The following is an excerpt from the new book Break Up The Banks! by David Shirreff (Melville House, 2016):
We need a new model of banking (and to an extent a reworking of the entire financial system), so that it is less likely to need rescue by the taxpayer and is more likely to serve the real economy, not a narrow interest group.
It is understandable that, in the present economic climate, governments are reluctant to do more than tinker with the system for fear of incurring further costs—and the further wrath of the taxpayer.
But this is a blinkered, short-term view. We owe it to future generations to get it right, or more right, this time. This wouldn’t be unprecedented: after all, if Glass-Steagall had been kept in place, it can be argued that the world would not have gotten into such a mess over the last decade. This is the grand scale on which we need to be thinking.
Can we design a banking and financial system that won’t in turn be unpicked by future generations? I think we can.
But I also think it requires a major intellectual leap in how we think about banking.
First of all, perhaps we should think of the financial system as a utility, in the same way that we think of sewage systems and electricity distribution. After all, the basic functions of finance are to facilitate payments and keep track of cash balances. Banks must also safeguard deposits, pay them back on demand or on maturity, and make credit judgments on borrowers. All of this is very important, but it isn’t especially glamorous.
To inspire confidence, banks have tended to be housed in prestigious buildings. That has come to obfuscate their basic function and has given bankers an exaggerated sense of their own importance. Victorian sewage works and pumping stations were also housed in prestigious buildings, but there was no illusion about the stuff they were pumping. When it comes to banks, there is. Part of the confusion that has arisen (both in bankers’ sense of their own importance and in the eyes of the broader society) comes from the contrast between the basic functions of banking and the considerable power that some bankers have wielded in the past, from financing wars to bailing out countries. But the recent financial crisis has shown, more strongly than previous crises, that banking activity can readily impose a cost on society—and that this cost is not taken into account when rewards are distributed among banks’ investors and employees.
Let’s try to break down what exactly banks and bankers do.
Basic Retail Banking
The building blocks of a financial system, commonly understood, are banks, a central bank, and a set of rules that govern how they should operate. Key to that is the retail bank.
First and foremost, ordinary men and women (who can also be seen as voters and taxpayers) need a reliable place to keep their cash. A bank is generally more reliable than the underside of a mattress. To maintain confidence in that bank, it must be governed by soundness principles and conduct-of-business rules. Experience also shows that retail deposits are “stickiest”—most stable and long-lasting—if there is some kind of deposit insurance, either from the government or from a deposit-insurance fund, or preferably both. Further soundness is secured if limits are set on how those bank deposits are used.
Even though there are always limits on what a bank can do with your money, that point is worth pressing further. For instance, a “narrow bank” (to use the economist John Kay’s term), the soundest bank thinkable, would be allowed to invest only in domestic government bonds of short-term maturity. Deposits at a “narrow bank” could conceivably have an explicit 100 percent government guarantee. Such a bank would indeed be sound—but it might be too sound. Rather than gaining a meager return on government bonds, a proportion of the deposits might prudently be put to work. Experience has shown that banks can reasonably extend their investments to (modest) mortgage lending and personal and small-company loans—at least, up to a strictly limited proportion of deposits.
In all cases, any bank, no matter how narrow, would need a level of capital to tide it over periods where late payment or losses on loans exceed the net inflow of deposits and loan service payments.
In the end, retail banks must be so robust that their failure is near-impossible. Deposit insurance—implicitly or explicitly backed by the government—means that a run on a retail bank is unlikely, unless the government itself faces bankruptcy. (We’ve seen this scenario play out all too vividly over the last two years, but that’s not a banking problem—it’s a problem of state solvency.) Because even conservatively managed retail banks tend to be allowed to make home loans and to take liens on property as security on small-business loans, they are inevitably exposed to housing and commercial property busts. But, in the eyes of the broader society, that is generally considered an acceptable and manageable risk, provided regulators insist on low loan-to-value ratios.
To be absolutely clear: retail banks are not meant to be completely bombproof. A simple retail bank does not need to be bombproof if it is a financial institution that the government cares about and would support in a crisis. But this would be the only kind of bank that would have such implicit or explicit support. Wiseacres will say it was retail banks, such as HBOS and Northern Rock, that got into most trouble during the crisis. The fact is, these were not simple retail banks; they were heavily interconnected with other financial players, and they had contingent lines of credit to supposedly remote strategic investment vehicles (SIVs) that they had to honor in the face of a liquidity crisis. Regulators should never have allowed them to extend themselves in that way. In April 2007, the UK’s Financial Services Authority actually advised Northern Rock that it was under-using its capital and could afford to expand its business. In the United States, Washington Mutual, which was taken over by JPMorgan Chase as crisis struck in September 2008, was an example of a retail and mortgage bank which expanded beyond its retail brief, including buying wholesale mortgage loans, exposing itself to starvation of short-term funding. Likewise, Countrywide Financial, on the face of it a simple mortgage bank, was heavily exposed to the most toxic parts of mortgage securitizations at the time of its rescue by Bank of America in January 2008. Those banks found plenty of willing creditors and investors in the wild days before the crisis.
