Regulation and the logic of the banking sector

What the events of the last two years have made clear is that the state is not just the lender of last resort to the banking sector, but is also effectively is guarantor. This is rather uncomfortable for many of us. In the economic good times, the banks make lots of money, pay lots of tax, give staff what, compared to what most of earn, are extraordinary bonuses, and, because of their importance and status in the economy, end up advising governments and becoming destinations for ex-politicians to move to once they leave politics (hence Tony Blair and Al Gore now being part of JP Morgan Chase). However, in bad times, then the government is expected to bail the banks out, whether the problem, to use Charles Morris’ key difference, is whether the banks have become illiquid, or insolvent. Banks are viewed as too big to fail, and too important to fail because of the potential implications should they collapse. The ghost of the Great Depression continues to haunt us.

So on the one hand the profits of banking are privatised, and although they are subject to tax, taxation is often avoided or at least reduced through banks, entirely rationally from their perspective, doing everything they can to reduce their liability. But on the hand, the risks of banks are socialised. It isn’t just banks that are now so big that the risks of their operations have become socialised, as governments have bailed out all manner of businesses since the recession began. But banks are still special, because unlike other types of business, they literally create money.

Banks create money by lending more money than they hold in terms of capital deposits at any moment in time. One of the joys of having taught first year economics in the past is the look of wonder on students’ faces when you show them how credit spreads throughout an economy, and how deposits expand and expand when lent over and over again. This means that banks are special – they can do things that other types of business can’t (at least not to the same extent).

So banks have a key social role – they provide liquidity and credit to both individuals and businesses. Allowing them to fail means that that whole system is subject potentially to systemic risk and potential collapse. So, on this logic, it makes sense for banks risks to be at least partially underwritten by the state. This is usually referred to as the lender of last resort function, where, if a bank gets itself into trouble and runs out of the everyday funds it needs to run things, its working capital, it can borrow from the central bank. Doing so, however, means that it has to pay a higher rate of interest than it would do than if it could simply borrow from its own sources or from other banks. Lending from the central bank is done at a premium, so is a last resort on the part of the banks (who have to pay more interest) and the state (which only wants to lend to banks on this basis when there is a danger of systemic collapse).

However what’s happened in 2008/9 is that banks have not just lent as a last resort, they’ve taken over banks, bought shares in them, provided them with liquidity, and allowed banks to lend against assets which the marketplace (such as it is for paper such as CDOs) have come to regard as so troubled as to be worth only a small percentage of its original value. They’ve also guaranteed bank loans and so face potentially massive exposure should those loans fail in the future. Central banks have done far more than the lender of last resort role – they’ve intervened to stop banks from failing. This is not temporary funding to deal with a liquidity problem, but medium and even long-term funding to deal with a solvency problem. Governments have taken the risk associated with banking into the public sector.

Banks are now beginning to make profits again. This is great as loans made to the government are being repaid, and banks will pay taxation on those profits, helping to at least partially fund the massive bail out. However, it does raise some rather difficult questions about what the role of banks exactly is.

If banks are bastions of free market capitalism, then what on earth is the state doing preventing them from becoming insolvent? If banks are too big to fail, then that would indicate a huge flaw in the way they’ve developed. If size is the problem, this would point to a policy of breaking banks up so that they can be allowed to individually fail safely in the future. Perhaps we need to look back to Theodore Roosevelt who understood that sometimes capitalism needs to be made more, well, capitalistic. In a free market firms need to be able to both enter and exit freely without disturbing the market as a whole. Banking is an awfully long way away from this. Regulation would be about breaking banks up into smaller units, and having a strong role in making sure that banking systems as a whole are adequately capitalised (Canadian banks seem to have got through the crisis rather less bruised than in other countries because of this). It would also mean that central banks are limited to being lenders of last resort and no more. Banks would be made to conform more to the capitalistic model of smaller organisations in fiercer competition with one another, with a regulator looking for systemic risks, and individual banks being allowed to fail.

On the other hand, if banks are going to depend on being bailed out by the state, then it not clear whether we gain from having private banks being bailed out publicly. This is probably the worst of all possible worlds. Banks can take what risks they like, ultimately, knowing that if they come off then they make huge profits, and if they don’t come off, then they can rely upon the government to help. This makes no kind of sense. Under these circumstances the government might as well nationalise the banking sector on the grounds that banking is a social function with a unique quality (the ability to create money) as this will at least cut down the risks to the taxpayer.

Neither of these options is particularly palatable. But we do begin to have to think about the role of banking in an economy, recognise that it is not like other kinds of business, and have some kind of debate about what we want to happen next. Resentment against banks and banking remains high and may be rising as redundancies and unemployment more generally rise. But it does seem to me that banks have to recognise the logic of either being competitive businesses, or being extensions of the state. They can’t be both.

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