We can approach commercial banking as having three main roles: making loans, facilitating payments, and taking deposits. This chapter starts with these functions, looking at the risks and how they might be addressed. It also suggests that the banking industry has spread too widely into other services and become too powerful.
Loans
Bank loans facilitate both new and existing economic activity, creating money as necessary to achieve this.1 Doing this in a way that maximizes activity without taking too much risk is a challenging intellectual activity. Michael Manove and colleagues provide a challenge for those evaluating loans in banks by suggesting that they are lazy if they rely too much on collateral rather than on careful evaluation of the economic merits of the new projects! I have little experience in this area, but—particularly when linked to SMEs—it seems it can be both productive and exciting as a vocation.
Charging too Much
This chapter is, however, more concerned with the size and costs of loans. Making loans and taking deposits involves charging interest, which we discussed in Chapter 6 as the price of capital, and which has long been regarded with suspicion from an ethical perspective. Two elements of this distaste for interest touch modern banking practice.
First, charging high rates of interest is reprehensible if it means rich people are profiting from the distress of poorer people who have to borrow to survive. As a problem, it has probably been with us since interest was invented. We can talk about informal sector loan sharks, but there are also interest rates charged on credit cards—particularly when aggravated by penalty charges and outrageously expensive insurance. There are other forms of sub-prime loans, which are more likely to create financial stress for the borrower. It is unjust to exploit misfortune and ignorance. Lots of good work is done in this sector by those working for credit unions, micro-lenders, and various charities (non-government organizations), who help poor people avoid crippling interest. Some of their best work is in providing help with budgeting and other financial advice and assistance. It would be good to see more people in the formal banking sector being more concerned with ensuring that people’s ignorance is not exploited, and that they are guided into more sensible behavior and lower credit charges.
One element of this is help to renegotiate heavy financial loads. One of the marks of a civilized society is that it has fair and efficient ways of relieving people of unbearable debt burdens. If you have read Charles Dickens’s Little Dorrit, you will know of the debtors’ prisons of 19th century England. We now have systems of bankruptcy that mean that a competent court can require a lender to forgive debts that cannot be repaid. It is important to ensure that these systems are preserved and if possible enhanced—being aware that interventions can have perverse side effects. If contracts are not fair to both borrower and lender, lenders will withdraw from the markets and poorer people may be even worse off.
Lending too Much
A second reason for being wary of interest is that debt is a poor way to finance risky ventures. Interest does have the advantage of convenience, because it can be clearly defined and the level set without difficulty if there is limited credit risk involved. Making an equity investment means that there are additional costs involved in evaluating the size and volatility of the profits. These additional costs are not much greater, however, than evaluating loans where the borrowers are over-extended—as credit failures continue to illustrate!
On the borrowers’ side, debt exposes them to interest rate and other risks. This both restricts what they can spend and imposes economic, social, and psychological costs when they are bankrupted—even in civilized societies. Bank loans should only really finance a relatively small part of risky ventures—not just businesses, but also long-term housing loans.
Many people argue that overall debt in the economy is too high and creates credit crises—that lead to the loss of many businesses and undermine confidence. This view is often associated with Hyman Minsky, who says:
Whenever full employment is achieved and sustained, businessmen and bankers, heartened by success, tend to accept larger doses of debt-financing. During periods of tranquil expansion, profit seeking financial institutions invent and reinvent ‘new’ forms of money, substitutes for money in portfolios, and financing techniques for various types of activity: financial innovation is a characteristic of our economy in good times (2008, 199).
The implication is that people, and governments, are living beyond their means. This is true if the debt has been used to finance consumption rather than investment (what Minsky calls Ponzi finance). Lenders can be criticized for encouraging this, and will suffer the credit losses that follow. There is, however, also the possibility that the funding instrument is inappropriate. Businesses could often have less debt, and use more equity funding, and housing could be financed by more sustainable instruments, as suggested in the next section.
Using additional equity is not controversial from a theoretical perspective. The Modigliani–Miller capital irrelevance proposition holds that, under certain conditions, capital structure will not influence the value of the firm. There has, however, been debate about what is sometimes called lazy capital, with many authors suggesting that managements will waste cash flow if they are not highly geared (borrowed to the hilt so that almost all the cash flow is required for interest payments). It seems to me that the arguments for higher gearing justify corporate restructures and share buybacks that serve the interests of the financial sector at the expense of other shareholders.2 There are effective, more direct, ways of supervising managers other than putting them under the pressures of excessive gearing. Of course, tax can further distort gearing decisions, although does not have to do so. In Australia, our dividend imputation system has minimal distortions and we have less gearing in the corporate sector as a result.
