Monday, 2 May 2011

The worm in the apple: what went wrong in retail banking

In my last post I debunked the myth that the financial crisis was caused by evil investment bankers gambling our precious savings on the international financial casino, and pointed the finger firmly at the massive expansion of high-risk lending by retail banks in the traditional forms of lending - corporate loans, personal loans and in particular mortgages. In this post I shall examine the role of government in encouraging and supporting excessive risk-taking by retail banks, and show that the financial crisis was in fact underpinned - and you could even say, caused - by the implicit support that all governments give to retail banking.

Since my last blogpost the Independent Commission on Banking (ICB)  has produced its draft report. My comments in this blog are inevitably influenced by this report, and at times I shall refer to it directly. But that doesn't mean I agree with it.

I shall start with a discussion of the taxpayers' guarantee for retail depositors.  How many of my readers realise that most retail deposits were actually already guaranteed - not by government - prior to the financial crisis? The Financial Services Compensation Scheme (FSCS) guarantees retail bank deposits up to a practical limit of £31,700.   I should make it clear that the retail deposits protected by this scheme are current accounts and interest-bearing bank (or building society) demand and notice deposit accounts.  ther forms of savings accounts, such as personal pensions, ISAs and high-interest long-term savings linked to life insurance, are also protected by this scheme.  But they are regarded as INVESTMENT accounts and form part of investment banking - and yes, evil investment bankers gamble with that money. That's how they generate the returns.

So when Alistair Darling guaranteed all retail bank deposits to halt the run on Northern Rock, he was committing taxpayers' money to bail out retail deposits in excess of £31,700.  Now why should taxpayers, most of whom are much too poor to have that amount of money sitting around in bank deposit accounts, pay to protect the savings of people who are much better-off than they are?  And pensions and life insurance endowments - the life savings of ordinary people - weren't covered by this guarantee, so remain at risk. Why did he do this? And why did he - and everyone since, including the ICB - regard it as so important that relatively rich retail depositors were protected?

Here's the reason.  Guaranteeing retail deposits has NOTHING to do with preventing people from losing their savings. It is all about keeping banks lending.

Because of the way our financial system works, when banks stop lending it is economically disastrous. Bank lending controls the supply of money in the UK economy. I'm not going to explain here how the fractional reserve banking system works, but in effect all investment in our economy is done by means of bank lending. When banks don't lend, nothing moves - businesses don't grow, people don't spend, government doesn't invest.  Although banks can invent the money they lend, they do have to have some money in reserve to settle that lending. Some of that cash is provided by retail deposits.  But they can also borrow cash cheaply to settle loan drawdowns, either from other banks (notably investment banks) or from the central bank.  So why do they need deposits?  The answer is, they don't - but people think they do.

Banking textbooks insist that bank lending is made up of fractions of deposits they receive from retail savers.  The "money multiplier" is routinely taught as the mechanism by which banks are able to lend.  It is therefore widely believed that banks can only lend if people and businesses provide money in the form of deposits.  The more money retail depositors put into banks, the more money banks can lend out.  The more money banks lend out, the more the economy grows, and the more revenue government receives in taxes and can spend on things like the welfare state.

We (people, businesses, government) want banks to lend. Because of it we can afford things we couldn't otherwise have. That has been the model for a long time and I haven't seen as yet any serious plans to change it. In fact in the last twenty years banks, encouraged by financial deregulation and free market economics, massively expanded their lending, and we (people, business, government) lapped it up and begged for more.  The result was a credit bubble, which in turn fuelled a housing price bubble, which when it collapsed brought down the financial system.  Many people who bought into the credit bubble are now saddled with heaps of debt they struggle to repay.  Many people who bought into the housing price bubble lost their homes.  Many, many people have seriously lost confidence in the whole banking system. Bankers are currently the most hated people on the planet.

If retail depositors lose confidence in the banks and stuff their money under the mattress instead, the money multiplier tells us that banks' ability to lend is seriously reduced.  This isn't true, because banks will simply borrow the money for loan settlement from somewhere else. But people - even those who should know better - believe that lending will collapse if retail deposits disappear. Therefore government will provide unlimited support to retail depositors to ensure a continuing supply of money to support lending. Hence the almost hysterical insistance by almost everybody that it is ESSENTIAL to guarantee retail deposits.  Indeed it is, if you believe the money multiplier.  Lose your retail deposits and you lose your financial system.

This need is so acute that quite silly measures may be taken to protect retail deposits. Full separation of investment and retail banking not only doesn't protect against future failures, it significantly reduces returns to both retail depositors and, even more, to pension and endowment holders.  But if retail depositors believe that their money is put at risk by evil investment bankers gambling with their money, they will cry out for full separation - and government will give in to them even though it doesn't solve anything. In proposing ring-fencing of retail banking the ICB has attempted to calm depositors' fears enough to avoid full separation - but it admits that this might not work and the government might still have to agree to full separation.

It's all about confidence, in the end.  In fact the whole thing really is a confidence trick. Blame investment banking for a crisis actually caused by stupidly risky retail lending, because if you undermine confidence in retail banks people might move to credit unions and small building societies instead (which don't generate money for the economy). Tell retail depositors you are concerned that they should not lose their savings, when what you are actually doing is ensuring a supply of cash reserves to the banks so that they can lend even more.  And above all, pretend that the financial system works the way it does because there is no other way of organising it, and that bank lending is a good thing, really.  Well, ok, bank lending to people that can't afford it maybe isn't such a good thing. But bank lending to businesses is good, isn't it? That's what we are hearing at the moment. "Get the banks lending to businesses! Get the economy moving!" And what happens when banks lend silly amounts of money to businesses that turn out to be insolvent? Yes, you guessed - the taxpayer coughs up again. Serious losses in corporate and commercial lending were contributory factors in the failure of both RBS and HBOS.

The worm in the apple is the retail depositors' guarantee. Unlimited taxpayer support of what is a fairly large proportion of retail bank cash reserves means that banks can continue to take stupid risks in retail lending in the certain knowledge that they will be bailed out every time.  Yes, under the ICB proposals investment banks would not be bailed out once retail banking is ring-fenced.  But retail banks still will be supported end-to-end by an unlimited taxpayers' guarantee.  Roll on the next financial crisis and bank bailout. Wonder who we'll blame next time? I guarantee it won't be retail banking.

It doesn't have to be like this. We really don't have to be so dependent on bank lending. Let's find a better way of organising our financial system. Break the link between bank lending and economic growth. Get rid of taxpayers' guarantees for well-off people.  Force banks to manage their risks properly.  And above all, recognise that prosperity founded on credit is an illusion which can't be sustained. Real growth comes from real money, generated by real people buying and selling real goods and services.


  1. Interesting. But it still rankles that one man could bring a bank to the point of collapse. I do feel sorry for those bankers trying to put it all right but not paying themselves huge bonuses would help!

  2. Having now read a few posts I get the feeling you are developing a new model for the financial system...

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