Duncan’s Economic Blog

Banks: Three Big Questions & Three Places to Start

Posted in Uncategorized by duncanseconomicblog on January 13, 2011

As we approach bonus season the banking sector and its future is once more moving up the political agenda. We’ve had the usual fight over bonus levels and remuneration and are witnessing a new battle over the level of the banking tax.

New MPs Chuka Umanna and Rachel Reeves have been taking an impressive lead in these skirmishes.

Both are certainly important issues and Labour is on the right side in each case. The government should take a firmer line on bonuses, especially at state owned institutions and the level of Osborne’s proposed bank levy is far too low.  

But with the Banking Commission due to report this year, I think it’s worth taking a step back and asking three bigger issues. 2011 will be a big year for banking policy – possibly a once in a generation chance to get things right and it’s important that Labour goes into that debate with a grasp of the bigger picture and agenda for the kind of change we need. Especially as an emasculated Vince Cable is unlikely to make much progress alone.

I’d pose three major questions to get that debate started.

First, how can we reform the sector to make major crises, like that of 2008, less likely? Remember that it wasn’t a bolt from the blue, but merely the latest in a long series of similar events of increasingly magnitude.      

Second, how can we make sure that banks do what we want them to – namely act as intermediaries channelling savings into productive investment? The declining level of investment in the UK economy is a major economic problem, and the solution lies partly in the banking system.

Finally, how can we rebalance the economy so that tax revenues are not so reliant on the financial and property sectors?

To get readers thinking, I’d suggest reading three articles – all published in the last year and all important contributions to this debate.

First, the LSE’s Future of Finance report, and in particular the work of  the Bank of England’s Andy Haldane. FT Alphaville summarised this as follows:

The period from the early 1970s up until 2007 marked . . . [a] watershed. Financial liberalisation took hold in successive waves. Since then, finance has comfortably outpaced growth in the non-financial economy, by around 1.5 percentage points per year. If anything, this trend accelerated from the early 1980s onwards. Measured real value added of the financial intermediation sector more than trebled between 1980 and 2008, while whole economy output doubled over the same period.

In 2007, financial intermediation accounted for more than 8% of total [gross-value added], compared with 5% in 1970. The gross operating surpluses of financial intermediaries show an even more dramatic trend. Between 1948 and 1978, intermediation accounted on average for around 1.5% of whole economy profits. By 2008, that ratio had risen tenfold to about 15%

Banking has undergone, at least arithmetically, a “productivity miracle” over the past few decades . . . Risk illusion, rather than a productivity miracle, appears to have driven high returns to finance. The recent history of banking appears to be as much mirage as miracle.

If the returns of the sector, returns that have been of huge of importance to the British economic model are actually a “mirage”, then this certainly matters.

Next, it’s worth having a look at Mark Blyth’s (a Professor of International Political Economy at Brown, in the US) recent piece from the Huffington Post. In particular his views on the “banking business model”.

Cassidy’s November New Yorker piece asks, “What Good is Wall Street?” If it significantly adds to capital formation, then the argument for compensation orders of magnitude beyond other sectors is somewhat justified. The problem lies in showing this, since doing so rests upon a series of counterfactuals that are hard to prove. For example, the existence of a $400 billion swaps market doesn’t mean that its absence would result in lower GDP growth. It does however mean lots of fees for those who arrange the swaps.

Looking at the link between what banks do and capital formation, Cassidy notes that the part of Morgan Stanley that does link borrowers to savers and raise capital, traditional investment banking, delivered a mere 15 percent of 2009 revenues. For Citibank “about eighty cents of every dollar in revenues came from buying and selling securities, while just 14 cents on every dollar came from raising capital for companies.” As such, the claim that these institutions are doing “God’s work,” AKA capital formation, seems to skate on rather thin ice.

First of all, you give up on customers and develop counterparties. That is, you fatten your trading book, and to do that you need lots of different products to trade, hence the growth of complex and opaque securities. Second, you use said securities and the firm’s balance sheet to develop massive amounts of leverage so that even if the margins on each trade are thin, with enough volume you can earn a lot of cash. Finally, you ‘cover’ all this by writing deep out of the money options that give you a near risk free income stream: until it doesn’t.

This is how banks actually make their money, until 2007, when it all went wrong.

This article, which builds upon Haldane’s work, is important in that it sheds light on what banks actually do. We want, and need, banks that help in capital formation (investment), it’s less clear that we need some of these other activities. Adair Turner famously desribed much of banks’ activites as “socially useless”.

Finally a Tyler Cowen article from December on inequality and the financial sector:

Cowen writes that:

For the time being, we need to accept the possibility that the financial sector has learned how to game the American (and UK-based) system of state capitalism. It’s no longer obvious that the system is stable at a macro level, and extreme income inequality at the top has been one result of that imbalance. Income inequality is a symptom, however, rather than a cause of the real problem. The root cause of income inequality, viewed in the most general terms, is extreme human ingenuity, albeit of a perverse kind. That is why it is so hard to control.

(Also summaried here by the Economist)

We need to have a proper debate on financial refrom that moves beyond bonuses and levies, I think these articles are a good place to start.

