Since the banking crisis of 2008 and subsequent chaos in the global financial system, governments and central banks around the world have implemented all manner of extraordinary policies to prevent another major bank failure.
Interest rates have been cut to zero, banks have been flooded with reserves and governments have taken on huge quantities of toxic assets. Understandably, people are angry.
Yet although investment banking is widely blamed for the crisis, the roots of these problems lie in retail banking.
It is generally known that two of the UK’s four biggest banks – Royal Bank of Scotland and Lloyds Banking Group – failed and had to be part-nationalised during the credit crunch. It is less widely known that the other two biggest banks – Barclays and HSBC – have also undergone major restructuring since the crisis, shedding thousands of jobs and shrinking their balance sheets considerably.
The building society sector also experienced a considerable shakeout in 2009 as a consequence of the global meltdown. One, Dunfermline, was nationalised, others were bought by larger banks and building societies and another, Kent Reliance, was even bought by a private equity company.
Unfortunately, this has caused indigestion for some buyers. The Co-operative Bank is about to undergo extensive restructuring owing to its 2009 purchase of Britannia Building Society, which it transpires had sufficient toxic loans to overwhelm the smaller Co-op’s balance sheet. Meanwhile Nationwide has struggled to integrate the three smaller building societies that it absorbed and it too has had to undergo major restructuring in the past few years.
So the UK’s biggest lenders and its entire building society sector have undergone radical surgery, with many still in intensive care.
Nor have smaller retail banks been immune. Northern Rock and Bradford & Bingley both failed and were nationalised in the crisis. A significant number of small banks, building societies and credit unions have also gone belly-up. Most depositors in smaller institutions are below the Financial Services Compensation Scheme limit, while in the US, Federal Deposit Insurance Corporation records show that thousands of small banks have failed in the past five years.
After the financial crisis, there were extensive inflows of deposits to small banks and building societies as people – encouraged by campaigns such as Move Your Money – moved funds out of banks that were seen as ‘risky’ and ‘bad for society’ into institutions that had a better image. We now know that these other institutions are no safer, and perhaps no better for society, than the big banks that are criticised so widely.
The 2008 crisis was no more a crisis of big banks than it was a crisis of investment banks. It was a crisis of banking in all its forms. And it has not yet ended.
The continuing shakeout and restructuring across the banking industry is immensely damaging to the economy. Weak banks stuffed with risky non-performing loans cannot lend productively and deleveraging bank balance sheets and building capital have deflationary effects in the wider economy.
But at least these banks are still alive, although badly wounded. If we keep them on life support for long enough – keep funding costs down with low policy rates and subsidies, guarantee riskier lending so that they appear to be doing something useful and provide them with lots of cheap liquidity – eventually they will recover, won’t they?
Unfortunately, the treatments being used to keep them alive themselves have toxic effects. Most were supposed to be short-term interventions to prevent disorderly collapse – it was never envisaged that they would continue for years on end. And some interventions seem to maintain banks at the expense of the wider economy.
Very low interest rates are supposed to encourage the flow of credit to borrowers who would be reluctant to pay higher rates. What they actually do is prop up highly indebted households and businesses, preventing bankruptcies and foreclosures.
New loans are generally at higher rates – in some cases much higher – than old ones, even though official rates are on the floor.
Preventing bankruptcies and foreclosures protects banks (and, indirectly, savers) as a sudden swathe of business and household debt defaults would spell disaster for many lending institutions, particularly the smaller ones. Unpopular though it is to say this, large universal banks are actually less likely to fail than small lenders concentrated in particular market sectors such as residential mortgages.
Very low interest rates also prop up the prices of safe assets, which are used as liquidity buffers by financial institutions. And they depress bank funding rates, both in the wholesale market and, perhaps more importantly now that banks are trying to reduce their reliance on unstable wholesale funding, for rates to depositors.
Treatments being used to keep the banks alive have toxic effects themselves
Deposit rates are below inflation (that is, negative real rates), while interest rates to new borrowers are rising. It is widely believed that banks are using the earnings from the spread to recapitalise – but are they really?