It is also argued that bank deposits offer security and liquidity that are socially beneficial, and valued by savers who are increasingly older and retired. Bankers call their business model maturity transformation, and in my experience have a great deal of difficulty in even hearing the question as to whether too much liquidity could be economically undesirable. At what point do costs exceed the benefits? Is it desirable to have as much liquidity as our banking system currently offers? When one adds the sources of immediate liquidity (demand deposits, credit card limits, lines of credit and cash), one gets more than a year’s GDP. Many people, ahead on their mortgages, can conceivably borrow years of salary without speaking to their bank managers! The current levels of liquidity are excessive as they cannot be sustained without a government guarantee. They are surely leading to a misallocation of savings to short—rather than long-term investments.
The high liquidity and short-term interest rate fluctuations offered by bank deposits may actually be more of a problem than a boon for elderly people.
• To the extent they want to live off the interest income, it gives them what has been one of the most volatile sources available—and currently the lowest returns in history.
• Being increasingly at risk of dementia, they have no protection against making imprudent decisions if they lose their sense of the value of money. I have heard of a number of cases where individuals spent money unwisely, or gave away large sums they could ill afford.
• Even if they are in possession of all their senses, they are vulnerable to their less responsible children, or smooth talking investment advisors who might recommend high-risk investments.
If this is true, then much of the debt can be converted into longer term contracts that would be less risky both for borrowers and investors.
Sharing Revenue
There are varieties of ways of sharing risks other than through company equity. Shopping center rentals are often based on the retail lessees’ turnover. A related and ancient practice is crop sharing. The landowner gives over his land to a tenant in return for a portion (often half) of the crop. They both therefore share the risk of poor weather or declines in the price. It can work for long periods: visiting St Catherine’s Monastery at Mount Sinai, we were told the contracts between the Monastery and the tenants had been formally written down when Napoleon conquered Egypt over 200 years ago, and had been in force long before that. The contracts seemed unfair, however, with only 30 percent of the produce going to the tenants.
The idea might be applied further in agriculture and mining. Commodity futures shift some risk from producers to investors and consumers. They are, however, incomplete insurance contracts. Farmers remain vulnerable to weather and other crop conditions. Crop sharing for cash crops entirely sold in public markets are not difficult to monitor. While not an investment, South Africa’s Eskom provides electricity to Alusaf’s smelter at a price related to the price of aluminum, which allows it to participate in profits at a lower risk to Alusaf.
There are probably many other such contractual arrangements. Lawyer, Tim MacDonald, for instance, has been designing contracts that allow investors to get more access to revenue, before deductions for operating expenses and taxes, for 30 years.3
Salary-linked housing finance is the best product idea that I have had, although I have not yet been able to persuade anyone to introduce it. At this stage, it is outlined in some papers and a couple of boxes of product specification. I remain convinced, however, that it could provide both an ideal investment for retirees, and provide financing housing with the lowest risk.
The basic instrument is simple: Homeowners contract to pay a predetermined proportion of their income for a predetermined period. This provides significant advantages:
• No interest rate or inflation risk
• A hedge against their salary increases being less than average
• A reduction in the initial repayments compared with conventional mortgages—as they will pay more later
They would be particularly attractive to pensioners, who could invest through some pooled vehicle and share in salary growth. They also obtain significant advantages:
• An investment return linked to the salary inflation of the pool of homeowners so giving them standard-of-living increases related to general prosperity.
• An investment that pays regular monthly cash flows to match their spending needs.
As a financial instrument, it would be in a different class and offer real diversification benefits. The real returns would be independent of interest rates, share prices, and property rents. For homeowners, it insures the same risks as the livelihood insurance suggested by Robert Schiller in The New Financial Order, but without any basis risk.
There are obviously obstacles to the introduction of the product, especially operational risks and moral hazards, but these are no different from collecting income tax. For those interested in a more detailed consideration, there are more details in my 2011 paper. I would be happy to collaborate with anyone who would like to try to introduce them into some market!
My knowledge about the issues in payment systems comes from following my friend David Porteous’s work at Bankable Frontier Associates. Their report4 outlines the advantages of new payment mechanisms (such as debit cards and mobile phones) in facilitating economic activity in poorer countries especially. These mechanisms make possible some transactions that distance previously made impossible, and are often safer and more convenient. By bringing more transactions into the formal sector, they also make it easier to collect taxes and catch criminals using money-laundering rules.
