Unreasonable expectations and unpalatable truths
At the ICAEW's conference "Do Banks Work?" last week, there was a fascinating interchange between Ian Gorham of Hargreaves Lansdowne and RBS's Ross McEwan. Apparently RBS had refused a large deposit from Hargreaves Lansdowne, to the irritation of the asset manager. "There is a problem placing client money", said Gorham. And he went on:
"Banks don't need people's savings, because they now have much more capital to support lending. This means that savers receive much lower interest rates on deposits. For an ageing society, this is a problem".This is a variant on the "banks don't need savings because they are awash with cash due to QE" meme. It does at least have the merit of understanding the structure of a balance sheet - for the same assets, if you have more equity you need less debt. But the WHOLE POINT of all the regulatory reforms of the last seven years was to force banks to deleverage - permanently. The inevitable consequence of this is, of course, that they need less debt. Deposits are bank debt. Clearly, they need less money on deposit than they used to.
Or - do they? Here is Ross McEwan's response.
"There is a huge amount of money floating around the financial system looking for a home. The supply is greater than the demand, and that causes the price to fall."So, for McEwan, the problem is not so much that banks need less on deposit, it is that more money is trying to find its way into banks. There is too much supply, not insufficient demand.
McEwan is right. There is indeed too much money in the financial system. It has been deliberately created by central banks to encourage people to invest productively instead of sitting on cash. It has singularly failed, largely because no-one joined up the dots. Money never leaves the banking system except in the form of physical cash. Putting more of it into the banking system therefore cannot possibly increase the flow of money around the system. It is rather like pouring more water into a stagnant pool, without removing the leaves and debris that have blocked the outflow and caused the stagnation . You simply end up with a much larger stagnant pool. So since they have destroyed demand for deposits and killed the interbank market with QE, central banks now have to introduce additional policy measures such as negative rates on reserves to try to improve the velocity of money. Governments, too, get in on this game, providing subsidies to banks to encourage them to lend and bungs to people to encourage them to borrow. These interventions have some effect, of course, but at the price of more and more state intervention in the banking system. It is, in effect, creeping nationalisation.
But Gorham, too, has a point. Banks do not want to take deposits for which they have no immediate need: they would rather customers placed them somewhere else, and they don't really care where. So this interesting exchange touches on a deeper question. What exactly do we want our banks to do?
Traditionally, banks accepted deposits, made loans and provided payment services. They paid interest on deposits, charged higher interest on loans, and imposed fees on payment and other services. But that was at a time when the demand for loans roughly matched the supply of deposits, and free-while-in-credit banking didn't exist. Now, the supply of deposits vastly exceeds the demand for loans, interest rates are on the floor, and payments have become a vital (and largely free) public service.
And this, as both Gorham and McEwan acknowledged, creates a problem. Customers - including asset managers, apparently - want banks to provide a deposit-taking service regardless of whether banks have a productive use for the money. Banks may of course provide such a service, but if they can't use the money to fund profitable activities, they will not pay customers for it. Why should they borrow money at interest when they have no profitable use for it? It would be wholly irrational, and probably a failure of fiduciary duty towards their shareholders.
So, banks are starting to demand payment for deposit-taking services. Some banks are already charging institutional customers for the placing of very large deposits. And among retail customers, there is a growing scandal over the mis-selling of bundled current accounts, which in effect are an attempt by banks to charge fees for transaction services without being seen to do so. The imposition of fees on deposit-taking is, of course, a proxy for the negative interest rate that deposits should bear in a banking system where the supply of money exceeds the demand for it. Unless the demand for money picks up - and that means a considerable increase in profitable lending - savers will continue to receive very low or even negative rates, especially on demand deposits.
Banks have the right to refuse deposits. Indeed, under certain circumstances (such as if they suspect the money comes from a dodgy source), they are obliged to. And it is prudent of them to refuse deposits that would make their balance sheets unstable. Banks have been under severe regulatory pressure to reduce reliance on forms of funding that are prone to runs. The worst is wholesale funding.- which is exactly what Hargreaves Lansdowne's client money is. No wonder RBS refused it. Not only does RBS have no productive use for it, the bank would pay a levy to the government for accepting it.
The scars of the 2008 crisis run very deep. People still don't trust banks. They want to lend their money to banks, because - let's face it - these days it is very hard indeed to manage without a bank account. But they don't want to tie up their money in term deposit or notice accounts, because that means that in the event of a bank failure they would not be able to get their money out. This is reasonable. What is not reasonable is the expectation of immediate access to savings AND positive returns.
