Tag Archives: banks

Banks versus business

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The latest in my catch-up reading has been British Business Banking: The Failure of Finance Provision for SMEs by Michael Lloyd. This is obviously a bit niche but of great interest as the vacuum in finance for growing businesses has often been identified as one of the reasons for the UK’s weakness in translating an excellent research base into lasting commercial success and eventually productivity gains. The stock of bank lending to SMEs in the UK was £166bn at the end of 2018, according to an OECD survey. (It will perforce have increased signigicantly in 2020.) If this sounds a lot, it was only about one tenth the stock of their residential mortgages. The UK banking sector just doesn’t do much business lending.

I’ve long thought lack of competition is a key part of the story. The commercial banking sector has consolidated steadily over the decades – I’m old enough to remember some of those swallowed up, like Williams and Glyns and National Provincial. In this book Michael Lloyd argues that while the development of an oligopoly might have been part of the cause of the SME finance gap, introducing more competition won’t be part of the cure now. There has been some new entry such as Santander, but the newcomers are not interested in the SME sector either.

He anyway sees the gap as a quasi-cultural one, linked to the “free market” philosophy embraced more eagerly in the UK even than in the US, and in the centralisation of banking decisions. He advocates a restoration of relationship banking spearheaded by a state Investment Bank. What we are getting instead is a National Infrastructure Bank – needed, but unlikely to do a lot for SMEs around the country. However, I find the relationship argument persuasive: I’d see it in terms of a vast loss of information that has come about through bank mergers and centralisation. Automated decisions are based on too little information, whereas old-fashioned bankers in boots would have a wealth of information about local SMEs.

It’s a hard problem to solve even with a government willing to have a go. Still, this is an interesting book for those worrying at the issue, well worth a read.

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Power and legitimacy

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Paul Tucker’s book Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State is a significant contribution to the literature about the trade-off between participatory democratic influence over policy decisions and the technical complexity of much policy and regulatory activity. The focus is on central banking, not surprisingly given the author’s long experience at the Bank of England. However, the book also dips into competition policy. This is my territory, having spent 8 years on the Competition Commission. I’m not entirely convinced by the argument here.

Tucker’s conclusion is that when politicians delegate policy decisions to independent, technocratic bodies, they need to do so in accordance with some key ‘principles of delegation’. To date, they have not done so, and hence the crisis of legitimacy, at least as far as it applies to economic institutions. There are five design principles: there should be a clear statement of the body’s purposes, objectives and powers, to stop mission creep; its operating procedures should be set out; so should its operating principles – how will it go about conducting its delegated policies; there should be sufficient transparency that the institution can be monitored and held to accunt by elected politicians; and there should be some rules for how it can respond to emergencies.

These seem on the face of it perfectly reasonable. But pause on the third – central banks and independent competition authorities should have the way they implement policy set out for them. Thus, Tucker argues, a competition authority’s remit might be set in broad terms as ensuring markets are competitive, or ensuring there is no abuse of dominance; but it should not be left to the competition authorities themselves to turn this into operational rules. He notes that there have been significant changes in competition policy in the US and EU over time, shifting from the older institutionalist tradition to a focus on consumer welfare. As the book notes, this reflected developments in economic theory, adding: “The significance of these momentous changes is not whether they were grounded in good economics but that each occurred without any amendments to the governing legislation.” Thus, “This gives us a glimpse of why the public might not be clear about the pupose and objectives of antitrust regimes.”

Like a number of commentators on competition policy recently, Tucker believes – wrongly  – that the ‘Chicago School’ approach of using a consumer welfare criteria means competition authorities can only look at prices. On the contrary, although that has been the practice (because measuring prices is easier), they can take into account other aspects of economic welfare such as quality or range, or incentives to invest and innovate – this is set out in the CMA’s guidance documents, for instance. In the world of zero priced digital goods, that is exactly what they should do.

