Bank Reform is Essential for Capitalism.

Andrew Smithers.
Financial News, a Dow Jones Company, 8th March 2010

Economists so seldom agree that any assembled group is likely to have more opinions than members (N economists = N + 1 opinions). It is therefore unusual to find so much agreement as there is today about the need for new and massive bank regulations. This positive consensus is, however, combined with the widespread concerns that any reforms will be woefully inadequate, because bankers have such strong political clout that they will succeed, once again, in thwarting changes which are in the public interest but not in theirs.

Concern about the influence of bankers on public policy must not, however, cause us to be unfair to them. It is for instance common, but I think largely wrong, to blame commercial bankers for our current troubles and for the huge costs required to bail out financial institutions that have fallen on taxpayers. In order to understand this it is necessary to appreciate the exceptional nature of finance, compared for example with selling groceries. Bankers share a number of similarities with burglars. They both make money by taking risks - not all of which are in the public interest. While some of the risks that bankers take provide an important service to the economy, the recent disaster has been accompanied and magnified by a sharp increase in the proportion of their risk taking which is economically destructive rather than desirable. It is possible to ascribe this sudden shift either to a sharp change in the attitudes and morality of bankers, or to a marked rise in opportunities. The latter is clearly more likely and, as I explained in my previous article (published 14th December, 2009), was the result of the folly of central bankers in feeding excess liquidity into our economies and failing to notice the danger signals provided by the resulting asset bubbles.

While we should be fair to commercial bankers, we must not confuse fairness to the individuals concerned with the lack of need for massive reform of their industry. It means that our focus should be on reforming bank regulations rather than reforming bankers. Too much attention has been put on restraining bankers’ remuneration, and nothing like enough on why banks can afford to pay their staff so well.

The profitability of banks has changed dramatically in recent years. In the UK the return on bank equity averaged around 7% from 1921 to 1971 and 20.4% since.* In the US finance contributed 4% of corporate profits after tax in 1982, but the most recent data available (Q3 2009) show that this has risen to 36%. The real return on equity for companies in general has been remarkably stable at around 6% over the long-term. So the profitability of UK banks from 1921 to 1971 was in line with the general average for companies.

There are two likely explanations for the recent abnormally high returns. One is the uncompetitive nature of modern banking, and the other is its high profit volatility. It would be heavily against the public interest to allow either to continue. A lack of competition is always damaging; the need for regulation to avoid excessive profits and pay being extracted by an industry which is allowed to operate under insufficiently competitive conditions is another of those few matters on which economists are agreed.

Traditional banking business seems to be reasonably competitive, which is why the industry used to produce normal returns. It is only since commercial banks became seriously involved in activities such as market making that the industry has been able to “rent gouge”, which is the term used by economists to describe the ability of inadequately competitive industries to make monopoly-style profits. The disadvantages that this ability poses for a country are a “clear and present danger”. The high rewards to both shareholders and management are not a reward for skill. They are rightly seen as unfair and this brings capitalism itself into disrepute. It is often assumed that businesses and businessmen are in favour of capitalism. Nothing could be further from reality. The essence of capitalism is competition and the key aim of business management is to avoid it. Those who, like me, value limited and democratic government and doubt whether it can survive without capitalism will naturally be concerned with it being brought, by association, into disrepute. Once such monopolistic profits have been imbedded in the system it becomes, as the current debate shows, difficult to eradicate, because of the wealth and consequent influence that it generates.

The natural monopoly element in market making, which is only one of the ways in which modern banking has become a rent gouging activity, can be readily demonstrated in both theory and practice. As time passes the weaker market makers go bankrupt, and as the others become larger, there is a rising barrier to new entrants. As we have seen recently, it becomes increasingly difficult for government to allow the survivors to fail, as they are too large and too interconnected to do so without extensive carnage in the economy.

Extreme volatility of returns is the other probable foundation of excessive returns in banking. Fundamentally this depends on the subsidy to banks that comes from the effective guarantee that tax-payers give, often explicitly but sometimes implicitly, simply because of the damage that is done to the real economy when bank depositors fear that they will be unable to withdraw their funds. Bank shareholders have limited liability. They cannot lose more than the amount they have invested, but there is no limit to their profits. This asymmetry naturally encourages companies to take as much risk as possible but, outside banking, these risks are constrained by the terms on which they can borrow. But as tax-payers are seen to be underwriting depositors, this constraint disappears. Anyone whose debts are guaranteed by the government needs no equity at all. The guarantee is thus a massive subsidy.

Banks today are thus making monopolistic profits, with the added benefit of being subsidised to make them. Two reforms are therefore essential. First, minimum equity ratios must be increased to a multiple of their current levels, to offset the subsidy of the tax-payers guarantee and second, to encourage competition, large financial companies should have to have much higher equity ratios than smaller ones. Getting there will be a battle of the good guys, Paul Volker included, against the bankers. I hope and expect that we will win, but don’t expect the war to be a short one.

* See Banking on the State by Piergiorgio Allesandri and Andrew G. Haldane, published by the Bank of England November 2009.

This article first appeared in Financial News.