The problem is that banks have overheads – staff costs and premises, for example. When interest rates are very low, banks do not earn much. Yes, if funding costs are low too they make a profit on the difference. Yet margins are being squeezed, which is affecting bank profitability across the board. All the major banks report reduced interest income and rising costs.
Margin squeeze is particularly tough for small players, so very low interest rates tend to benefit large retail banks at the expense
of smaller ones. When margins are tight, the winners are those with the largest market share.
Another problem, according to Steve Hanke at the Cato Institute, is that very low interest rates kill the interbank market. It simply is not worthwhile for banks to lend to each other when they can pretty much earn the same for parking excess reserves safely at the central bank. This impairs the flow of funds around the financial system.
Central banks around the world have used quantitative easing and term lending (repo) on an unprecedented scale to offset the collapse of unsecured interbank lending, in effect ensuring all banks have excess reserves so do not need to borrow from each other. But this does not encourage banks to lend, all it does is enable them to make payments. And as risky lending ties up capital – and banks are short of that because of their horribly risky lending books – is it any wonder they are charging high prices for risky lending? They do not really want to do it.
So very low interest rates destroy bank margins and slow the velocity of money. Providing banks with cheap funds offsets this to some extent as it enables them to refinance their existing loan books at lower rates, improving their spreads and keeping variable rates to existing borrowers at historically low levels, thus avoiding defaults.
The idea behind initiatives such as the Funding for Lending Scheme (FLS) is that if existing loan books can be refinanced at better rates, banks will be able to take on new risky lending, particularly if the scheme includes a concession on regulatory capital requirements, as the FLS does.
However, there is a big flaw in this thinking. Refinancing loans at lower rates may improve banks’ margins but their balance sheets remain horribly risky. And reducing the regulatory capital requirement does not make the risks go away. Risky lending is risky lending, whether or not regulators want capital allocated to support it.
Fiscal and monetary authorities seem con-vinced that if you throw enough money at banks – or reduce interest rates enough – they will be compelled to lend. They might – but not to risky people and businesses. They will look for opportunities to lend at near-zero risk.
They will not have far to look. Central bank deposit accounts and government debt are safe assets earning them a few pennies while adding no risk to balance sheets and keeping regulators happy. Although the FLS includes penalties for failing to lend to the real economy, for weak banks the penalty may well be worth their while taking in order to obtain cheap risk-free funds. No wonder the Co-op Bank took £900m from the FLS in the first quarter of 2013.
Surely everyone now knows that QE – and its close relatives, the long-term refinancing operation and other central bank extended-term repo operations – does not do what was hoped. Flooding the place with liquidity ensures banks can always make payments but it does not force them to lend productively. What it does is create a liquidity swamp in financial markets, causing all manner of perverse effects.
Propping up asset prices helps banks to maintain good liquidity buffers but it creates a scarcity of collateral for repo and other secured lending, reducing the flow of funds around the shadow banking system and impairing lending by non-banks. QE and its relatives are regressive since they directly benefit the rich most. The jury is out on what effect, if any, they have on unemployment and real incomes for the majority.
Despite the calls for banks to be made safer, deposits have never been so at risk as they are now
Not only is keeping banks on large amounts of life support toxic for the economy, it is toxic for them too. The longer banks stay on life support – offering little to the wider economy and kept alive by transfusions of public funds – the more people and businesses will look for other ways of obtaining the finance they need.
New players will join the banking industry, especially online where entry barriers and costs are much lower. New initiatives to channel investment to businesses will appear. New ways of enabling people to save will be created. Even new ways of financing traditional purchases such as houses will be found.
The big banks’ stranglehold on payments may even be broken. There are already ideas for the payments network to be made more accessible to smaller and newer players, and alternative ways of making electronic payments without going through banks. In the end, banks as we know them may become redundant. In which case, do we really care whether or not they recover?
The actions of governments and central banks immediately after the 2008 crisis averted a banking system meltdown. But retail banks are in terminal decline and the measures we are taking to keep them alive only make their eventual demise more certain. Maybe what we will eventually do is switch off their life support and let them die in peace.
