The slow death of banks

The slow death of banks

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In 2008, there was a crisis. A bank failed, causing chaos in the global financial system. Because of that, everyone is now terrified of another chaotic failure. So from that moment on, governments and central banks the world over have implemented all manner of extraordinary policies to prevent another major bank failure. Interest rates have been cut to zero, banks have been flooded with reserves, governments have taken on board huge quantities of toxic assets. Understandably, therefore, people are angry that despite all this, banks are apparently not lending to the wider economy. Small businesses and young households, in particular, are finding it hard to raise finance. And although investment banking is widely (and in my view wrongly) blamed for the crisis, the roots of these problems lie in retail banking.

The Great Restructuring

I have recently been struck by the extent of retail bank restructuring in the UK. Everyone knows that two of the UK’s biggest banks failed and had to be part-nationalised in the crisis. But it is perhaps less widely known that the other two big banks have also undergone major restructuring since the crisis, shedding thousands of jobs and shrinking their balance sheets considerably. And the building society sector experienced a considerable shakeout in 2009 as a consequence of the crisis. One building society (Dunfermline) was nationalised, others were bought by larger banks and building societies and one (Kent Reliance) was even bought by a private equity company.  But this has caused indigestion for some buyers. The Co-Op Bank is about to undergo extensive restructuring due to its 2009 purchase of Britannia Building Society, which it now transpires had sufficient toxic loans to overwhelm the smaller Co-Op’s balance sheet.  And the Nationwide has struggled to integrate the four smaller building societies that it absorbed: it too has had to undergo major restructuring in the last few years. The five biggest UK lenders and the entire building society sector have all undergone radical surgery. Many are still in intensive care.

Nor have smaller retail banks been immune. Northern Rock and Bradford & Bingley both failed and were nationalised in the crisis. And a significant number of small banks, building societies and credit unions have gone belly-up. Most depositors in smaller institutions are below the FSCS compensation limit, so we never hear about these failures: but in 2012, losses were imposed on large depositors at Southsea Bank, which caused some press interest though the implications were not fully taken on board at that time. In the US, FDIC records show that literally thousands of small banks have failed in the last five years.

After the financial crisis, there were extensive inflows of deposits to small banks and building societies as people – encouraged by campaigns such as Move Your Money – moved funds out of banks that were seen as “risky” and “bad for society”, into other institutions that had a better image. We now know that these other institutions are no safer, and perhaps no better for society, than the big banks that are so widely criticised.  The 2008 crisis was no more a crisis of big banks than it was a crisis of investment banks. It was a crisis of BANKING, in all its forms. And it has not yet ended.

The continuing shakeout and restructuring across the banking industry is immensely damaging to the economy. Weak banks stuffed with risky non-performing loans cannot lend productively, and deleveraging bank balance sheets and building capital have deflationary effects in the wider economy.  But at least they’re alive.  They've survived the crash, though they are badly wounded. So if we keep them on life support for long enough – keep funding costs down with low policy rates and funding subsidies, guarantee riskier lending so that they appear to be doing something useful, and provide them with lots of cheap liquidity – eventually they will recover, won’t they?


Unfortunately, the treatments we are using to keep them alive themselves have toxic effects. Most of them were supposed to be short-term interventions to prevent disorderly collapse. It was never expected that they would be continued for years on end. And some interventions seem actually to maintain banks at the expense of the wider economy.

Very low interest rates are supposed to encourage the flow of credit to borrowers who would be reluctant to pay higher rates. What they actually do is prop up highly indebted households and businesses, preventing bankruptcies and foreclosures. New loans are generally at higher rates – in some cases MUCH higher rates – than older ones, even though official rates are on the floor. Now, preventing bankruptcies and foreclosures protects banks (and, indirectly, savers): a sudden swathe of business and household debt defaults would spell disaster for many lending institutions, particularly the smaller ones. Unpopular though it is to say this, large universal banks are actually less likely to fail than small lenders concentrated in particular market sectors such as residential mortgages.

Very low interest rates also prop up the prices of safe assets, which are used as liquidity buffers by financial institutions. And they depress bank funding rates, both in the wholesale market and, perhaps more importantly now that banks are trying to reduce their reliance on unstable wholesale funding, rates to depositors. Deposit rates are below inflation (i.e. negative real rates), while interest rates to new borrowers are rising. It is widely believed that banks are using the earnings from the spread to recapitalise…..but are they, really? The problem is that banks have overheads – staff costs and premises, for example: the retail branch network is expensive to run. When interest rates are very low, banks don’t earn much. Yes, if funding costs are low too they make a profit on the difference. But margins are being squeezed, which is affecting bank profitability across the board: all the major banks report reduced interest income and rising costs.  Margin squeeze is particularly tough for small players, so very low interest rates tend to benefit large retail banks at the expense of smaller ones. When margins are tight, the winners are those with the largest market share.

