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A broken model

A broken model

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In my article on the slow death of banks, I suggested that banks maintained on life support would eventually become redundant as new forms of financial intermediation took their place. This is the first of two posts in which I discuss what those new forms might look like.

The key change that we are seeing is what we might call "disintermediation" - flight of both lenders (depositors) and borrowers from traditional deposit-taking lenders to other types of financial intermediary, many of them specialists in particular aspects of financial management networked to other providers that do different things. This has already happened to a large extent in the US, but the UK and European models of banking are founded on universal banks and it is difficult for many people even to imagine what a banking system deconstructed into its component parts looks like. But when you break down the traditional banking model, it becomes apparent that there is a fundamental conflict at the heart of universal banking that makes it untenable as a business proposition in the current climate.

If you ask people what the job of a bank is, you are likely to get two quite different answers:

- to provide a safe place to put money

- to provide capital to business and households for investment.

Because of the growth of automated payments and decline in the use of cash, we can add to this the role of banks in maintaining the flow of money through payments and receipts and ensuring that people receive wages and pay bills securely. The payments systems themselves (CHAPS, BACS, VISA, SWIFT among others) are separate organisations, but the gateway to them is via commercial banks and liquidity is provided by the central bank.

Putting these three things together, it is plain that people expect banks both to provide security for savings and payments AND provide risk capital for businesses. The apparent impossibility of achieving both of these appears to be lost on politicians who call for banks to make their balance sheets safer (so as not to put deposits, and by extension taxpayers' money, at risk) then criticise them for reducing risk lending. This is fundamentally inconsistent.

Prior to the 2008 financial crisis, banks were going for provision of capital to the economy in a big way, leveraging up their balance sheets and taking ever-larger risks in all areas of their business, and particularly in corporate lending, commercial real estate and residential mortgages. They regarded deposits as "funding" to support this activity, and it is probably fair to say that they did not regard keeping savings safe or ensuring the security of payments as their top priority.

Since the financial crisis, the pendulum has swung the other way. Pressure from regulators, politicians and customers, coupled with banks' own risk aversion, has led to safety becoming the top priority. Everyone has ideas about how to make banks "safer", but few seem to realise that a safe bank is also a risk-averse one: if a bank can't take risks with its balance sheet, it is unable to provide the risk capital that businesses need.

Even good customer service is not really possible while such a fundamental conflict exists. Either depositors who want safety are well served, in which case borrowers' needs are not met, or borrowers' need for risk capital is met, in which case depositors cannot have safety.

But at the same time as there is pressure to make banks safer for depositors, there is conflicting pressure to make them riskier. This is coming from two directions: firstly the aforementioned political pressure on banks to lend more at higher risk in order to revitalise stagnant economies, and secondly the withdrawal of implicit support from government in the event of bank failure. Depositors and senior bondholders are no longer sacrosanct. They can, and do, lose money when banks fail.

This creates a problem. In their quest for safety, banks are looking for more deposits because they are a more stable funding source than wholesale funds that can be withdrawn without warning. But if deposits are no longer safe from loss, what can banks offer depositors that they cannot find in managed funds? Demand deposits at least give the flexibility to withdraw funds at a moment's notice. But there seems little reason for time deposits in banks to exist at all. They compete directly with mutual funds, which would be fine if banks regarded themselves as asset managers, actively managing funds placed with them to the benefit of their depositors. But they don't. And even if they did, they are rubbish at it. The wealth management divisions of universal banks may excel at portfolio management, but not their mass-market retail banking divisions. Retail banks do not "look after people's money", and never have done. They exist only to lend. Time deposits are therefore a complete anomaly. And even demand deposits are not exactly essential, since there are alternative forms of liquid investment, such as gilts and (for larger amounts) money market funds. Savers have more investment choices now than at any time in the past. They do not have to put money in banks.

But there is a form of bank deposit-taking that has become essential. Back in the 1960s, we had a cash-based economy. Workers were paid in cash, pensioners and mothers queued up in the Post Office to collect their pensions and benefits in cash, people paid their bills in cash, essential and discretionary spending was in cash. The majority of the population seldom used banks.

Compare that with today. 94% of the UK adult population have bank accounts. Wages, pensions and benefits are paid directly into bank accounts, as are payments to businesses. Household bills are paid by direct debit or bank transfer. Essential and discretionary spending is done with debit cards and online payments. With the advent of contactless cards and mobile phone transfers, cash is no longer needed even for very small payments. Cash makes up a far smaller part of our economy than it did in the 1960s. It has largely been replaced by banks and the electronic payment services they provide, which have become essential to our economy. RBS's recent IT outage for 3 hours caused ATMs to eat debit cards and restaurants & shops to decline card payments. Its previous one caused BACS payments and direct debits to fail and disrupted customer accounts for weeks. THIS is why depositors insist on safety - and they are right to do so. The money that they put in banks is no longer just discretionary saving for a rainy day. It is their day-to-day living expenses. Loss of access to this money even for a few hours causes them distress. Loss of this money due to bank failure could cause enormous hardship.

