Friday, 16 May 2014

Banking – Back to Basics

Time for banks to return to their bread-and-butter operations after having almost poisoned the global economy

Banking is like food – best kept simple with as little processing as possible.  This is because, in their role as the intermediaries controlling flows of money in an economy, banks provide the nutrients which help the economy grow.  What was supposed to be a straightforward process became convoluted as banks cooked up ways to move loans onto others.  The resulting concoctions were devoured by investors around the globe, resulting in serious indigestion once the toxic nature of the ingredients was discovered.  Given that the packaging of dodgy debt was one reason for the scale and severity of the global financial crisis, the common sense move would be to change back to a plain vanilla variety of banking.

A recipe for trouble

We rely on food getting from the farms where it is grown to our supermarket shelves every day.  Too much or too little food would cause problems as would food ending up in the wrong places.  We also rely on banks to look after our money in the same way.  Savers leave their surplus cash in banks who make it available for others to borrow.  This simple analogy is how we tend to perceive the role of banks but, as with many things, the reality is more complicated.

Banks have access to a growing range of funds allowing them to lend as much as demand allows.  This gives them a substantial amount of control over how much money there is in an economy.  Central banks look to control lending using interest rates but the global financial crisis has shown that this is insufficient.  Interest rates tend to be too low when economic growth is booming, giving banks scope to lend more than is optimal.

This problem has been exacerbated with banks being able to sell on loans to investors in the form of bonds.  By passing on the risk associated with lending to others, banks circumvented the normal limits on lending and levels of debt exploded as a consequence.  Debt from banks was sold on as bonds such as CDO and MBS with this alphabet soup of financial instruments eventually proving sickening to the financial system.  Banks had our cake and ate it and the result has been years with the economy being starved of credit.

Creating these nauseating bonds was like using MSG to flavour food – an easy way to get an immediate boost but not good in the long term.  Most of us would steer clear of extra nasty additives in our food for fear of the future consequences.  Bankers, on the other hand, gobbled up any magic pills which boosted their profits in the knowledge that it would not be the banks themselves that would pay the price.  This is a problem which is endemic to banks operating without sufficient regulation.

Smaller is better

Considering the propensity for banks to poison the entire economy, their operations should be pared back to a more traditional and wholesome role.  One means to do this would be to limit the activities of banks and break up larger financial institutions that have parts which operate like conventional banks.  Banks should be limited to a scope within which they cannot get into trouble and need to rely on the government for support.  More speculative aspects of their business should be left to others who should be prevented from accessing our deposits.  Other forms of financing are flourishing and this is already replacing part of what banks do.

The basic idea behind this is already out there and is known as the Volker rule.  It has been endorsed in principle by many in politics including President Obama.  Yet, the implementation of this idea has stalled due to opposition from an unsurprising source - the banking sector.  This highlights another benefit of having smaller banks – a reduction in the dominance of the finance sector.  The wealth generated by banks has given them the political clout to push for more freedom to chase profits.  Banks have built themselves up to be the champagne in the economy (providing skilled jobs and lots of tax revenues).  Yet, since it is all too easy for the bubbles to go flat, a return to a bread-and-butter setup would be preferable.

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