The Bankwatch

Tracking the consumer evolution of financial services

Banks have broken their social contract with corporates and government | “what are banks for”

A brilliant question.  Mark Carney, Central Bank Governor of Bank of Canada’s answer is equally direct.  This paper is clear insightful and highly useful for the debate and discussion as the next steps of regulation of banks occurs.

What are Banks really for | Carney – Bank of Canada

The financial system should be the servant of the real economy. As one of my international colleagues recently remarked, “it is time the banks stopped swanning around like the Queen of England and resumed their traditional role as handmaidens to industry.” It is apparent that an era of self-absorbed finance that viewed itself as the apex of economic activity led to widespread misallocation of capital.

To say that the economic crisis and the unwinding of debt and bubble valued assets has coloured the reputation of bankers would be something of an understatement, and such strong words from a Central Bankers is indicative of jut how far the traditional relationship between corporate, banks and central banks has shifted.

In fact this goes to the heart of the matter, and goes to the heart of the need for regulation.  Boys will do bad things if left un-tethered, and the rules of the playground must be brought back to keep everyone in line.

Carney goes on:

We now face important policy questions about which activities banks should perform, which should be located in sustainable, continuously open markets, and which should be prohibited.

The very role of banks and banking is now in question.  I keep going back to the predictions formed based on my own research over the past 2 years and summarised here in Feb 09, that, broadly, concludes we will see two tiers of banking service models.

… however banks and financial services will be offerred through two broad service models:

  1. Financial utilities – significant operating restrictions in light of implicit and explicit government guarantees underpinning the business
  2. Risk takers – not clearly defined as yet – will be dependent on regulation applicability  [In terms of the Risk Takers noted above, that risk was intended to convey banks who choose to take risks with new services models and product models, not risks of economic nature such as derivatives]

Participation in those service models will largely be driven by capitalisation accompanied by intrinsic trust of their board and the national governments’.

Banks role and relationship with Central Banks is summarised by Carney.  These core aspects of the banking model lean more towards the financial utility service model, and its a fine line.

    1. payments
    2. transform maturity of assets and liabilities (financial and social value)
    3. Central bank provides
      • deposit insurance
      • lender of last resort to illiquid institutions

    There in a nutshell is banking.  Anything not in that definition is not banking – it is something new and whether good or bad, must be recognised as just that – new.

    This paragraph from Carneys talk resonates with me and goes to the core of banking as I remember it:

    These support mechanisms are carefully crafted to discourage banks from taking inappropriate risks while still providing the necessary support. They are also accompanied by a robust regulatory framework. Bankers implicitly accept a social contract that gives them access to liquidity support in times of a stress in return for regulation of their behaviour at all times.

    That bankers ‘social contract’ was a condition of membership that involved ‘moral suasion’.  An example of moral suasion is management of interest rates, and when we see banks refusing to reduce rates commensurate with bank rate reductions, that social contract between banks and central banks is broken.

    So long before derivatives and ‘own account’ trading, we had examples of banks that were outside the original social contract Carney fondly remembers.

    This statement is fascinating and clear about the fundamental difficulty banks have to operate with:

    Banks have relationships with their customers. They follow borrowers over time and monitor their payment history and reliability. When performing their role properly, banks tailor their products to the borrower, imposing higher or lower standards as appropriate. In contrast, markets are transaction oriented. They act as an intermediary between savers and borrowers but maintain relationships with neither. Consequently, market instruments are more robust when the underlying product is more standardized. Determining whether an activity is best financed through a bank or a market depends on the relative benefits to that activity of specialization versus standardization.

    In response to increased competitive pressure from markets, banks have become direct participants in markets. This move helped to sow the seeds of the crisis through three channels in particular; wholesale funding, securitization, and proprietary trading.

    This nicely summarises the backdrop to legislation such as the Glass Steagall Act and its rescission recently.   Banking and investment for their own account, customer banking and transaction banking became intermingled.

    More importantly for the current crisis were the introduction of investment vehicles designed to straddle banking and investment.

    … …  banks increasingly used securitization to straddle relationship banking and transactional market-based finance. Under the originate-to-distribute business model, banks originated a set of loans, repackaged them as securities, and sold them to investors. In essence, banks took specialized loans and sold them in standardized packages.

    The matter of incentives naturally follows:

    Incentive problems also plagued this transition. In many banks, a culture that rewarded innovation and opacity over risk management and transparency eventually undermined its creators.

    Then the collapse under the weight of the banking, investment and shadow banking markets.

    “More and more of the traditional functions of banks – including maturity transformation and credit intermediation – broader range of intermediaries and investment vehicles, which have been collectively referred to as the “shadow banking” system.

    Financial institutions, including many banks, came to rely on high levels of liquidity in markets. In the United States, the total value of commercial paper rose by more than 60 per cent and the ABCP market by more than 80 per cent in the three years before the crisis. In essence, the shadow banking system practiced maturity transformation without a safety net – that is, it was wholly reliant on the continuous availability of funding markets. The collapse in market liquidity that began in August 2007 crystallized these risks.

    Banks were doing non-bank activities and non-banks were performing bank activities.  In short the system sufferred anarchy.

    The next step is to de-leverage financial institutions in a careful, orderly but determined manner.

    Financial deleveraging is now one of the dominant forces in the global economy. After a decade during which household debt, leverage in the financial sector, and cross-border capital flows all rose rapidly, all have slowed or are now falling. The duration and orderliness of these shifts will help to determine the severity of the global recession.

    This sets the tone for shifts and significant adjustments to regulation for financial institutions and banks.

    Financial deleveraging is now one of the dominant forces in the global economy. After a decade during which household debt, leverage in the financial sector, and cross-border capital flows all rose rapidly, all have slowed or are now falling. The duration and orderliness of these shifts will help to determine the severity of the global recession.

    Written by Colin Henderson

    March 30, 2009 at 17:27

    Posted in Uncategorized

    2 Responses

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    1. Very thoughtful post!

      We are left with a very tough challenge indeed: we should not leave risk takers grow too big without being regulated, we should not let regulation create ‘entities that are too big to fail, but that do fail’.

      Adding to that the problem of fostering innovation that tends to be more vivid in the unregulated part of the system. We should not let over-regulation prevent meaningful new value propositions like the ones that are currently sprouting in p2p lending or payments.

      A set of questions that will certainly take years to be addressed, but that does not explain why banks have so far remained so silent on the subject.

      Frederic Baud

      March 31, 2009 at 02:39

    2. Thanks Frederic. Your point re Banks being silent is significant – they are quiet.


      March 31, 2009 at 22:53

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