Banking, Post the World Financial Crisis - Detail
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Posted by David Chan on 2008-Dec-14 02:13
As we watch Governments bailing out the banking industry globally through injecting massive amounts of cash and guarantees, it occurs to me that there may be a way of setting out a new framework for banking and financial services in the future.
This paper sets out a proposal of what should be done post the crisis. Before going on to set out the proposal in more detail, it is useful to look at some of the main factors leading to the Crisis. If you know about Fractional Reserve Banking and Securitisation, then you can skip the next few paragraphs.
Fractional Reserve Banking
Banks create money by lending more than they have on deposit. This is called Fractional Reserve Banking (FRS).
Say someone deposits £100 with a bank for an interest of 5%. The bank is now in a position to lend out that £100. Say someone wants to borrow that £100 and is willing to pay the bank 10% interest. Then the bank can make 5% of £100 on the deal. The borrower takes that £100 and trades uses it in business. And in the course of business he receives some cash, say £90. He then lodges the £90 in the bank and the bank is then in a position to lend that out too, so and so forth.
So an initial amount can generate many times the number of loans. While everyone is paying back interest on time, the system works well. The investor makes what he expects on that deposit, the banker can generate many times that deposit in loans. This number of times is called the Bank Multiplier. Experience has shown that multipliers of 5 or 6 are a reasonably safe bet. In recent times some banks have worked on multipliers of 10.
This shows how banks make money as well as profits.
So if a bank has a multiplier of 5, then on a single deposit of £100, they can lend £500. If the interest charge on loans is 5%, they will get back an equivalent 25% of their original £100 investment. That is the power we are giving to private banks!
Regulation and Circumvention
Most modern economies regulate the banks by setting out the amount of reserves the banks must hold. In effect, they set the multipliers that the bank can work on. Also, banks do not lend money without additional guarantees. Most loans require some form of security such as a property or some form of asset that the bank can cash-in in the event of a default.
Now a bank can only lend a set multiple of its reserves on the balance sheet. Once they have achieved this volume of business, they must gain more deposits or more capital to expand their business. This is in theory what should happen. However, in recent years, banks have used a device called Securitisation to reduce their total holdings in loans. This takes some of the loans off the banks balance sheet and allows the banks to create more loans.
A loan is just a promise by the debtor to repay the loan according to a payment schedule. Basically, it is a stream of income into the future. This income steam has a value in the marketplace. People such as Pensions providers or anyone who has to pay out regular amounts will pay a capital sum for this income stream. This capital sum is greater or less depending on the risk of the debtor defaulting. By having security, there is a perceived lower limit because, if the debtor defaults, you can take the asset and sell it.
This is basically what securitisation is about. A bank can bundle up a set of loans and offer to sell it to the marketplace. When it sells the loan, it reduces its total loans and gains cash which is very good for its balance sheet. It has off-loaded the risk to other investors and allows its reserves to finance more deals. Also, in most countries, the seller can recognise a certain level of profit from the loan sales made. From the buyers point of view, he gets an income stream with a lower limits of loss determined by the secured assets. Now both the seller and buyers use financial models to predict what is a fair price. So a lot depends on these financial models used by the two parties.
If everything works out according to plan, the Bank shifts debt off its balance sheet and can recognise some profit from the deal through securitisation. The buyer gets a stream of income secured on an asset. As long as the repayments follow what is expected and the default rates are in line with the model predictions, then the loans should be repaid.
However, things can go wrong.
What Can Go Wrong
The expected default rate is exceeded. This has a bad effect on the buyer as he does not get the money he expects. It is also bad for the seller because the buyers will be more cautious on the next securitisation paying less. It is also bad for the banks because some of their loans that they hold on their own books may have to be valued down, reducing their balance sheet,
The underlying asset values fall. When the underlying asset values rise, the lenders are more tolerant of missed payments. But, when the assets fall below their security value, lenders are more inclined to foreclose on the debt. This is what happened when the property prices in the US started falling. Also, the balance sheet values of the bank had to be written down to reflect the new prices.
