Six years on from the financial crisis there are signs of recovery, but Chris Martin questions the extent to which the banking system has changed since 2008, arguing the new system of regulation and control has yet to prove itself. If confidence in the banks is to be rebuilt, they must be organised and regulated to benefit the wider economy rather than their own more narrow interests.
In his 2010 book Whoops! Why Everyone Owes Everyone and No One Can Pay, John Lanchester compares the balance sheets of Apple and the Royal Bank of Scotland (RBS) on the eve of the 2008 Financial Crisis. RBS had assets of £1.9 trillion. This was significantly more than UK GDP, but it had capital of only £91 billion. Bankruptcy occurs if the difference between liabilities and assets exceeds the value of capital. The value of RBS’ assets, including substantial amounts of derivatives and corporate loans, both heavily linked to housing markets, were risky. But its liabilities, mainly short-term borrowing and customer deposits, were not. A fall in the value of assets of only 5% would bankrupt the bank. By contrast, Apple had $19bn of liabilities against $21bn capital: there was no risk of Apple failing. This comparison highlights the risks the banking sector was taking before the financial crisis. RBS was not unusual. It had a gearing ratio (liabilities as a proportion of capital) of around 20; many banks had ratios in the 40s and even 50s.
In retrospect, the financial crisis looks like a disaster waiting to happen. Six years on, the economy is finally beginning to recover; national income is getting back to its 2007 value, real wages may be about to start rising, increased interest rates are approaching and there seems to be a cautious increase in optimism. Sustained growth requires a robust and responsive financial system. After the trauma of the last few years, can the banks deliver this?
Some things have changed since 2008. The average gearing ratio of UK banks has halved, to 20 (although note this was the pre-crisis ratio at RBS). Markets in the obscure financial assets that were at the heart of the crisis (collateralised debt obligations, asset backed securities and other exotic financial instruments) are subdued, only about half their pre-crisis size. But some things have not changed.
The financial crisis highlighted the dangers of systemic failure, where the failure of one part of the financial system risks bringing everything down. “Too big to fail” is still a problem; in fact the wave of bank failure in 2007-8 has made the banking sector less competitive. Regulators are certainly more vigilant, more intrusive and better armed than before. But the new system of regulation and control has yet to prove itself. And some suspect that the powerful banking lobby (the financial system accounts for over 10% of total UK tax revenue) may succeed in further reducing the impact of regulation.
Is there a danger of “banker bashing”? Inevitably, yes; populist attacks focusing on the stellar rewards earned by some in the financial system, strike a chord with many. Amid this heated debate, there is not much discussion of what might be the most important question: what type of banking system would be best for the UK? From that perspective, the fundamental role of the banking system is to channel savings into the most desirable uses. The banking system should be structured so this is done efficiently.
There are two main issues. First, how much risk should banks take? Lending is risky (the demand on banks, post-2008, that they both reduce risk and increase lending is paradoxical). Banks are skilled in risk management, but do not consider the wider social consequences of failure. Given that the costs of the financial crisis are estimated to be in excess of £7 trillion in the UK ($22 trillion in the US), the socially optimal upper-bound to risk-taking may be much lower than anything the banking system would tolerate (and this only considers monetary costs; the social and psychological costs are hard to measure but may be enormous).
Second, what type of risks should banks take? Economic prosperity requires a banking system that provides the credit on which modern economies depend. In the years before 2008, banks shifted away from this core purpose, focusing more of their activities within the financial sector itself, using increased borrowing from other banks in order to purchase massive portfolios of the exotic financial assets which were the immediate cause of the crisis.
The banking system is a central part of our economic infrastructure. It should be organised and regulated to benefit the wider economy rather than the more narrow interests of the banks themselves. Continuing with the current structure, with a small number of mega banks, too big to fail and too large to control, may not be the best way forward.
Note: This article gives the views of the author, and not the position of the British Politics and Policy blog, nor of the London School of Economics. Please read our comments policy before posting.
About the Author
Chris Martin is Professor of Economics at the University of Bath. He is a specialist in macroeconomics and monetary economics, especially models of interest rate setting, the Phillips Curve relationship between inflation and output and non-linear macroeconomic models.
The banking sector has been Protected – both MORALLY & professionally – as government’s has relied upon the financial sector to provide a pseudo economy – thus, the facilitation of “loans” rather than a real political force that actually IMPROVES the lives of the many – not just the few. Hence, the recession was born.
Banks are also responsible for funding the Financial Ombudsman Service (FOS), and has influenced policy in this area too. I, like many, have experienced this service – it is set-up in a way that FAILS to reach for the TRUTH. VAST amount of people have been failed by it – not because their case was difficult, but because its policy remit influences the practice, and this is where FAILURE occurs to so many consumers.
It is clear to many that CHANGE in this area is not going to happen. A Democracy – that is strong should always be willing to confront and reassess areas where Failure has weakened social mobility, and stagnated lives. It is not simply Fair for POOR systems to dominate society – as it is not representative of a democratic practice or STATE that says it is democratic.
While the question Is a good one, by the author, the powerful news media and those “privileged” who have so much to protect, will, as usual, do whatever it takes to ensure that the current system is PROTECTED – simply because it also protects their lifestyles too.
