08 01 2009

Saving capitalism from itself (2): When banks stop working

The financial sector is at the centre of the present crisis, and it is - like the crisis from the bursting of the internet bubble in 2000, but unlike other recent financial crises – principally “made in USA” and exported to the rest of the world.

But before we go into details, let us remember what the central role of the banks is in a capitalist economy. The banks have the main function to take the money from people who want to save and channel it to people who want to borrow. In this way the savers do not have to find borrowers themselves. They entrust their money to the bank and it does the job of screening borrowers and make sure they can pay back the loan they get. Furthermore, the bank receives money, which the saver in principle can withdraw whenever he or she wants to (sometimes paying a penalty for doing so), while the borrowers normally get longer term loans. So it converts short-term deposits to longer term loans.

For this to work, trust is essential. People have to trust that the bank is good at screening the borrowers, and that it will manage the funds in a way, in which their money is available whenever they need it. Historically, this trust has often broken down and that results in a run on a bank, as everybody wants to get their money out before it is too late. To keep up the trust, the banks are therefore bound by prudential rules (requiring e.g. that they maintain a certain amount of cash at the central Bank) and are supervised by some authority (a superintendent, the central bank or whoever). This has often turned out to be insufficient to maintain the trust in the system, and therefore guarantee systems have been set up in most countries, whereby savings (up to a certain amount) are guaranteed by the state.

The banking system makes it possible for companies or persons to undertake larger investment projects without having to put up all the money out of their own savings. This is not to say that this is the only mechanism. Other mechanisms to ensure the funding of investment projects are the issuing of shares, where people by buying the shares can become a small co-investor, or issuing of company bonds, whereby people can give a loan directly to the company. But the banks are central to the functioning of the productive or commercial sector. If the banks stop working, the whole system stops working.

This role of capturing savings and channelling it to borrowers is often referred to as “retail banking” and often the adjectives “old-fashioned” or “conservative” are added. The understanding is that this is a thing for banks or countries that are stuck in the past, They have failed to develop and to understand the “new economy”. They simply “didn't get it”.

The new financial system started to develop after the grand waves of liberalisation of the financial markets that started in the Anglo-Saxon countries in the eighties (Reagan and Thatcher) and was further deepened under the Clinton and Blair administrations in the nineties. Other countries were slowly following suit, and there was a strong pressure everywhere to liberalise capital flows and deregulate the financial sector (“cut red tape”) not withstanding the repeated banking crises that followed (e.g. in Sweden in 1992, where most of the recently liberalised banking sector went into deep crisis).

The key-word to the deregulation of the financial sector has been innovation: new financial instruments which should be able to make the financial markets work better. Some of these constitute new or improved services that are doing something good for the economy: insurance against exchange rate fluctuation, future markets where companies can get a guaranty that they can buy necessary inputs a a given price, insurance against defaults of buyers etc.

But the most harmful innovations turned out to be directed at freeing the banks from the remaining regulation, in particular the limits on the relation between the money the bank loans to clients and their equity (own capital). Banks are required to finance part of their operations out of their own money, i.e. the money provided by the shareholders. So if something goes wrong, they will first loose their own money and after that the savers' money. This puts a limit on how much the bank can loan without raising more capital from the shareholders. And to get around that, they started a system reselling loans to investors through Special Investment Vehicles (SIVs) so that these loans didn't appear on the balance sheet. In principle, what they were doing was the same as when banks channel short term deposits to longer term loans. But as they did it on the side-line, it was not put on the books of the bank and thus circumvented the regulators, who chose to put a blind eye – who wants to be attacked for hindering innovation and progress?

The SIVs should in principle be functioning as autonomous entities independently of the ”mother” bank. They bought the banks' loans and resold these as special bonds to other financial institutions or the public. These bonds were backed by the loans, so it was a sort of repackaging and reselling of the loans. To create trust – and secure a good price for these special bonds – they were rated by supposedly independent rating agencies. Most of these bonds were rated as AAA or slightly below, meaning that they should be very secure to invest in.

It turned out, they were not. And the reason for this was principally incentive problems. The special loans were not screened as the banks would screen there own clients, and the agents placing the loans had an incentive to place as many as possible as they were paid accordingly. Innocent investors, trusting the banks “sponsoring” the bonds and the rating agencies giving them a good rating, bought the bonds (often through the same bank and following the advice from the bank). And then the whole thing turned out to be a scam. Worthless loans given to US customers, unable to pay them back, were resold over the whole world as first-class bonds. What is perhaps most surprising is that even institutional investors, who should know better, bought this trash, including venerable Swiss banks.