While particularly important in poorer countries, there may still be innovative work that can be done in developed countries to develop systems that are more efficient and ensuring that pricing reflects the total costs, and does not distort incentives. I, for one, find loyalty programs and card points an intrusion. One cannot ignore them as you are asked questions about them at every checkout. Can someone please find a better way?
Money-Laundering
Payments have an integrity side other than ensuring that the right parties are paid. Organized crime needs banks, and apparently respectable banks have often proved more than willing accomplices. This issue appears to have been addressed more actively since the World Trade Centre attack when the physical risks became clear. However, there remains a great deal of work in this area to assist law enforcement agencies to identify more serious issues of crime, and for tax authorities to collect their fair share from international tax evasion. The work of the international Financial Action Task Force is worth supporting. There is much that many financial institutions could do to ensure that they support the letter and the spirit of this important activity.
Tax avoidance and evasion sits along a spectrum from the legitimate to the criminal. It is an easy slippery slope for integrity—and there are different places to draw the line. “Everybody does it” is a poor justification. The most comfortable place is where you would suffer no embarrassment if the tax authorities and your best friends knew your details. A tax problem means that you have enough: pay it!
Ancillary Banking Operations
Banks offer a wide range of financial services other than direct banking. These include custodial business, foreign exchange (FX) dealing, extensive dealing in derivatives, stockbroking, investment management, insurance, and merger and acquisition advice. The investment and insurance related services do not flow naturally from their core business, but arise partly because the banks have an unfair commercial advantage. Customers are invariably also borrowers, and who can afford to argue with their bank manager? I think the approach of the Depression era Glass–Steagall Act in the United States was correct, and should be applied everywhere. There are economies of scope in permitting a wide variety of financial services from one organization, but the distortion of competition and concentration of power is undesirable, and the systemic risks considerable.
There are also many opportunities to take secret profits and make excessive charges, as the customer may not focus their minds on the ancillary business. The misselling fines that have been imposed around the world are often the result of these ancillary offerings.
Ensuring that the banking conglomerates are broken up is essentially a task for legislators, but for as long as they are permitted, and if you are involved in buying these ancillary services for your organization, you need to exercise precautions to ensure that there are no conflicts of interest and you are getting the best deal. If you are working in banking groups, the challenge is to make your charges transparent and educate your clients in what is best for them. They are sure to appreciate it! If you can set up new businesses outside the big groups, so much the better.
Risk management has a high profile in the banking industry. The experts agree that it is crucially dependent on an organization’s risk culture. The discussion then normally moves on to how to ensure that everyone in the organization takes responsibility at some level for the management of risk. Poor risk management can, however, be seen an offence against justice as stakeholders are not being given their due. Stakeholders include all those who are at risk of being harmed by the organization—including the environment and future generations. Culture can thus be seen as the organizational equivalent of character, and risk culture can be seen as the manifestation of virtue within the organization. A lack of prudence in risk management is linked to the injustices of the market manipulation, money laundering, and sanctions busting in which many of the large banks have been engaged. Risk culture fails when inappropriate informal behavioral norms and expectations override the virtues as suggested in Table 3.1, which maps the elements of poor risk culture in financial institutions mentioned by Michael Power and colleagues (2013) against the corresponding virtues.
Table 3.1 The Risk Management Virtues
Elements of culture from Power et al. (2013) |
Corresponding virtues |
“Necessary to restore trust”(12) |
Integrity—being trustworthy |
“Meet customer needs” (12) |
Justice—giving all their due |
“Deviant subcultures” (13) |
Self-control |
“Over-confident corporate risk-taking” |
Justice—failure to avoid harm |
“‘Brash’ and aggressive ‘tones from the top’.” (13) |
Wisdom or prudence |
“Breaches were routinely disregarded” (13) |
Integrity |
“Introspection, lack of insight or sufficient self-criticism, rejection of external criticism” (14) |
Wisdom |
“Above all fear” (14) |
Courage |
“Complacency … There are recurring themes of missed warning signals, failure to share information.” (14) |
Integrity |
If risk management should be an exercise in the cultivation of the virtues, it is unlikely that additional regulation alone will be successful. We do not learn virtue by following rules. Confucius has it: “If people be led by laws, and uniformity is sought to be given them by punishments, they will try to avoid punishments but have no sense of shame.” Detailed rules must undermine personal responsibility by encouraging the tick-the-box approach.