The provision of liquidity to retail and institutional customers is one of the principal services provided by banks. It's an essential market function, and when banks restrict liquidity the whole economy suffers - just look at the effect of capital controls in Greece, for example. But since providing liquidity creates risk for banks, it is reasonable for them to charge for it. So the underlying problem here is people's unreasonable, though wholly rational, desire to have their cake and eat it. Customers cannot have both immediate access to, and positive returns on, their deposits. If they want liquidity, they must pay for it in the form of low, zero or even negative returns. Liquidity has a price, and the more safe we want our banks to be, the higher the price of the liquidity we want them to provide may have to be. For Hargreaves Lansdowne, the price was infinite.
Ian Gorham's annoyance at RBS's refusal to accept very large deposits of client money therefore misses the point. Asset managers are not supposed to be providing liquidity for their clients, and banks don't have to help them to do so. Asset managers are supposed to be investing for the long-term. It is a measure of how unreasonable people have become that they expect not only banks, but asset managers too, to generate high returns on their savings while providing immediate access.
However, it is not just demand deposits that face interest rate compression. Time deposits do too, even though for banks they are a good source of stable funding. And that is because the world has changed. We are now in a low-growth, low-inflation, low-interest rate paradigm, which shows no sign of shifting any time soon, despite the optimistic forecasts of central banks and other institutions. Low expectations of growth and inflation depress investment and encourage hoarding, both of which put downwards pressure on interest rates: while an ageing, asset-rich society increasingly regards the primary aim of financial management as avoiding losses rather than taking reasonable risks. Passivity is all the rage. Stagnation is not just due to QE - it has an underlying demographic driver.
The days are gone when bank managers borrowed at 3%, lent at 6% and were on the golf course by 3pm. These days, much of their lending is at far narrower spreads: deposits earn less, but so do the mortgages which make up most of their business. Banks face stiff competition in all areas of their business: for savings, from funds and asset managers; for loans, from online providers and peer-to-peer lenders; and for transaction services, from mobile money and fintech. It simply is not possible for banks to provide the services of the past and remain profitable.
Retail banking, in particular, is looking more and more like a public utility akin to water or railways, heavily regulated and requiring extensive public subsidy to enable it to function at all. This seems inevitable: surely it is time we grasped this particular nettle, and stopped pretending that retail banks can be effective providers of financial services to the real economy without government support? I wonder if attempting to unpick state support of banking is going in the wrong direction. Banks that cannot rely on state support in a crisis are inevitably risk-averse, and that makes them less willing to provide finance to the riskiest part of the real economy - small businesses and startups.
Ross McEwan says that banks must "face their customers". Indeed they must, and that means being honest with them. If customers have unreasonable expectations, banks must tell them unpalatable truths. In a world of excess money, customers cannot have significantly positive returns on deposits. The price of liquidity, too, may be higher than some customers want to pay. Similarly, with lending, some customers will be unable to access finance at a price they can afford, because the lending risk is higher than the bank wants to accept. As a result of all this, some people will be pushed out of the banking system: for example, self-employed people who prior to 2008 would have obtained a self-certificated mortgage now cannot borrow to buy a house, and savers who want higher returns are looking at alternative providers. This is a feature, not a bug. Having safer banks inevitably means excluding riskier customers and those who want abnormal returns on savings.
The question is what we do about those customers. This to my mind is not being adequately addressed. It is not safe to assume that the unregulated sector can meet the needs of those voluntarily or involuntarily excluded by the banks. Historically, financial crises have always started in the unregulated sector, and spilled over to banks primarily through the payments system, because all money, even that supposedly deposited in the unregulated sector, actually lives in banks. Unregulated financial institutions are customers of regulated banks. If access to finance for marginal borrowers is key to unlocking future growth, it may be better for the state to accept the risk of lending to them rather than allowing society to take the risk of unregulated lenders blowing up the whole system. And similarly, if the old being able to live on the returns from their savings is beneficial to society, then it is rightfully the role of the state to enable it.
Regulators and banks would like us to believe that things are now "back to normal" after the disaster of 2008. But this is as unreasonable as the expectations of customers. Things are not "back to normal", and they never will be. We are in the middle of a process of fundamental change. What the "new normal" in the distant future will look like, we don't yet know. But one thing seems clear: the banks of the future will be very different from the banks of the past.
The slow death of banks - Pieria