CREDIT CRUNCH & THE BANKING CRISIS.
There has been much comment on the banking crisis and the credit crunch, much of it ill-informed, so I thought I would try to provide and analysis and an explanation.
The key questions are:
"How did we get here?"
"Who is to blame?"
and
"What should we do about it?
"How did we get here?
The History of banking is long and complicated and what follows is a massive over-simplification but I have tried to extract the key events and principles. I will concentrate on three main issues:
- The difference between Commercial banks and investment banks
- The development of Fractional Reserve Banking
- Central banks and regulation.
There is a fourth, which is around the bond market, mortgages and the housing market but I am proposing to leave that out for the moment.
The difference between commercial banks and investment banks. They are very different animals and must not be confused or mixed up together.
Investment banks used to be called Merchant Banks. The two pure classic merchant banks were Rothchilds and Barings who were always bankers but many merchant banks were originally merchants, then merchants and bankers, then merchant banks and now investment banks. It is an entrepreneurial activity backing ventures and arranging finance for them, for example trade with the East Indies, building railways in South America and more recently management buy-outs. It also involves speculating on their own account, recently on a grand scale. It is a very useful activity, often very profitable, but it is a risky business and from time to time goes spectacularly wrong. It has nothing whatsoever to do with commercial banking, which should be the rather boring business of taking in deposits from the general public, looking after their money and savings and lending on good security.
So let's look at the commercial banks and what is now called Fractional Reserve Banking. Originally commercial banks took in deposits from people with money to spare, paid interest on it and lent some of it out at a higher rate to those who needed it and also had good credit ratings, always keeping a reserve of capital to cover bad debts and withdrawals by customers. Then they discovered that they could lend out more than the total of their cash deposits and make a bigger profit. However, this was limited - if they lent out too much or made risky loans, their depositors lost confidence, withdrew their money and the bank went bust. This happened from time to time and there were regular bank failures and minor crises which served as a lesson to the others and ensured that the banks remained responsible and depositors remained way and careful where they put their money. It kept people honest, or most of them anyway.
Unfortunately there were always some innocent depositors caught up in these failures which is the downside of free market capitalism.
Inevitably when people get hurt they call for protection, and they look to Government, and the Government's answer was what we now call Central Banking. In England it developed slowly over more than a century and ended up with the Bank of England having a monopoly of note issue and taking on the responsibility of "Lender of Last Resort". Under these arrangements all other banks deposited reserves with the Bank of England in return for a qualified guarantee that the Bank of England would always lend to them if necessary, albeit at penal rates, to cover unexpected withdrawals. The Bank also became the de facto regulator of the banks, determining the proportion of their lending that they had to deposit with the Bank of England as reserves, and it issued banking licenses. This was "results based" regulation - the Bank had a relatively free hand to decide what was required and a big stick to enforce it.
This looked like a great idea - the Bank of England ensured that banks didn't go bust and the regular minor crisis became things of the past. There was just one snag - This system allowed both the commercial banks and the public to believe that their deposits were effectively guaranteed by the Bank of England so they didn't have to worry about behaving responsibly. Depositors could safely put their money with any bank and the banks could be as irresponsible as the Bank of England would allow. As an example, lending is the main source of a bank's profits and every bank would like to lend a higher multiple of its reserves if it can get away with it. With the public lulled into a false sense of security the only restriction becomes the regulator, the Bank of England, and I think I am right in saying that whereas in the days of the free marker the banks had to keep reserves of around 50%, today it is around 10%.
So every individual bank is now much safer than before but the system as a whole is much less stable. Everything now depends of the Bank of England getting it right and most of the time it has done a good job - but if it gets it wrong just once the whole system comes crashing down. So the effect of Central Banking is that instead of a series of minor crises we have occasional mammoth collapses.
This is what happened in America in the 1930's and what we are seeing now.
In America the free market lasted until 1913 when the continuing stream of small bank failures finally gave rise to the US Central Bank, The Federal Reserve. Unfortunately, instead of evolving over a century, The Fed arrived all at once and hit the ground running - and it did not do well. The Bank of England had always ensured that commercial banks could not get involved in investment banking and in the pre-1913 free market in America it was impossible - retail depositors would simply have withdrawn their money. But the Fed saw no such problems and it took only 20 years to create a major banking crisis.
The post mortem concluded that the mixing of investment banking and commercial banking was a major cause of the banking crisis and the Glass-Steagall Acts of 1933 expressly prohibited it in future.
This gave us relative stability for 70 years but from 1982 the Glass-Steagall acts were progressively dismantled and they were finally repealed in 1999. Under pressure from events across the Atlantic, in 1986 the Bank of England removed all restrictions on who could own whom ("Big Bang"). Once gain, it has taken about twenty years to create another crisis.
There is a lot more here to do with the bond industry, mortgages, and off Balance sheet" finance, but I am going to leave that out for now.
The final nail in the banking coffin came with a progressive change in the regulatory system from a "results based" system managed by the Bank of England (up to the early 1980's) to a "rule based" system managed jointly by the Bank, the FSA and the Treasury (from 1977). This is a whole subject by itself but suffice to say that "rule based" regulation will always fail; and splitting responsibilities always leads to disaster.
So, my conclusion are:
1. In a free market there will be lots of different banks making different decisions, and some will get it wrong... The market punishes those who get it wrong and there will always be failures. This acts as an object lesson to the
others, ensuring that most of them remain honest, responsible and cautious, but it is messy, and innocent
bystander get caught in the cross-fire.
2. It is tempting to protect the public from these continuous but self-contained failures by creating a central bank
which will stand behind the commercial banks so that when they get it wrong the public are protected.