People may think that they prefer easily followed prescriptions. The apparent certainty, however, offers a false sense of comfort and reinforces immature thinking. It also fosters uniformity and has the potential to create greater risks. Rules without understanding are not second best; they are dangerous. John Braithwaite illustrates from the Three Mile Island nuclear power incident, changes from which subsequently have led to a 90 percent reduction in automatic shutdowns:
When something went wrong that was not covered by a rule, operators lacked the systematic wisdom—the risk analysis intelligence—to think systematically about what needed to be done. So the nuclear regulation paradigm changed to be less about government inspectors checking compliance with rules. An important part of the new paradigm became regulatory scrutiny of risk management systems and re-integrative shaming within the nuclear professional community of companies that failed to improve those systems (2005, 86).
From a slightly different angle, Jodi Goodman and colleagues have looked at the success of giving detailed feedback in training. They find that the “specificity of feedback is beneficial for initial performance but discourages exploration and undermines the learning needed for later, more independent performance” (2004, 248).
Dominant Personalities
If an excess of rules is one way of undermining a culture virtue, an aggressive senior management that fails to consult, let alone empower their staff, is perhaps even more effective. There are many examples. In Australia the failure of HIH, the largest insurer in the country was the subject of a Royal Commission. The commissioner, Justice Owen (2003) expressed it this way:
The problematic aspects of the corporate culture of HIH—which led directly to the poor decision making—can be summarised succinctly. There was blind faith in a leadership that was ill-equipped for the task. There was insufficient ability and independence of mind in and associated with the organization to see what had to be done and what had to be stopped or avoided. Risks were not properly identified and managed. Unpleasant information was hidden, filtered or sanitised. And there was a lack of sceptical questioning and analysis when and where it mattered.5
Dominant personalities are a poison that has to be confronted, and courage is required to do so. It would be easier for boards to consider character, and be suspicious of signs of arrogance, when appointing members and executives. Remuneration packages could also be based less on grandiose views of the role of the leader. Limited terms can keep politicians in line and could help in business too. If you are faced by a dominant and bullying individual in your organization, you could look at the discussion of bullying in Chapter 13.
Systemic Risks
If we are concerned with flourishing communities, we will be concerned for the weaknesses and fragility of the financial systems within those communities. As banks must trade and accept payments from each other, they inevitably have exposure to each other. There is a need to ensure that payments are netted or settled as soon as possible so that all parties can easily calculate their exposure to an institution that is weak.
This appears to have been done effectively for payments in most countries, but not for exposures arising from derivatives and FX, which therefore present a systemic risk. The FX market particularly continues to grow and this year has apparently reached the quadrillion level. As such, it may be too big to manage, and the latest Basel findings are not surprising:
… substantial FX settlement-related risks remain due to rapid growth in FX trading activities. In addition, many banks underestimate their principal risk and other associated risks by not taking into full account the duration of exposure between trade execution and final settlement. While such risks may have a relatively low impact during normal market conditions, they may create disproportionately larger concerns during times of market stress (2013, 3).
Andrew Haldane and Robert May have suggested a hub and spoke approach to simplify derivative markets—rather than the current “cat’s-cradle” of financial network interactions. This would require trades to be settled by international clearing houses, and there are already entrants to this market.6 It will require regulation to require standardization of contracts and to ensure that all banks participate. There is much creative work necessary to design effective institutions to provide for all derivatives and not just FX contracts.
Unmanageable chains and layers create similar systemic risks. Lloyds of London almost failed in the 90s because of a reinsurance spiral. Members were not aware of which risks they were insuring because the different layers of insurance were not visible to them. The 2008 financial crisis was also exacerbated by institutions unaware of the concentration of risks though multi-layered asset backed securities and credit default obligations. I have also been told of stock lending spirals where the original owners do not know who currently has possession. It is difficult to believe that such spirals are efficient, let alone necessary. The lack of transparency also suggests overcharging.
Dynamic hedging of put options and a variety of other trading systems that sell when prices drop present another systemic risk. Programmed arrangements have been blamed for the 1987 market crash, and a variety of capital requirements and trading rules have thus far prevented a system-wide recurrence. There are, however, losses every time the market drops. Life insurance companies issue guaranteed annuity contracts that they protect using dynamic hedging. Actuarial company Milliman reports that the hedging programs saved the life insurance industry $40 billion in September and October 2008, but they also lost $4 billion in those 2 months.7 There is no comment on who suffered the $40 billion losses, but it would presumably have been some hedge funds and the banks that offered the derivative contracts. This is another Miller–Modigliani application. Spreading investment risks around the market does not necessarily add value, just frictional costs. Companies that offer investment guarantees should have capital to absorb the associated risks; otherwise the capital may not be available when it is needed.