8 Responses

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  1. Luis Enrique said, on January 13, 2011 at 4:38 pm

    to add to your recommended reading, Mervyn King’s Bagehot speech is a barnstormer

    http://www.bankofengland.co.uk/publications/speeches/2010/speech455.pdf

    I’m a fan of Kotlikoff’s LPB …. it’s never going to happen in totality, but I wonder if there’s scope for a partial fix. For example, if we could get the “real economy” funded by mutual funds that could never go bust, and which simply lose value in recessions, that might help. But I’d need to think about that.

    Otherwise, just get those equity cushions much higher, and much cruder (don’t allow them to fiddle it)

    I don’t know how you are so sure investment in the has been too low. You must be telling a story about some gap between private returns and social returns. I find it easier to believe investment has been too low from social p.o.v. but correct from private p.o.v. that to believe that for some reason private investors have left investment opportunities offering private returns unexploited. If you look at things that way, there’s a role for government to invest with social returns in mind.

    I’m not a fan of crude intervention on bonuses – too superficial and too likely ineffective for reasons set out here
    http://liberalconspiracy.org/2009/02/12/bankers-and-bonuses/

    I have a half-assed idea that the root cause of high banking income and pay has to do with the closed network nature of production – the extent to which networks of personal contacts matter. I think this goes some way to explaining both bank’s pricing power and individual banker’s bargaining power when it comes to securing the lion’s share of the surplus. So what might make banking more of a commodity – more competitive, and banks less vulnerable to threats from bankers to jump ship to other banks. I don’t know. Perhaps technology has the answer.

  2. Luis Enrique said, on January 13, 2011 at 4:44 pm

    oh – if there’s going to be a bank levy because bank shareholders benefit from implicit insurance from CB, I think there should be a bank income super tax for the bank employees that benefit from same

  3. Luis Enrique said, on January 13, 2011 at 4:59 pm

    If we could start promoting the use of mutual funds like Kotlikoff suggests, bankers who work for them (or as brokers selling loans to them, designing exotic financial products embodied in them etc.) would be exempt from the income-super tax on basis that we are much less likely to bail out a mutual (because they cannot become insolvent). That might help push things in the right direction.

  4. Richard W said, on January 14, 2011 at 4:47 am

    ” First, how can we reform the sector to make major crises, like that of 2008, less likely? Remember that it wasn’t a bolt from the blue, but merely the latest in a long series of similar events of increasingly magnitude. ”

    Banks do not get into trouble because they run out of money. They become insolvent when they run out of capital. The banks are too big to fail. No matter what size the bank is the options will be nationalisation, merger or bailout, No bail-out promises are not credible. Therefore, forcing up their capital requirements is the only realistic way to make them so safe that they will not fail. A more competitive banking sector is a contradiction to less risk in the banking system. The least competitive ( Canada ) banking sector in the advanced world is the one that performed the best in the GFC. Higher capital requirements will automatically reduce profitability.

    ” Second, how can we make sure that banks do what we want them to – namely act as intermediaries channelling savings into productive investment? The declining level of investment in the UK economy is a major economic problem, and the solution lies partly in the banking system. ”

    Stop taxing dividends and companies will raise more equity finance rather than relying on banks for debt finance.

    ” Finally, how can we rebalance the economy so that tax revenues are not so reliant on the financial and property sectors? ”

    Well lefties seem quite keen on increasing our dependence on them for tax revenue by increasing taxes on banks. I don’t think they have thought that one through. Cut taxes on capital and labour. Raise tax revenues from a LVT, Pigovian taxes and consumption taxes.

  5. Tim Worstall said, on January 15, 2011 at 6:28 pm

    “the level of Osborne’s proposed bank levy is far too low. ”

    Interesting: so you have some idea of what the rate should be then? Other than just “higher”?

    So, what is the actuarially accurate insurance levy for the implicit insurance that the banks get on their wholesale market liabilities?

    http://www.fdic.gov/deposit/insurance/assessments/risk.html

    FDIC rates seem to vary anywhere from 7 bps to 70. From what I can see Osborne’s levy (and I agree, I’ve only just Googled it) seems to range from 20 bps to 70 bps.

    Do tell how Osborne is so out of line therefore.

    Don’t forget, this is an insurance premium on currently uninsured deposits (or liabilities, as they are to banks) not a tax.

    • duncanseconomicblog said, on January 16, 2011 at 12:10 pm

      For a start the banker quotted in the FT two weeks ago saying “anything less than £5bn is a rounding error. ”

      Anf the levy should be more than an insurance scheme – it’s a way of raising revnue generally.

  6. gastro george said, on January 17, 2011 at 10:51 am

    It strikes me that one of the most important policy targets ought to be reducing the profitability of the wasteful portion of investment banking – that 80% of activity that takes a salami slice out of trillions of transactions. A Tobin-style transaction tax ought to suppress a lot of the froth.

  7. […] increasingly looks like the Vickers report will actually deal with some of the big issues around the banking sector. However last month I expressed some worries about how the government would […]


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