But that’s by the by. My hesitation about this principle is that the alternative – having operating rules set by elected politicians – would in reality defeat the purpose of giving economic regulators their independence. For what would stop legislators deciding that the economy is best served by preserving jobs at incumbent firms because they have the biggest economies of scale? This would be the pre-independence world of ministers deciding all mergers on public interest grounds. The time inconsistency problem common to so many regulatory contexts would return with a vengeance if legislatures can change the operating rules whenever they choose. Better to have these rules set by the technical experts, after wide public consultation. Sure, ideologies and tides in the realm of ideas would influence them, but less, it seems to me, than in the counterfactual world. Anyway, are elected politicians so respected now that they would reinject legitimacy back into economic governance? Opinion polling suggests they are among the groups the public trusts least.

Unelected Power engages an essential debate, however. There is a crisis of legitimacy in the western democracies. With QE, central banks have launched a radical change of policy with huge distributional consequences. The book has four sections: welfare, values, incentives and power are their headings. Although it touches on all the economic regulators, it is mainly about central banking, and on this is it authoritative. It will be an essential read for everybody involved in monetary policy, or researching it. It has a long bibliography; Tucker refers to legal and political science literatures as well as economics. One flaw is that it is heavy going in parts, surprsingly because he is a compelling speaker. Nevertheless, this is an important book.

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How can financial services serve?

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A 2010 book, Portfolios of the Poor, made a big impression on me because the researchers had taken great care to ask poor people (in Bangladesh, India and South Africa) in great detail how they managed their money and what their financial needs were. The answer was different from the enthusiasm at the time for micro-credit schemes. It turned out people with not much income need secure vehicles for saving and transactions; borrowing was a low priority, and few people will become entrepreneurs, micro or otherwise.

Jonathan Morduch, one of that team (with Daryl Collins), has now co-authored (with Rachel Schneider) a book taking a similar, detailed look at the finances of American families. They investigated (using the same method of detailed diary-keeping and interviews over an extended period) families in several parts of the country who ranged from single mothers living in poverty to nuclear families a notch or two above median income for their area. One could call them the ‘left behinds’. The results, written up in The Financial Diaries: how American families cope in a world of uncertainty, is just as illuminating.

The headline is that the volatility of income is a bigger problem for most of those interviewed than their level of income. This volatility is closely linked to the way the labour market in the US has moved toward less stable conditions, with employers shifting risks steadily onto employees. “Over half of all income volatility was due to changes in income from the same job.” Even the higher income households in the sample experienced significant earnings volatility.

When income is uncertain, or even when it isn’t but is only slightly higher than regular outgoings, then emergency expenses – healthcare above all (this is the US!), but also car repairs when the car is essential for work – mean it is difficult for people to save steadily. The juggling involved in managing their finances, and the fragility of financial security, also occupies so much mental bandwidth (as per Scarcity) that people find it hard to get off the financial treadmill by any long-term planning. Clipping coupons seems a high priority compared with saving up to pay for college, albeit there are some exceptional focused individuals.

Perhaps it isn’t surprising to learn that financial services do not serve most of these households (up to and beyind the median) at all well. Much financial advice is geared at long-term questions like retirement saving, which is an unimaginable luxury for this 50%-plus. Few products a geared at saving for short-term goals – such as saving enough for a deposit to rent a new apartment – and certainly not with a combination of commitment devices to encourage the saving but enough access or control to make the money accessible in a real emergency.

The same bias to the long term financial needs of the well-off colours comment about pay day loans or check cashing services – payday loans have ultra-high APRs but their customers are often looking at per week costs over the short term. Lisa Servon’s The Unbanking of America: How the New Middle Class Survives, which includes her experience working in a check cashing service, is a great companion volume to The Financial Diaries. (There’s an excellent NPR program about it.)