The relation between the SIVs and their “mother” banks turned out to be in a grayzone. As the SIVs collapsed, the banks have been forced to take at least part of these loans on to their books again with enormous losses. This financial innovation has thus undermined the banking system and made a mock out of the regulation system in many countries.

Even without these innovations, banks normally suffer under economic downturns, unless they have been very prudent (“conservative”). Companies facing falling sales are unable to pay their loans, as are many people loosing their jobs, etc. When a bank has been extremely imprudent, as is the case with the SIVs, the bank itself goes in to crisis. As nobody, except in some lucky cases the bank itself, can know what the quality is of the loans the bank has given, trust among the banks also breaks down as each bank fears to be drawn down by the bankruptcy of its neighbour. So suddenly every transaction among the banks has to be in cash or backed by a secure asset. This break-down of trust practically paralysed the whole banking system in the developed world in the autumn of 2008.

The reaction to this situation in most developed countries is well-known: enormous rescue packages to recreate the trust by guaranteeing deposits and recapitalising the faltering banks.

The big question is: then what? The heart of the capitalist system has been failing and is threatening the whole system, so what will be done about it? Some claim that this is “the end of capitalism as we know it”, and that profound changes therefore will be coming.

I believe not. The most discussed rescue model is the “Swedish solution”. The (centre-right) Swedish government nationalised an important part of the recently liberalised banking system in 1992 to avoid a total collapse. A condition for access to recapitalisation with public funds was that any loss that the bank might finally face should be born by the shareholders first and in thereafter by the state. Once the crisis was over and the nationalised banks were in an acceptable shape, they were sold again (with a significant loss for the state). But the system as such did not change. Sweden has also suffered under the present crisis and even if most of the banks are still intact, is has been necessary to set up an enormous public guarantee fund for the banks and other financial institutions of 1.5 trillion Swedish Kroner (USD 205 bn.). So the “Swedish solution” is foremost a short-term intervention model, not a new way of conceiving the role of the banking system in a capitalist economy.

The reason I believe that not much will change is that there is no political force in the developed countries claiming deeper changes, despite the huge bill the public is picking up to clean the mess created by the highly paid financial wizards, who - like the medieval alchymists - claimed to be able to create value out of nothing. And profound changes only come along when the change is needed and there is a considerable political force pressing for it. So I would only expect minor changes - unless the crisis becomes much more severe than it is now.

What is needed to save capitalism from itself? I would say: bringing the banks back to basics. Banks may be private, but as the current crisis shows all too clearly, the banking system is too important to be allowed to fail, so in the end bad private management turns out to be a public problem that tax payers have to sort out.

  1. The banks should be forced to concentrate on their boring old role as retail bankers, channelling savings into longer term loans. All sorts of speculative businesses should take place in separate entities with no linkage to this main business and explicitly without any public guarantees.

  2. The banks should obey by prudential rules, and these should be enforced rigorously in the different countries. Perverse incentives which tempt the bank management to make reckless lending should be explicitly ruled out (e.g. linking earnings to lending). The banks can provide all other sorts of services they may want, but they should not create any hidden obligations for the bank - all obligations should appear on the balance sheet.

There are some more intriguing problems. What about deposit guarantees for banks that capture deposits from foreigners? These guarantees may be impossible for the state to give if the banking sector is too big, as the claims may add up to many times the GDP. This is the “Icelandic question” (where deposits are said to be around 10 times the GDP), but is also relevant for the UK and Switzerland. Some international (or at least a European) deposit guarantee system paid for by the banks themselves?

What will actually happen depends on the correlation of strength within the ruling elite. The financial sector has become extremely forceful during the last decades. It has been battered by the present crisis, but it will soon come back insisting that too much regulation (“red tape”) will stiffen the markets, destroy creativity and hamper development. So intents to regulate will most likely be watered down. It may thus turn out to be difficult to save capitalism from itself. Expect more financial crises to come in the future.

Even so, the financial sector will inevitably shrink in the near future. That means fewer jobs in the sector and may be even that management will have to do with more earthly earnings. A columnist asked recently in Wall Street Journal (apparently consternated ), whether a job in the financial sector was less important for society than in other sectors? The simple answer is that most of us do not consume financial services, they are a necessary input in certain productive processes. Exactly the same as with government bureaucracy. The more effectively these services can be delivered, the cheaper the goods and services we do consume will be. So if we could reduce the bureaucracy in the financial sector, we could could use more people and resources to take care of our children, our sick and our elderly instead of our money (which they are not very good at taking care of anyway).

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Thorbjorn Waagstein

Thorbjørn Waagstein, Economist, PhD, since 1999 working as international Development Consultant in Latin America, Africa and Asia.

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