But who would invest in a truly safe, boring retail bank today? A deposit-taking bank that makes a modest amount of mortgage and retail loans, and invests the balance in government bonds, is unlikely to make a heady return on investment. So it would attract only the most conservative investors. A return on equity of more than 6 percent is unlikely. The government might even have to subsidize the business to make it attract any investors at all. But it would be safe. On balance, that would be in the longterm interest of customers and taxpayers.
If the financial system can be thought of as a utility, one could certainly view this kind of retail banking as a key facet thereof—part of the necessary infrastructure of a properly functioning society. This, would not rule out state or municipal ownership, though in that case, the trick would be to keep banks out of the hands of hungry politicians. As we’ve seen, the experience of the German Sparkassen is that they can be very useful for supporting local businesses. But they are also in danger of being steered toward supporting prestige projects and other vote-catching schemes by local politicians and other board members. That’s a big problem—but it is not insuperable.
Corporate and Wholesale Banking
Bigger companies also need a bank that can handle complex cash flows, provide them with foreign-exchange and other services, pre-finance projects, offer buyer credits to their customers, and support them through mergers, disposals, and acquisitions. They also need advisers to take them through the issuing of new shares or bonds, and perhaps to provide commodity hedges and other derivatives.
The question is: Are these services best provided by a one-stop commercial-cum-investment bank? Or should there be a clear distinction between commercial/wholesale banking and what we know as investment banking?
And, whatever the answer to that, are there dangers in allowing a single bank to provide such services? For instance, are there unmanageable conflicts of interest? And is a bank that sees all these flows likely to front-run its clients?
In my opinion, a sensible division of labor would be for the commercial/wholesale bank to provide customers with lending, cash management, and standard foreign-exchange and interest-rate hedging services, but to outsource anything more complex to an investment bank. It could also provide financial support to investment banks—but only to a limited extent, and with appropriate credit and performance-risk controls so that the interconnectedness that made the collapse of Lehman Brothers so traumatic is avoided. Commercial/wholesale banks should not be allowed to make their balance sheets available for investment banks, or other shadow banks, as a place to “park” underwriting positions and other trading exposures.
A commercial/wholesale bank would need to be a critical size to achieve economies of scale. But those economies of scale must not involve cross-subsidy from a retail operation. Nor should the commercial/wholesale bank be integrated with an investment bank to produce a bank so large and powerful that, along with other similar beasts, it could control pricing in the market.
Universal banks, such as JPMorgan Chase, Barclays, and Deutsche Bank not only provide these one-stop-shop services to corporate clients. They also take retail deposits, and they have clients on the investment side that buy the securities that they issue for corporations. The retail deposits offer these universal banks a stability, and access to cheap money, that they would not otherwise enjoy. But for the retail depositor there is no obvious benefit in putting his deposits at risk with a bank that lends to big companies and deals in world markets. The depositor has no chance of sharing in the upside if the bank makes egregious profits. But he, or the taxpayer/deposit insurer, has a risk that the bank makes egregious losses. No one testifying to the Vickers Commission or the Liikanen group of high-level experts was able to volunteer a good reason why retail customers might benefit from putting deposits with a corporate and investment bank. It is only universal bankers themselves who talk of the stability that these deposits offer the bank (because they cross-subsidize other parts of their business).
Of course, it is inevitable that corporate/wholesale banks that are not cross-subsidized by retail deposits will be more costly to run. Corporate financial services may therefore be more expensive. But that will reflect the real cost of doing business. If governments decide that they need to subsidize the development of certain business sectors, they can do that with loan schemes, tax breaks, or even via development funds, or perhaps a development bank—all of which would be more transparent than the current system of hidden subsidies.
It is also inevitable that there will be a distinction between financial services provided to less sophisticated fund managers or private investors, and those provided to investors qualified as professional counterparties. In a simple division of labour, corporate/ wholesale banks would provide basic financial services—such as cash management, custody, and foreign exchange—direct to investment clients. They would outsource more sophisticated services—such as the buying and selling of securities, derivatives, and other hedging instruments—to brokers or investment banks, acting as agent only—provided the client is sufficiently sophisticated and its articles of association allow it to use such instruments.
Sophisticated investors might thus use corporate/wholesale banks as custodians and to provide simple financial services, but for more sophisticated trades they would need to use a broker, or an investment bank.
“Pure” Merchant and Investment Banking
A partnership is generally reckoned to be the best model for a merchant or investment bank. In it, the partners put their own capital at risk. That makes sense. An investment bank provides advice and transaction services to clients, underwriting—if only briefly—the placing of shares or bonds, and taking equity or lending stakes to launch new ventures or reshape existing ones. The partners share unlimited personal liability for net losses sustained by the partnership.
I advocate a return of investment banking to the partnership model.
This is not simply to put the clock back to an alleged “golden age” of investment banking; it is because there is a better alignment of interests between partners and the bank. Partners are also less likely to give employees incentives to trade recklessly, given their interest in the fortunes, good or bad, of the bank of which they are owners.
From Break Up the Banks!. Used with permission of Melville House. Copyright © 2016 by David Shirreff.