The key change we are seeing is what we might call ‘disintermediation’. That is, a flight of both lenders (depositors) and borrowers from traditional deposit-taking lenders to other types of financial intermediary, many of them specialists in particular aspects of financial management and networked to other providers that do different things.
This has already happened to a large extent in the US, but the UK and European models of banking are founded on universal banks and it is difficult for many people to imagine what a banking system deconstructed into its component parts looks like. Yet when you break down the traditional banking model, it becomes apparent that there is a fundamental conflict at the heart of universal banking that makes it untenable as a business proposition in the current climate.
If you ask people what the job of a bank is, you are likely to get two quite different answers: to provide a safe place to put money or to provide capital to businesses and households for investment.
As a consequence of the growth of automated payments and the decline in the use of cash, we can add to this the role of banks in maintaining the flow of money through payments and receipts and ensuring that people receive wages and pay bills securely. The payments systems themselves (Chaps, Bacs, Visa, Swift, among others) are separate organisations but the gateway to them is via commercial banks and liquidity is provided by the central bank.
Putting these three roles together, it is plain that people expect banks both to provide security for savings and payments as well as provide risk capital for businesses. The apparent impossibility of achieving both of these appears to be lost on politicians who call for banks to make their balance sheets safer (so as not to put deposits, and by extension taxpayers’ money, at risk) then criticise them for reducing risk lending. This is fundamentally inconsistent.
Prior to the 2008 financial crisis, banks were pursuing the provision of capital to the economy in a big way, leveraging up their balance sheets and taking ever-larger risks in all areas of their business, particularly in corporate lending, commercial real estate and residential mortgages. They regarded deposits as “funding” to support this activity, and it is fair to say they did not regard keeping savings safe or ensuring the security of payments as their top priority.
Since the financial crisis, the pendulum has swung the other way. Pressure from regulators, politicians and customers, coupled with banks’ own risk aversion, has led to safety becoming the top priority.
Everyone has ideas about how to make banks safer but few seem to realise that a safe bank is also a risk-averse one. If a bank cannot take risks with its balance sheet, it is unable to provide the risk capital that businesses need.
Even good customer service is not really possible while such a fundamental conflict exists. Either depositors who want safety are well served, in which case borrowers’ needs are not met, or borrowers’ need for risk capital is met, in which case depositors cannot have safety.
At the same time as pressure is being exerted to make banks safer for depositors, there is a conflicting pressure to make them riskier. This is coming from two directions: the aforementioned political pressure on banks to lend more at higher risk in order to revitalise stagnant economies; and the withdrawal of implicit support from government in the event of bank failure. Depositors and senior bondholders are no longer sacrosanct. They can, and do, lose money when banks fail.
Delicate balancing act
In their quest for safety, banks are looking for more deposits because they are a more stable funding source than wholesale funds, which can be withdrawn without warning. But if deposits are no longer safe from loss, what can banks offer depositors that they cannot find in managed funds?
Demand deposits at least give the flexibility to withdraw funds at a moment’s notice. But there seems little reason for time deposits in banks to exist at all. They compete directly with mutual funds, which would be fine if banks regarded themselves as asset managers, actively managing funds placed with them to the benefit of their depositors. But they do not. And even if they did, they do not have a good track record at it. The wealth management divisions of universal banks may excel at portfolio management but not their mass-market retail banking divisions.
Retail banks do not look after people’s money and never have done; they exist only to lend. Time deposits are therefore an anomaly. And even demand deposits are not essential since there are alternative forms of liquid investment, such as gilts and (for larger amounts) money market funds. Savers have more investment choices now than at any time in the past. They do not have to put money in banks.
That said, there is a form of bank deposit-taking that has become essential. About 94 per cent of the UK adult population have bank accounts. Wages, pensions and benefits are paid directly into bank accounts, as are payments to businesses. Household bills are paid by direct debit or bank transfer. Essential and discretionary spending is done with debit cards and online payments.
With the advent of contactless cards and mobile phone transfers, cash is no longer needed even for very small payments. Cash makes up a far smaller part of our economy than it did in the 1960s. It has largely been replaced by banks and the electronic payment services they provide, which have become essential to our economy. RBS’s recent IT outage for three hours caused ATMs to eat debit cards and restaurants and shops to decline card payments. Its previous one caused Bacs payments and direct debits to fail and disrupted customer accounts for weeks.