Who said it was about DEMOCRACY?
Reluctantly, I have to take issue with one of Frances’ comments. In my experience, risk assessment is not a highly rated skill in modern bank lending, particularly at a strategic level. Profit-making is given a far higher priority. Risk assessment is certainly considered when structuring a particular loan, but whether it is the right time in a business cycle to be making that loan seems to be given little consideration nor whether it is the best time to be exposed to that business sector.
Fund managers are well aware of this failing and wait to take advantage of banks’ poor strategic risk assessment. As a result, banks frequently take equity risks for low debt returns and funds are able to take debt risks and earn high equity returns. So I would suggest to Mr Martin that banks are not skilled in many areas of risk management and to Frances that they need to learn to take less risk. That would produce a more successful and stable economy.
This post, like far too many, ignores the reality of both the banking system itself and the nature of lending.
Firstly, banks are commercial organisations which primarily exist to create value for their shareholders. If their purpose is to change from shareholder value creation to “wider social purpose”, they cannot remain commercial organisations.
Secondly, the sort of lending that the economy most needs is actually the riskiest form of lending. Small and medium size businesses – particularly startups – have frighteningly high failure rates and often have little in the way of assets to offer as security. Yet those who wish to reform banks often want banks to do more of this sort of lending AT THE SAME TIME as reducing their overall risk level. This post falls into this trap. How do you resolve this conundrum without state guarantees for higher-risk lending?
I have walked this path many, many times and always end up in the same place. It is not possible to resolve both the need of enterprises for risky lending and the need of the suppliers of capital (depositors, mainly) for safety without involving the state in lending. Regulation alone will not do: if regulation adequately provides safety for the suppliers of capital, it all but eliminates risk-taking. And an economy in which banks are prevented from taking risk is a stagnant economy.
Believe me, I do not say this lightly. The author has not taken his argument far enough. The implication of this post is that banks cannot remain commercial organisations.
Frances, I do agree that the author has not taken his argument – or ‘this story’ – far enough.
Additionally, while we talk about the ‘banks’ – only emphasising of ethics of individuals and lending practices – we fail to enter an important mention of the Credit Union, and where this fundamental organisation seemingly boasts a rebirth of a ‘community development’ objective.
Both personally and professionally, I have been frustrated by the failure of the Credit Union CEOs – and other senior team members who are responsible for achieving a spotlight on this community lending organisation – in its attempt to gain business through its community network base, and take advantage of the dwindled confidence that the consumer has with banks… or bankers! Many times I still see Credit Unions hidden in darkest places in boroughs and question whether it is gaining the attention it needs in order to achieve its business goals. It’s important to be seen as well as heard, in business. Yet, the Credit Union seems to be relaxed in its position – a comfort too far that has my own ‘business development’ mind in totally perplexed.
Winning the heart & minds in any lending practice is a key objective for business – as it is for individuals who want their skills & ideas potential harnessed in business development funding. Policies that are innovative in counteracting the challenged economic climate and Inspire Minds and Change Attitudes, is a great template for achieving Upwards Social Mobility in our communities. Senior leaders in banking have to do more to ‘bridge the gap’ between their advantaged positions and those who are passionate and ambitious to progress in their own goals.
Isn’t it amazing how Mr Martin talks about ‘organising’ and ‘regulating’ the “banks”, but no mention of what should be done about those running these ‘banks’ – the CEOs.
As I write this, the Serious Fraud Office has released a statement telling us that two employees OF Barclays banks have been arrested for fixing the Libor rate. Now, I am feeling perplexed – or, maybe not… umm. Are we really to believe that the CEOs of these banks had no input in any of this? Really!
Furthermore, whatever happened to the SFOs investigation into what caused CEO bankers to FAIL these banks – causing a recession? I suppose we’re to believe that CEO bankers had nothing to do with any of that? Fraud was clearly a conclusion when ‘balance sheets’ would of highlighted these problems way before 2007 – and less damage could have been done to people’s lives.. and the economy. When a Small Business owner presents a business plan to a bank, such information that reflects these banks balance sheets prior to 2007, would have rung alarm bells to the bank. The decision would have been a definite ‘NO’ to lending to the small business owner.
The fact is, this is not about achieving a Fair and Just outcome. This is about ‘saving’ and ‘protecting’ these individuals in extremely HIGH positions in the financial sector. I see a relationship here between them and politicians… oh yes!
Where was the protection of the Small Business owners who could not afford to be failed again… and were failed by these bankers in 2007? The suicide rate increased between 2007 and 2010 – as small business owners failed by bankers… and politicians, our politicians then stood by and watched these same bankers repossess the homes of these same small business owners…
Are we not surprised why there is so little trust fro politicians?
As for your comments about ‘banker bashing’ – well, I think ‘banksters’ should be bashed… and the politicians who continue to protect them… and not the ‘ordinary’ hard working person who cannot afford to be failed again… and again. Then, to be called ‘skivers’ by politicians.. ???!!!!
Is there a drive to have an ethical individual who develops and runs an ethical banking system? Please let us know.