The situation is compounded by derivatives and insurance. In the last two decades, derivative instruments, basically one way bets, have multiplied the impact of adverse conditions. You can purchase insurance that pays-off when asset values fall below a certain level. When there are higher default rates which result in distressed sales which knock on to falling asset values which trigger-off insurance payments which further depress asset values as the insurers cash their assets to pay off their liabilities.
2008 World Financial Crisis
The world financial crisis in 2008 was triggered in 2006 when the lenders in the American sub-prime market started seeing their default rates increase. Both Fannie Mae and Freddie Mac relied upon the securitisation model rather than financing their own loans. Not only the US markets but the UK market was using this Securitisation model of mortgage financing. Subsidiaries of US corporations had started to look at Europe as a potential market for this Securitisation. This alerted the Capital Markets to the possibility that billions of dollars of loans may be toxic. This coupled with the creative derivative insurances and the lack of visibility in international trading of financial products caused banks to question the credit worthiness of their fellow banks. They knew someone had to own these assets but it was not clear who. This resulted in them being reluctant to lend short to other financial institutions.
Several attempts were made to 'plaster over the cracks'. In the UK, one of the top ten mortgage lenders, Northern Rock had to be nationalised. AIG, a major insurer had to be bailed out by the US Government. Merrill Lunch had to be rescued by Citicorp and Lehman's was allowed to fail. Despite these efforts, the crisis still rolled on. It is only when Governments intervened in the World Financial Markets by putting the tax-payer as the guarantor has this had an effect for the better.
Giving commercial organisations the power to indulge in FRL allows them to make supernormal profits. The market in banking is not free. There are significant barriers to entry for any supplier. The information to the buyer is extremely restricted. Banks have to be regulated. So when Banks get big enough or become important enough to a nation's economic infrastructure, the have a hold over the actions of the government. In effect, by allowing private enterprises to have the power of FRL, we are creating an oligopoly that allows certain advantaged individuals to make even more money.
In modern economies, there is a major problem with taxation. The tax burden on most industrialised nations ranges between 30% to 50% of their GDP. Taxes on income deter initiative and risk taking. Taxes on assets are seen as unfair. With the globalisation of trade, there is a potential problem with where taxes should be levied on the transactions.
We are already seeing Government intervention in banking through partial nationalisations and loan guarantees. Whether we like it or not, Governments will be a major player in financial services over the next few years. Rather seeing this intervention as a sin, perhaps we should view this as an opportunity and a virtue.
I propose that the Government remove the ability to conduct Fractional Reserve Lending from commercial organisations. Instead, we should only allow a nationalised bank, lets call it the National Bank to lend on the FRL basis. This bank will have a monopoly on FRL in any one country.
This bank should be run at arms-length from the Government with the objective of maintaining the liquidity of the financial market and providing a good return to the Government. A model for such arms-length governance can be found in corporations such as the BBC. In the UK, interest rates are set by the MPC which is an independent committee appointed by the Government. Similarly, the financial objectives for National Bank could be set by a similar independent committee.
The Bank will be guaranteed and underwritten by the taxpayers. It's framework of operation should be set out in Legislation. It's Board members should also be independent and appointed by the Government for a fixed term with responsibilities. They will have statutory responsibilities and should also be accountable to the Government.
The National Bank will offer commercial loans to organisations or individuals at commercial rates with good security. It will also allow individuals to deposit amounts at commercial rates. It will not offer checking accounts nor the usual consumer services associated with banks. In effect it will act as the 'manufacturer' giving a safe return for deposits and a good rate of interest on secured loans. Based on deposits, it can generate a volume of loans based on its Fractional Reserves. So, it is the only organisation that is permitted to multiply the money supply. The extent it does this will be set down by the Treasury.