Resolution Plans
International regulators8 have called for the introduction of resolution plans, also known as living wills, to address systemic risk particularly. These recognize that no risk management system can prevent catastrophic losses overwhelming the institution’s capital. Plans need to be in place to respond quickly so that the failure of one institution does not damage others. This is especially important for banks so that they can be recapitalized quickly and resume lending. The insurance industry, not being government supported, usually has exclusions for catastrophes including Acts of God and Force Majeur to protect themselves and so that they can continue to function.
For banks, there need to be triggers for freezing deposits and turning them into longer-term instruments to avoid bank runs, and for writing off equity when it appears that there have been credit losses. There would be an earlier point at which subordinated debt would be converted to equity (tier 2 into tier 1 in Basel terms), and further points when other creditors and depositors would have part of their value converted into equity. The points should be set at levels (obviously subjective) where there would be no point in withdrawing deposits. The share price at which conversion takes place can be predetermined at a level that effectively wipes out shareholders. New shareholders can then vote for a rapid change of board and management if they feel it appropriate. Similar approaches can be applied to insurers. It will be objected that it is not possible to value assets sufficiently quickly—and this could lead to considerable inequity if the assets were subsequently found to be much better than originally judged. There would be no objection to providing appropriately priced options to previous shareholders to recover their losses. The point is that, absent government support, failure is quite likely at the levels of gearing banks typically use—and society ought not to have to suffer the pain of waiting for banks to recover and resume normal lending, nor of compensating investors for business risks. Sebastian Schich and Byoung-Hwan Kim show that market participants still widely believe that governments offer implicit guarantees to bondholders, but report changes to these beliefs as resolution plans are implemented.
It can be seen as a matter of integrity. Institutions need to address their weaknesses and mortality. Even if regulators do not require such plans for all institutions, they can move in this direction themselves. It is again a question of communicating uncertainty and the same arguments apply as in Chapter 7. Companies that work on helping their clients understand should obtain a marketing advantage in greater customer trust, and protection against bank runs in times when panics occur.
Chapter summary: The main social function of banks is facilitating payments, which include the taking of deposits and the provision of liquidity. It is, however, risky to use bank deposits to make long-term investments, and high gearing is economically and socially destructive. Banks have become too influential in modern economies; it would be better if they were not involved in housing finance or investment management, and reduced their share of the unmanageable complexity of some derivative markets. All of these have created forms of over-servicing and failures in risk management that are linked to ethical failures of the leadership, some stemming from arrogance. Dealing with systemic risks requires banks to have resolution plans.
1McLeay et al. (2014) of the Bank of England provide a concise summary of modern banking, and how banks create money.
2I have been unable to find much in the way of direct criticism of this view in the large literature stemming from Jensen and Meckling (1976). A possible exception is Walter Novaes (2003) pointing out that managerial power may also explain capital structure. The huge costs of the 2008 banking crisis, however, nullify previous research showing small gains from gearing. Andrew Haldane and Vasileios Madouros (2012) show that the simple gearing ratios used by Basel 1 were good predictors of bank failure. Rather than addressing the agency problem, the encouragement of gearing seems to have caused an increase in the managerial expropriation of wealth, and huge credit losses.
3Accessed November 24, 2014. http://evergreeninvestors.com/author/tim-macdonald/.
4B. F. A. “The Journey Toward ‘Cash Lite’ Addressing Poverty, Saving Money and Increasing Transparency by Accelerating the Shift to Electronic Payment.” Accessed August 30, 2014. http://www.uncdf.org/sites/default/files/Download/BetterThanCashAlliance-JourneyTowardCashLite.pdf.
5Accessed August 30, 2014. http://www.hihroyalcom.gov.au/finalreport/Front%20Matter,%20critical%20assessment%20and%20summary.HTML#_Toc37086537.
6See, for instance: http://www.cls-group.com/Pages/default.aspx. Accessed December 22, 2014.
7Accessed 12/22/2014. http://www.actuaries.asn.au/Library/Standards/LifeInsuranceWealth/2012/LIWMPCVariableAnnuitiesOctober12.pdf (page 6).
8For details see http://www.financialstabilityboard.org/wp-content/uploads/r_121102.pdf. Accessed December 12, 2014.