Servon’s book also includes some descriptions of tech-based financial products aiming to serve low-income customers better, as does this one. None has been a stellar success yet. Morduch and Schneider suggest legal limits on the total amount a lender can recover from a borrower, enabling short term lending to take place without it turning into a permanent, even increasing, debt burden. They write: “By pushing more of the consequences of underwriting decisions on to lenders – in the form of losing their money – they [ie total loan recovery caps] make lenders more cautious and selective in how much and to whom they lend.”

The book underlines how common is the experience of being on the edge financially, citing large-scale surveys to complement their detailed work. The latest US Census showed less than 4% of the population below the poverty line for the whole of 2008-2011, but 90 million (nearly one third) experiencing poverty for two months or more of the three years. In 2011 alone, 8.3% were below the line all year but about a quarter for two or more months.

Both The Financial Diaries and The Unbanking of America are illuminating reads, above all, for paying attention to what people say, rather than just theorising about them. Even before reading the latest rash of stories about the absymal behaviour of the banks, one can only conclude that unbanking will be a good thing as long as entrepreneurs – and the regulators who make or break them – can deliver at long last on the ‘service’ part of financial services.

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Bankrupt banks

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I’ve been browsing through a new book, [amazon_link id=”0817918841″ target=”_blank” ]Making Failure Feasible: How Bankruptcy Reform Can End Too Big to Fail[/amazon_link], edited by Kenneth Scott, Thomas Jackons and John Taylor. The book is the product of a Hoover Institution project formed in 2009 to address concerns about the moral hazard that would result from bank bailouts. The project quickly concluded that a bank ‘resolution’ procedure was vital, and proposed a Chapter 14 of the US Bankruptcy Code to create a mechanism ready to be applied to restructure or liquidate any large financial institution of systemic importance that gets into trouble.

[amazon_image id=”B015M9SQYK” link=”true” target=”_blank” size=”medium” ]Making Failure Feasible: How Bankruptcy Reform Can End Too Big to Fail[/amazon_image]

The book spells out the rationale for a bank resolution mechanism and explains in more detail how the Chapter 14 would work. It argues that the proposal would make it easier for US banks to comply with the ‘living will’ requirement of the Dodd-Frank Act. As the book notes in a later chapter, however, a domestic resolution procedure, even for the US, is only a partial answer for banks that are of global importance. The Bank of England and IMF have said there are 16 of these institutions. And there is, the cross border chapter here says, no consensus internationally about the right approach to bankruptcy. So if there is another global financial crisis in the short term, we will be in huge trouble again.

Still, it is good to see that people have been working on detailed bankruptcy proposals – although the detail will be of interest mainly to banking specialists, which I’m not. Let’s hope the regulators get on to the global complexities soon.

Other people’s money

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Catching up with post-holiday stuff has slowed me down, but I finished John Kay’s new book, [amazon_link id=”B00UJD8AS2″ target=”_blank” ]Other People’s Money: Masters of the Universe or Servants of the People?[/amazon_link] on a flight back from his native Edinburgh yesterday. It is characteristically excellent, drawing the main threads out of the complexities of modern financial history and the post-crisis consequences, and writing with beautiful clarity and style. It’s up there  with John Lanchester’s [amazon_link id=”014104571X” target=”_blank” ]Whoops![/amazon_link] as a guide to understanding what has happened in finance. I agreed with every word. I don’t suppose he’d want the job, but it would be marvellous if we could put John in as Chancellor to sort things out.

[amazon_image id=”B00UJD8AS2″ link=”true” target=”_blank” size=”medium” ]Other People’s Money: Masters of the Universe or Servants of the People?[/amazon_image]

The book tells the story of the financialisation of the British and global economies in its first section, and the transition from relationship-based financial services focused on customers and the real economy to transactional and trading-based financial entities.This progressive shift in behaviour, values and institutions affected the whole of the corporate sector. The book offers a telling contrast between the 1987 and 1994 annual reports of ICI:

“ICI aims to be the world’s leading chemical company, servicing customers internationally through the innovative and responsible application of chemistry and related science. Through achievement of our aim we will enhance the wealth and well-being of our shareholders, our employees, our customers and the communities which we serve and in which we operate.”

versus

“Our objective is to maximise value for our shareholders by focusing on businesses where we have market leadership, a technological edge and a world competitive cost base.”