3. The "Central Bank and Regulation" formula prevents the frequent small specific crises but creates occasional
large systemic crises instead.
4. It also places huge responsibility on the regulator. Results based regulation may work for most of the time but
rules based regulation is always bound to fail.
OK - so who was at fault?
The Bankers.
Clearly the bankers have a lot to answer for and they are currently taking most of the flak. But consider their dilemma : Investment banking is essentially sophisticated gambling and makes huge profits most of the time but occasionally they go spectacularly bust. As long as they are playing with their own money it doesn't directly affect the system but when they are owned by a commercial bank they can play with vastly increased sums and when it goes wrong it puts the whole system at risk. So, if the commercial banks meddled in investment banking they made huge profits but made their collapse inevitable in the long term. However, if they were responsible, then their profits were modest, the share price languished, and they got taken over.
Or, consider a Building Society taking a responsible view and restricting mortgages to 70% of value and three times income (which was the regime enforced informally by the Bank of England under its "results based" regulation). With competitors offering 100% or 125% of value and 5 times income they would do hardly any business and would have to lay off most of the staff in their mortgage department. They would make derisory profits, if any at all, the shareholders would be furious and the company would be taken over. Alternatively, if it was a mutual, it would be subject to petitions to convert to plc status.
So they were caught in an impossible situation. While the music was playing they had to get up and dance - when it stopped they went bust.
The Public. The public must be to blame to a certain extent because anyone taking out a 125% mortgage must know that they are taking a risk.
However, for the last decade the government has been telling them that it had the situation under control, the business cycle had been banished, the regulators would ensure that everything was OK and getting on the property ladder was the only way forward whatever the cost.
They must have been naive to believe all this but then a lot of them were naive - and why not - who was going to tell them otherwise? Well, I did, in 2003 to 2005, but I stopped in 2006 when I started hearing "Dad, if I hadn't taken your advice I would have made a 40% profit on that house by now".
The Media : The media are largely irresponsible and completely hypocritical. When prices are rising they advise investors to jump on the bandwagon and write tributes to the buccaneers driving it - but when the wheels come off they shift smoothly into criticising the buccaneers and explaining why the bandwagon was always unsafe. However, the media have only exacerbated the problem, they can hardly be accused of directly causing it.
Capitalism and the free market. This is a whole subject on its own and I don't have time for it here. Suffice to say that blaming capitalism and the free market is an easy cop-out for those who are unwilling or unable to investigate the real issues properly. The system that has failed is being described as an unregulated system so more regulation is required. But this is rubbish. The system that has failed was a highly regulated system. Firstly, regulated systems fail less often but more spectacularly than free systems, and second the regulation was, on this occasion, a mess.
The Regulators : There are two kinds of regulation : 'Result based', which is what the Bank of England used to do thirty years ago - there were very few rules and the Bank had a free hand to decide what was acceptable at any given time and the authority to do more or less whatever it deemed appropriate to enforce it. And then there is 'Rules based' regulation which is what we have now - and it will always fail - there are a myriad of bureaucratic rules and the process inevitably degenerates into 'box-ticking'. The players quickly work out how to do what they want while still ticking the boxes, while the regulator cannot change the rules unilaterally or quickly and can't act without hard evidence (it's rules based, remember). It also lulls everyone into a false sense of security - "It must be OK because the regulators have approved it".
Finally, having three separate regulators is a recipe for disaster. We now know that the Bank warned the FSA but the FSA did nothing - under the old system, if the Bank was worried it could have intervened informally behind the scenes.
The Government : There is no doubt in my mind that Governments on both sides of the Atlantic are largely and ultimately to blame. Firstly, they chose a regulated system in the first place, secondly, the repeal of the Glass-Steagall Acts in America made a disaster inevitable and forced the Bank of England to follow suit. Then the changes in the regulatory system in 1997 made matters worse. Gordon Brown claimed to have given the Bank of England its independence but in fact took away a lot of its regulatory authority, leaving it primarily with the job of setting interest rates - but interest rates had to be set to maintain an inflation rate determined by the Government and the inflation rate target was wrong.... When a toaster that cost £25 in 1997 cost only £4.50 in 2007 and this is replicated right across the consumer goods sector then clearly the inflation target should have been negative. To maintain a 2% inflation rate the Bak was forced to set interest rates too low which caused the money supply to expand at more than 10% a year for most of this period and this in turn encouraged the bubble.
FINALLY, WHAT SHOULD WE DO ABOUT IT?
1. Well, much as I hate to say it, given the mess we are in I think keeping the banks afloat is probably the only way out. Whether this is the right way of doing it, I don't know. I don't know enough about the technicalities to know if there are other, better alternatives.
2. It is imperative that the investment banking vehicles are floated off or closed down - and kept separate from commercial banking.
3. To re-capitalise the banks, deposits from investors must be attracted back in and this means raising interest rates to attract savings. If this means another blow to the housing market, we will just have to live with that. Holding up the property market by keeping interest rates artificially low simply delays a correction which must come eventually anyway.
4. We must ensure that "off-balance sheet" financing is forbidden - it caused trouble in the commercial world (eg., Enron) and it has now caused havoc in the banking system (this relates to the issue I have not covered, the bond market).
5. We don't need more regulation - we need better regulation - and we need to make people responsible for their actions, both investors and banks. This means some people will get hurt - but if you try to prevent some people getting hurt you ensure that we all get hurt.
6. If we don't need more regulation, just better regulation, then we certainly don't need EU regulations which is "rules based regulation" par excellence.
Andrew Moncreiff
26 February 2009