport, currency and so on.
Above all we need a strong financial services authority. An independent commission to supervise the entire financial sector separate from government and the Bank of England with entrenched powers and peopled by men and women with the security of tenure and independence equivalent to high court judges. They must be paid by a levy on the banks but not able ever after to be employed by any bank or financial institution.
The banks should never again become so big that they cannot be allowed to fail nor so big that their business provides its managers with huge rewards. The London financial markets are a most valuable part of the British economy but for them to continue they cannot any longer be run by the thieves and rascals in charges of the big banks.
Incidentally, the problem of sovereign debt needs to be returned to where it used to be with discount houses supervised by the Bank of England. No longer can governments fiscal and monetary policy be subservient to the bond market.
About Richard Graham