No mystery behind banks behaving badly

Banks were misbehaving in the lead up to the global financial crisis but the blame lies elsewhere

Many fingers have been pointed (and fists waved) at the banking sector.  Bankers have been receiving massive pay-outs despite having acted irresponsibly in getting us into trouble.  While they deserve much of the blame for our current woes, it is like blaming students who are left in charge of running their own school.  Bankers were left to run their own affairs on the mistaken assumption that they could do so responsibly.  But the few rules in place to keep banks from acting out proved insufficient.  This raises the question – why were banks given so much leeway in the first place?

A recipe for trouble

Banks are in business to make money.  The most common way for a bank to do this is to loan out money at a higher interest rate than they pay to get access to the funds.  Given these basic guidelines, anybody running a bank would lend out as much money as possible.  This would not be a problem if there was only a relatively fixed amount of cash to go around.  To make more loans, a bank would have to get its hands on more cash which would involve higher costs if spare funds were in short supply.  The extra charges for banks would then result in higher interest rates and this would put off some potential borrowers.

Unfortunately, this is not how things work in finance.  Instead, using tricks such as electronic money, banks can create as much money as they want.  Any limits to lending have been further diluted as banks have come up with ways of getting loans off their books.  Financial wizardry has enabled loans to be repackaged as bonds and sold off to investors.  Such bonds (known as mortgage-backed securities) were popular due to a combination of a decent rate with seemingly little risk.  With lots of money sloshing around the global economy before the financial crisis, investors did not bother to delve into what the bonds actually entailed.

Banks had reduced their lending standards to include sub-prime borrowers as they no longer had to worry about whether the loans were actually repaid.  So what investors got were bonds that would drop in value once the debt-fuelled property boom came to its inevitable end.  The situation was made worse by the way in which bankers were paid.  Their substantial remuneration packages were linked to profits giving bankers an extra impetus to undertake risker actions.  Levels of pay got out of hand as it was easy to make money by tapping into the demand for credit. 

Even if bankers themselves were motivated to cash out after quick gains, it was thought that prudent business practices would keep banks running through thick and thin.  Yet, the number of banking bailouts showed that bankers favoured short-term profits (and big bonuses) over long-term survival.  With the government and the central bank expected to step in if banks got into trouble, it was worth taking extra risks as there were millions to be made and only the possibility of losing their jobs if things backfired.

No one in charge

With it seemingly obvious that bankers were heading for trouble, there was a glaring need for oversight and regulation.  Despite this, banks were increasingly given a free rein following a couple of decades of deregulation of the finance industry.  A wave of free market ideology had convinced a generation of politicians that any government interference would hamper the industry.  The result was that the finance sector was put on a pedestal and afforded the status of teacher’s pet as a source of tax revenues as well as jobs for skilled workers.

Any attempt at oversight typically succumbed to something known as “regulatory capture” where the government agencies designed to monitor the banking sector are too closely intertwined with the banks.  This is because personnel move back and forth between government and finance, always keeping the industry’s best interests at heart.  Even the central banks that were charged with ensuring financial stability did not find fault with the banks.

Instead of taking on the inherent problems in the banking system, central banks developed a narrow focus on inflation.  Interest rates were the main tool with which central banks attempted to rein in the vagaries of the finance sector.  But higher interest rates only target the demand for loans rather than the supply of credit from banks (who actually make more money when interest rates rise).  Interest rates went up too slowly to stave off the credit boom as easy loans from banks opened the way for us to get ourselves deeper into debt.  Given too much freedom, we can all get into trouble and banks have shown themselves to be no exception.