Deposits, including transaction accounts, do of course attract deposit insurance up to a limit. Deposit insurance is paid for by financial institutions through a deposit levy, and it is expected that as a last resort the sovereign would step in to top up the insurance fund - as indeed the UK government did in the financial crisis. But the limits are not high - many households and small businesses have more "in the bank" than the insurance limit - and the implicit sovereign support for larger deposits is now being withdrawn. And despite the "mission critical" nature of payment services, there still are no arrangements whatsoever to provide emergency liquidity to households and businesses suffering loss of access to transaction accounts due to bank failure. Despite the calls for banks to be made "safer", deposits have never been so "at risk" as they are now. Banks are no longer "safe places to put money".

So part of the banking model - the provision of a safe home for money - is broken. How will people respond to this? Over time, bank deposits are likely to decrease as customers move uninsured funds to safer havens, leaving only insured deposits. It has been suggested that customers will still choose to place uninsured funds with banks as a form of risk investment. But this is simply not credible. People put money in banks for safety, not for investment. And as retail banks are not sufficiently good at asset management to be trusted as investment managers, that is not likely to change.

The decline of large deposits due to withdrawal of the sovereign guarantee comes just as banks are increasing their loan to deposit ratios to improve the stability of their funding. This might increase competition for deposits, which would force up interest rates - good news for savers. But banks that are already suffering margin squeeze due to low interest rates on existing variable rate lending are unlikely to want to attract deposits at higher rates. They are much more likely to reduce lending, particularly the highest-risk lending. Unfortunately that is the lending we most want them to provide - investment funding and working capital for businesses. Sovereigns will plug the growing deposit gap with transfusions of central bank money in an attempt to increase lending - but this would simply increase banks' dependence on government support. And it would have a toxic effect on banks' balance sheets, too. In return for funding, central banks require assets to be pledged: as central bank funding starts to replace deposits, banks would be forced to pledge more and more of their balance sheets to the central bank. This process is already well under way in the Eurozone. Once a bank becomes dependent on central bank funding, and its balance sheet is encumbered with central bank pledges, it has no functional independence. The unencumbered assets on its balance sheet would be the poorest quality and therefore the most likely to fail: deposit insurance claims would therefore be inevitable in bank failure. As I've already noted, deposit insurance has an implicit sovereign backstop (well, maybe - see next paragraph), and the terms of deposit insurance allow the insurance fund to be used to bail out banks rather than reimburse depositors. Effectively, therefore, the riskiest part of the bank's loan portfolio would be guaranteed by government.

The idea that banks can provide risk capital to the economy without a sovereign backstop for essential deposits is simply unrealistic. If the sovereign backstop for deposits were completely withdrawn - and it is worth remembering that the EFTA Court's judgement in the Icelandic case was that the sovereign is not liable to cover deposit insurance in a systemic crisis - banks would be forced to massively reduce or even cease all except very well collateralised lending such as low-LTV residential mortgages to protect transaction accounts. Either we have deposit insurance, at least for transaction accounts, or we don't have risk lending.

So if the deposit-taking and risk lending model is fundamentally impossible without sovereign guarantee because of the need to protect transaction accounts and the existence of alternative safe investments, why do we need commercial banks at all? Why not simply create a public utility for transaction accounts and payment services - perhaps a GSE backed by the central bank? And while we are at it, since most alternative forms of "safe" investment involve government debt, why not create a state Savings Bank for people to put money in that they want to keep safe - money that could then be productively recycled to the economy via a state Investment Bank? These too could be GSEs, if you prefer this to be at arms-length from government. Yes, I've heard all the old chestnuts about the state being poor at capital allocation and private sector banks doing it much better. Frankly in the present climate this is nonsense. Commercial banks aren't allocating capital much at all. And when the private sector won't allocate capital properly - won't invest at risk for a future return, if you prefer - the public sector must do it for them.

Believe me, I do not say this without much soul-searching. I am in effect recommending nationalisation of banking - and I never, ever thought that I would reach this point. But I don't necessarily see this as a permanent prospect. I think there are already signs of a new, fundamentally different model starting to emerge: it may be that we will only need these state institutions to cover the transition period while the old model is moribund and the new one is forming. In my next post I shall discuss what this new model might look like.