This is why depositors insist on safety – and they are right to do so. The money they place in banks is no longer just discretionary saving for a rainy day; it is for their day-to-day living expenses. Loss of access to this, even for a few hours, causes distress. Loss of this money owing to bank failure could cause enormous hardship.
Deposits, including transaction accounts, do of course attract deposit insurance up to a limit. Deposit insurance is paid for by financial institutions through a deposit levy and it is expected that, as a last resort, the sovereign would step in to top up the insurance fund – as indeed the UK Government did in the financial crisis.
However, the limits are not high – many households and small businesses have more in the bank than the insurance limit – and the implicit sovereign support for larger deposits is now being withdrawn. And despite the mission-critical nature of payment services, there remain no arrangements whats-oever to provide emergency liquidity to households and businesses suffering loss of access to transaction accounts owing to bank failure.
So despite the calls for banks to be made safer, deposits have never been so at risk as they are now. Banks are no longer safe places to put money.
So part of the banking model – the provision of a safe home for money – is broken. How will people respond to this? Over time, bank deposits are likely to decrease as customers move uninsured funds to safer havens, leaving only insured deposits.
It has been suggested that customers will still choose to place uninsured funds with banks as a form of risk investment, but this is not credible. People put money in banks for safety, not for investment. And as retail banks are not sufficiently good at asset management to be trusted as investment managers, this is not likely to change.
The decline of large deposits owing to withdrawal of the sovereign guarantee comes as banks are increasing their loan-to-deposit ratios to improve their funding stability. This might increase competition for deposits, which would force up interest rates – good news for savers. But banks that are already suffering margin squeeze owing to low interest rates on existing variable-rate lending are unlikely to want to attract deposits at higher rates. They are more likely to reduce lending, particularly the highest-risk lending.
Unfortunately, that is the lending we most want them to provide – investment funding and working capital for businesses. Sovereigns will plug the growing deposit gap with transfusions of central bank money in an attempt to increase lending, but this would simply increase banks’ dependence on government support. And it would have a toxic effect on banks’ balance sheets too. In return for funding, central banks require assets to be pledged. As central bank funding starts to replace deposits, banks would be forced to pledge more and more of their balance sheets to the central bank.
This process is well under way in the eurozone. Once a bank becomes dependent on central bank funding and its balance sheet is encumbered with central bank pledges, it has no functional independence. The unencumbered assets on its balance sheet would be the poorest quality and so the most likely to fail. Deposit insurance claims would thus be inevitable in bank failure.
As already noted, deposit insurance has an implicit sovereign backstop and the terms allow the insurance fund to be used to bail out banks rather than reimburse depositors. Effectively, therefore, the riskiest part of the bank’s loan portfolio would be guaranteed
The idea that banks can provide risk capital to the economy without a sovereign backstop for essential deposits is unrealistic. If the sovereign backstop for deposits was withdrawn completely – and it is worth remembering that the European Free Trade Association Court’s judgment in the Icelandic case was that the sovereign is not liable to cover deposit insurance in a systemic crisis – banks would be forced to massively reduce or even cease all except very well-collateralised lending such as low loan-to-value residential mortgages to protect transaction accounts. Either we have deposit insurance, at least for transaction accounts, or we do not have risk lending.
So if the deposit-taking and risk-lending model is fundamentally impossible without sovereign guarantee because of the need to protect transaction accounts and the existence of alternative safe investments, do we need commercial banks at all?
Why not simply create a public utility for transaction accounts and payment services – perhaps a government-sponsored enterprise backed by the central bank? And while we are at it, since most alternative forms of safe investment involve government debt, why not create a state savings bank for people to put money in that they want to keep safe – money that could then be productively recycled to the economy via a state investment bank? These too could be GSEs if you prefer this to be at arm’s length from government.
The key point is that commercial banks are not allocating capital much at all. When the private sector will not allocate capital properly, the public sector must do it for them.