Commercial organisations that wish to operate in the Financial Services industry will be regulated by an independent regulator similar to the UK's Financial Services Authority which will have no connection with the Nationalised Bank.
Commercial organisations may lend money to customers but for each loan they grant, they must be able to cover the whole loan by giving cash out of their own reserves, or, by obtaining a secured loan from the National Bank of the same amount. The loan to be secured on some fixed asset valued in a conservative manner.
The National Bank will not operate local branch networks. Instead Financial intermediaries may operate such a network funded through levying a higher charge for overdrafts than the National Bank rates or through levying a charge for service.
Financial Services companies will also be able to take deposits from customers at a higher rate than the National Bank. These deposits may be used to fund loans but they will only be allowed to lend out what is on their balance sheets. They will not be allowed to operate Fractional Reserve Banking. Investors in these intermediary companies will not be guaranteed their deposits unless the intermediaries invest such deposits in the National Bank. Shareholders in these intermediary companies will have to accept their investments are at commercial risk and will depend on the ability of the directors to manage the commercial risks. That means, no bail-outs by Government.
Any profits made by the National Bank on its lending operations will be available to the Government to off set taxation.
In effect, I am advocating a manufacturing model where the base product or component (loans) are manufactured by the National Bank through using FRL. Other organisations can build on these components distribute products, and retail products direct to the customer.
Benefits of the Proposal
The proposal provides a good balance between enabling innovation whilst protecting the tax payer from the moral hazard resulting from allowing private banks to become so fundamental to the economy. October 2008 saw massive Government intervention in the Financial Services Market and it may not be over yet. Adopting these proposals will enable the Government to have good visibility on the amount of debt accumulating due to financial activities.
Another benefit, which will not be trivial, is the impact on fiscal policy. Charging the National Bank to make a profit on its lending activities will make a positive contribution. Profits made by the National Bank can be used by the Treasury to offset taxation. Banking is a profitable activity. Providing oligopolies with the right to FRL gives them the opportunity to make supernormal profits. By adopting this proposal, the benefits can accrue to the ultimate risk taker, the tax payer. If the National Bank is managed well, this may well yield a significant benefit to the tax payer.
By taking the power from private organisation to leverage loans through FRL, Governments can begin to break the power of bankers and the wealthy over their economy. The asset rich have a safe haven for their wealth through the Nationalised Banks. They may also invest their wealth in the new financial intermediary organisations to gain a higher return but, under these proposals, they will have to bear the risk. This proposal does away with the moral hazard that allows the wealthy to make one-sided bets. If they want supernormal returns, they have to bear some risks.
Some may argue that the proposals are against free markets. I would suggest that the proposals have a greater chance of creating a 'level-playing field' that is the basis of a good free market. The wealth making investments can be separated from the financial decisions as moral hazard is avoided. A market can still be created which addresses the imbalance of information between the financial service suppliers and its customers.
Sponsorship and charity funding need not suffer. As the financial intermediaries need profile and branding, they will still be in a position to fund sports. The National Bank, however, will not be allowed to grant sponsorship or fund charitable contributions. They will stick to the fundamental operations of a bank; providing a financial lubricant for the economy.
The proposals will also provide a safe haven for those who are risk aversed but cash rich. No longer will we see Local Authorities and Charities having to place their liquid funds in the market and run the risk of banks collapsing. Instead, they can deposit these with the National Bank and still earn interest safely.
Adopting the proposal will not stop innovation in the financial services marketplace. Intermediary organisations can still function providing services to those who have not the security to take a National Bank loan. However, these organisations will be risking their own capital rather than burdening the tax payers with the risk. If organisations wish to produce derivative products, they are still free to do so as long as they have the assets to underpin these products. Financial aggregation's may well take the place of High Street banks by operating a network and charging a premium for the use of such facilities.
With the Governmental response to the October 2008 crisis, we are partly on the way to nationalising the banking sector. Taking the additional step may not need that much funding. All it would take is the political will.
If you agree with this proposal, go to this link and sign the petition!