Related links:

The slow death of banks - Frances Coppola

When governments become banks - Coppola Comment


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I thought in the "good old" days there were separate retail and investment banks and everyone (or almost everyone) was happy. If I am not mistaken this whole thing changed during or shortly after the Reagan administration (please correct me if I am wrong).

As for your suggestion about a state "savings" bank, in principle I agree. However, I am just not sure if the same financial institution must play both roles (savings plus investment). In this case maybe we will have competition problems stemming from the monopoly of the state towards the rest of the commercial banks.

So, I was wondering if a slightly different model would be more efficient. For instance, the state bank should be a purely savings one with a 0% interest rate and a 100% liquidity capacity. Much like a "impenetrable state vault", where neither capital increase nor lending will take place and all deposits will be guaranteed, no matter how big or small.

Good to point that the view of BIS that unconventional monetary policy needs to be scaled down because of insufficient benefits, but I think that they would disagree with you on the alternative "Helicopter drop" style solutions. I think that even though global institutions like the IMF and BIS have researchers that truly understand our ills (Singh, Borio, Pozsar etc.), their leadership is in denial. We need leaders that will demand pro growth strategies, not contraction and internal devaluation.

Hi Frances,

You describe as “fundamentally inconsistent” people’s desire for banks to provide “security for savings” and to provide “risk capital for business”. I suggest the advocates of full reserve banking have had the solution to that inconsistency worked out for some time. At least the full reserve systems advocated by Positive Money, the New Economics Foundation, Richard Werner and Laurence Kotlikoff have got it worked out. They advocate systems under which depositors have to choose between two types of account. First there are 100% safe, instant access accounts where funds are not loaned on, so there is no risk and no taxpayer exposure. Second, depositors can choose accounts where their funds ARE LOANED ON, but in that case depositors carry the risk. So again, there is no taxpayer exposure.

That way, money which is supposedly 100% safe is not used to provide “risk capital for business”.

And an additional bonus is that banks cannot fail - at least they cannot fail suddenly, and it’s the SUDDEN failure that does the damage (as pointed out by Mervyn King is his “Bagehot to Basel” speech).

Incidentally, accepting the desirability of the “two account” system does not necessarily mean accepting full reserve, lock stock and barrel, far as I can see. But the two account system is an inherent part of full reserve.

Re the “fundamental conflict at the heart of universal banking that makes it untenable as a business proposition in the current climate”, I suggest the “conflict” is more “fundamental” than you suggest. I.e. the conflict has not arisen just in recent years. That is, for a bank (or any other institution) to first, take £X off depositors, second to promise to return £X while, third, lend on or investing the money in ways that are not 100% safe is basically fraudulent.

It is precisely the above risky activity that explains the collapse of hundreds of banks over the last five hundred years – or maybe even going back to Roman times.

Mervy King referred to this fraud or inconsistency in his “Bagehot to Basel” speech in 2010 when he said, “ If there is a need for genuinely safe deposits the only way they can be provided, while ensuring costs and benefits are fully aligned, is to insist such deposits do not coexist with risky assets.”

“Time deposits are therefore a complete anomaly.” I agree.

“And even demand deposits are not exactly essential…” I beg to differ: people want and need a stock of “instantly spendable money”, don’t they? I certainly do.

“Why do we need commercial banks at all?” My answer is: to administer instant access or “current accounts”, debit cards, etc. Obviously that activity, as you suggest, COULD BE nationalised. But I don’t see any big need for nationalisation – that’s more an ideological thing, perhaps.

Moving on . . . if one accepts that banks should no longer lend, and that all lending is done by entities like unit trusts (mutual funds in the US) which is the model that Kotlikoff wants, then funds for lending are supplied by people who are in effect shareholders. And that raises the question as to whether that increases the cost of such lending. Miller and Modigliani would say “no”. Various attempts have been made to criticise M&M, but none of them hold much water in my view.

Hi Frances - thank you for another interesting and thought-provoking article. However, regarding the need for risk capital in modern business, I can understand the need for risk capital in the case of start-ups and fledgling businesses, who would otherwise not be able to enter the market, but why would/should established businesses require ongoing debt?

In my (probably over-simplistic) view of the world, I always saw profitability as one of the key goals of business. Once able to achieve profitability, and put some money in the bank, that money could then earn interest which could be used for future capital outlay. When did this model become frowned upon, and why?

Why would it be bad to say 'the banks won't lend, let's raise interest rates so that prudently run companies with their accounts in the black are able to earn interest on their working capital and fund growth that way?'

Would this not reduce the pressure on banks to lend and shore up their deposits simultaneously?

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