“Don’t tell him your name Pike” Capt. Mainwaring.
Capt. Mainwaring is one of the hero’s of this book. John Kay remembers back to a time when bank managers were boring but trustworthy. When they took seriously the duty of care they acquired with other people’s money and spent time understanding the needs of their clients and customers. This model of bankers as pillars of the local community, a touch fuddy duddy but completely reliable lasted well beyond the time of Mr Mainwaring.
When I left University and was seeking a mortgage I met a clone of Mr Mainwaring at my bank, the Midland. He asked me all kinds of difficult questions about what I spent my money on, why I had a history of overdrafts, whether he could see the budget he assumed I had produced to demonstrate to myself that I could afford owner occupation, what my prospects were. God he was a pain, and God did he irritate me, and God was he right! This was the early 1980’s.
That bank manager was probably one of the last of the breed, in 1986 we had the big bang which aimed to release all the pent-up creativity of the financial industry. Old-fashioned bankers who wanted to understand exactly how clients were going to repay them were to become a thing of the past.
For those that have not kept up with the changes John Kay’s book is an excellent guide. If, like me, you still thought the role of banks was to take in deposits from lots of people and then lend that money out to businesses that needed help starting up or expanding, think again. If you thought that the bank of England created money by printing notes and pressing coins, think again.
Mr Kay examines how financial services have exploded over the past 30 years and whilst some of that has been positive we are now in the position of having “too much of a good thing”. In fact we have a critical area of the economic system which is generating instability and risk. More than this we have a process where a service, finance, has begun to transform the operation of the wider economy and society. A process of “financialisation” which undermines much which is valuable and creates enormous benefit for the few and enormous risk for the many.
Let us go back to the role of the bank to illustrate the scale of the issue. According to Mr Kay “Lending to firms and individuals engaged in the production of goods and services – which most people would imagine was the principal business of a bank – amounts to 3 percent of the total.” The vast bulk of banks balance sheets nowadays are the claims financial institutions have against each other. But what are these claims?
They are trading positions (or what you and I might call bets) on fixed income securities, currencies and commodities. JP Morgan’s exposure to derivatives of this kind is around $70 trillion. Have in mind that the annual Gross Domestic Product of the world is about $70 trillion. Deutsche Bank has $55 trillion worth of derivatives exposure. Against this it has deposits, the savings of people like you and me, of $577 billion and it lends money to customers of $397 billion. These are big numbers but they mean that what you and I think banks do amounts to 1% of their activities.
Mr Kay identifies 4 key functions of the finance industry: i) a payments system, cheques, ATM’s, bank transfers etc.; ii) “intermediation”, matching borrowers to lenders; iii) enable individuals to manage personal finance across lifetime and generations; iv) help individuals and businesses to manage risk. He then goes on to explore how modern finance does in relation to each of these. In each case we end we conclude that the financialised world is not serving us well.
If we take matching lenders to borrowers banks do provide an important “intermediation” service. Historically they did this by taking in lots of small deposits which people wanted instant access to and converting these into long-term loans. They could manage this trick because a) they had money invested by the owners and b) in practice not all those that deposited money with the bank would want it back at the same time. This meant they only needed to keep a fraction of the money deposited and invested on hand to pay out to those who happened to want it back.
In the mid 19th century it was typical that banks owners would have invested equity equal to 40%/50% of the banks total investments. This meant of course that 40%/50% of the loans that they made could go wrong and the depositors money would still be safe. However, banks decided they could be more efficient and create more profit if they pushed the logic of this along a bit.
By the start of the 20th Century the typical level of equity had dropped to around 25%. (See Admati and Hellwig) Post big bang however they went for it and did two things. First of all took the view that if a banks purpose is to lend money and it wants to expand then it needs more money. If depositors like you and I were not providing enough then they needed to go to the wholesale money markets and borrow big chunks from institutional and large-scale investors. They therefore borrowed a lot more, although still on short terms, but they did not increase the equity reserves.
In the run up to the financial crisis according to Admati and Hellwig the debts (deposits and wholesale borrowing) of many large banks financed 97% of their assets. What this means is, if more than 2% of its loans go bad the bank is insolvent. You might try going to a bank with a start up business and ask to borrow 97% of the costs, putting 2% in yourself. The banks would consider such a prospect as unfundable. So why are they fundable? Because you and I, as taxpayers, have been providing an implicit, and since 2007/08 explicit, guarantee to those that invest in banks.
One key outcome of the explosion in financial services has been the incredible growth in credit. As Mr Kay makes clear some credit is a good thing. When an economy is growing new businesses require credit to get up and running and to expand their activity. At these times and expansion of credit is a good thing. Indeed in times like this credit may well grow faster than the economy as a whole. It is important to appreciate the causal relationship however. Banks argue that the supply of credit will push growth. It may be of course that in reality growth pulls the supply of credit.
Everything is fine if credit is going into new productive investments creating new products and services that the public want. In the current economy however the demand for investment in new businesses is changing. New high-tech businesses do not have huge capital requirements. Google needs no factories or heavy equipment. Indeed many of the existing large businesses in the world fund their growth needs from internally generated cash.
Investors want good returns and security, a combination that seems contrary to economic theory. One way to square this circle is to invest in existing assets like houses and leverage your investment with borrowed money. So now around 70% of traditional bank lending is to purchase homes. Credit expansion fueling demand can be created by the stroke of a pen or more like the tap of a keyboard. Building houses to create supply is a much more complex and time-consuming business. The result asset price bubbles.
The investor appetite for this kind of business was insatiable in the early part of this century and led to the creation of asset-backed securities. This involves banks bundling mortgages together and “securitising” them. In other words selling the income stream that all the mortgages generated to a third-party, possibly another bank.
This basic asset backed security can then be “structured” and transformed into a collaterals debt obligation (CDO) which pays different rates of return to different investors from different slices of the asset. The purported purpose of all this financial jiggery-pokery was to diversify risk and to place it with those best able to manage it. And then to spread the problem a little further those with CDO’s would take out a Credit Default Swap (CDS) which insured them against defaults on the asset.
Now go back to what all this financial pile of crockery is standing on. A mortgage. Had it been just on my mortgage, taken out after I have been through a third degree interview with Mr Safe who pretty much knew every creaky corner of my finance and prospects then probably 2007/08 may not have happened. However, because there was such demand and so much innovation Mr Safe was long gone. Mortgages were no longer treasured and provided, they were marketed and sold. The third degree was replaced with the mirror test. You placed a mirror in front of the mouth and nose of the applicant and if it went misty they passed.
However high you build the pile and however sophisticated it is, if the underlying asset is worthless everything above it is.
The financialisation of the world since the mid 1980’s has transformed it in many ways, some subtle, some the opposite. Mr Kay’s book guides you through the changes with the insight of someone who really understands what has happened and applies very bright common sense to an area of very murky cleverness. The critique is withering and the implications revolutionary. His prescription for this illness is not ever more detailed regulation. As he puts it “too big to fail is too big.” What is needed is structural change to transform the drivers and incentives of individuals’ actions. The Wolves of Wall Street need to be repelled by the Home Guard of Warmington on Sea. Capt. Mainwaring might not be cool but he is trustworthy.
John Kay. Other People’s Money: Masters of the Universe or Servants of the People? Profile Books 2015