Steve Hanke at the Cato Institute argues that very low interest rates make it virtually impossible for banks to do risky lending. I take issue with this, because banks are charging SMEs far more than their low funding costs would suggest is reasonable. I think SME lending is constricted because of the mess that banks are in, not because of low interest rates. However, Hanke also says – correctly - that very low interest rates kill the interbank market. It simply is not worth banks’ while lending to each other when they can earn pretty much the same for parking excess reserves safely at the central bank. This impairs the flow of funds around the financial system. Central banks around the world have used quantitative easing (QE) and term lending (repo) on an unprecedented scale to offset the collapse of unsecured interbank lending, in effect ensuring that all banks have excess reserves so don’t need to borrow from each other. But this doesn’t exactly encourage banks to lend.  All it does is enable them to make payments. And as risky lending ties up capital, and banks are short of that because of their horribly risky lending books, is it any wonder that they are charging high prices for risky lending? They don’t really want to do it.

So very low interest rates destroy bank margins and slow the velocity of money. Providing banks with cheap funds offsets this to some extent, because it enables them to refinance their existing loan books at lower rates, improving their spreads and keeping variable rates to existing borrowers at historically low levels (thus avoiding defaults). The idea behind schemes such as Funding for Lending (FLS) is that if existing loan books can be refinanced at better rates, banks will be able to take on new risky lending – particularly if the scheme includes a concession on regulatory capital requirements, as FLS does. But there is one big flaw in this thinking. Refinancing loans at lower rates may improve banks’ margins, but their balance sheets remain horribly risky. And reducing the regulatory capital requirement doesn’t make the risks go away. Risky lending is risky lending, whether or not regulators want capital allocated to support it. Personally I think reducing the regulatory capital requirements for risky lending using FLS funds is insane. And it won’t work anyway.  The entire UK banking sector is trying to unload risky assets at the moment. Why on earth would they want to take on more? Fiscal and monetary authorities seem convinced that if you throw enough money at banks – or reduce interest rates enough - banks will be “compelled to lend”. Yes, they will – but not to risky people and businesses. No, they will look for opportunities to lend at near-zero risk. And they won’t have far to look: central bank deposit accounts and government debt – nice safe assets earning them a few pennies while adding no risk to their balance sheets and keeping regulatory authorities happy. Even though FLS includes penalties for failing to lend to the real economy, it doesn’t take a genius to work out that for weak banks, the penalty may well be worth their while taking in order to obtain cheap risk-free funds. No wonder the Co-Op Bank took £900m from FLS in the first quarter of 2013.

Then there is QE

I think the whole world now knows that QE – and its close relatives LTRO and other central bank extended term repo operations - does not do what it was hoped that it would. Flooding the place with liquidity ensures that banks can always to make payments, but doesn’t force them to lend productively: what it does do is create a liquidity swamp in financial markets, causing all manner of perverse effects.  Propping up asset prices helps banks to maintain good liquidity buffers but creates a scarcity of collateral for repo and other secured lending, reducing the flow of funds around the shadow banking system and impairing lending by non-banks. QE and its relatives are regressive, since they directly benefit the rich most: the jury is out on what effect if any they have on unemployment and real incomes for the majority.   

Propping up house prices –which is what Help to Buy does – benefits those with houses at the expense of those without: but it also maintains the value of collateral on lenders’ balance sheets, keeping their capital requirements down and therefore helping to ensure that they stay solvent. If house prices were allowed to fall to levels more consistent with average incomes, especially in London and the South East, I suspect most mortgage lenders would turn out to be insolvent. The cost of propping up house prices to prevent another financial crisis is what Albert Edwards terms “the indentured servitude of young people”. Young people leaving college with large amounts of debt will quickly acquire far more. They will spend their entire lives paying off debt.

So keeping banks on large amounts of life support is toxic for the economy. And I think it is toxic for them, too. The longer banks stay on life support –offering little support to the wider economy and kept alive by transfusions of public funds – the more people and businesses will look for other ways of obtaining the finance they need. New players will enter the banking industry, especially online where entry barriers and costs are much lower. New initiatives to channel investment to businesses will appear. New ways of enabling people to save will be created. Even new ways of financing traditional purchases such as houses will be found. And the big banks’ stranglehold on payments may even be broken: there are already ideas for the payments network to be made more accessible to smaller and newer players, and alternative ways of making electronic payments without going through banks.  In the end, banks as we know them may simply become redundant. In which case, do we really care whether or not they recover? Maybe what we will eventually do is switch off their life support and let them die in peace....

The actions of governments and central banks immediately after the 2008 crises averted banking system meltdown. But retail banks as we currently know them are in terminal decline, and the measures we are now taking to keep them alive only make their eventual demise more certain. We are witnessing the slow death of banks.

Related links:

Inflation, deflation and QE - Coppola Comment
The profitability problem - Coppola Comment


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