This has happened across the whole of the business sector throughout the west. It’s tragic. Risk taking at the expense of others, bonus culture, income inequality, short termism, declining business investment, overly-detailed regulation having utterly adverse consequences, and the taxpayer still in line to prop up the whole edifice if – or rather when – the financial sector gets hit by another tail risk it can’t cope with. As Kay underlines, and as [amazon_link id=”B00HZ634AU” target=”_blank” ]Admati and Hellwig[/amazon_link] pointed out so clearly, and even Alan Greenspan now admits, the banks have far, far too little equity capital and too much leverage. The summary here of Deutsche Bank’s balance sheet is terrifying.

The book is particularly clear about the inadequacy of banks’ current levels of shareholder capital vs debt on their balance sheets, and the nonsense of the Basel risk weightings, and banks’ claiming they can achieve 15% return on equity – always done by reducing the amount of equity in the denominator. Kay writes: “Return on equity is an inappropriate performance metric for any company, but especially for a bank; and it is bizarre that its use should have been championed by people who profess particular expertise in financial and risk management.” Bizarre, or perhaps just cynical.

So what to do about it? Especially as financial markets start displaying the kind of declines that could, potentially, wipe out a frail bank’s mimimal equity? The book has good answers. Kay starts with a set of principles for reform, including shorter chains of intermediation before the final customers, more focused and specialist financial institutions, a prioritisation and demonstration that the financial institution has its clients’ interests at heart (hello, Goldman Sachs), criminal and civil penalities applied to individuals (not fines on institutions), simpler regulation. Above all, politicians should abandon the illusion that the finance sector is special compared to other sectors of business. After all, the numbers don’t make sense; it has certainly not contributed as much to the economy as is claimed, and is not financing industry or serving the needs of investors.

In detail, the book favours structural remedies, not more and more regulation of behaviour – that is an arms race between banks and regulators that the former, with their ability to extract vast rents and hire lawyers/lobbyists will always win. Kay sees ring fencing of retail activities from investment banking as a ‘first step’. I agree: the too-big-to-fail-subsidy will always be too big for as long as there are any links. There needs to be a structural separation, and deposit guarantees only for utility retail/small business banking. He also puts great weight on individual civil and criminal responsibility.

Towards the end of the book comes one of many eye-popping quotations from Goldmans executives:

Sen C Levin (D, Michigan): When you heard that your employees in these emails and looking at these deals said, “God, what a shitty deal!)… do you feel anything?

Mr D.A.Viniar (CFO, Goldman Sachs): I think that is very unfortunate to have on email.

No wonder Kay concludes: “The finance sector of modern western economies is too large.” Spot on. It takes too many of the best graduates, distorts pay across the corporate sector, fails to innovate on behalf of its customers, and exposes taxpayers to unsupportable risks. Financial conglomerates need to be broken up, banks need to hold much higher levels of equity capital.

Financialisation has even damaged unfairly the standing of the role of markets (and economics): “The intellectual misconception behind the thought that prosperity might be enhanced by trade in baseball cards has been associated with an economic model that misunderstands the (important) role that markets play in enabling complex modern economies to manage information,” Kay writes. Prices are important signals – just not the prices on the trading room screens.

Shrinking the finance sector takes the book in its final pages to the influence of money and lobbying on politics. Which politicians are going to serve the people instead of the masters of the universe? Unfortunately I haven’t heard even the Labour leadership candidate my Tory best friend has renamed “The Gift that Keeps on Giving” addressing this. As for the American system, utterly bought by big money, beyond hope.

Meanwhile, I hope lots of people will read [amazon_link id=”B00UJD8AS2″ target=”_blank” ]Other People’s Money[/amazon_link] and then send it on to their elected representative with suitable passages highlighted, saying – if you want my vote next time, act on this.