Banker Bashing: cutting off your nose to spite your liquidity
The banks have had a pretty hard time since the financial crisis and rightly so. Their behaviour has been horrendous on so many levels that it's been embarrassing to be an employee.
But I think a fundamental misunderstanding of the role of banks by Government, regulators, the press and the general public has led to a dangerous overreaction in the aftermath of the crisis that will impact every one of us in some way.
A potent combination of obscene capital requirements, heavy conduct charges and general anti-bank sentiment has meant that the FTSE 350 banks index has lost half its value since 2008 and never recovered.
The symptoms of this difficult trading environment are surfacing in the form of UK productivity (as measured by output per hour worked), which has been exceptionally weak since 2008. Productivity growth has actually been weak across the developed economies since the Great Recession but it’s the last 3 years that is really worrying for the UK (see table below). Essentially what we are saying is that with the amount of people currently employed in the UK, we should be producing a lot more GDP, or Gross Domestic Product.
So how is this problem related to banks? Well there are several theories pointing to various causes of the productivity puzzle, and most of them are related to investment, or the lack of it.
This is where banks come in, and the part that is widely misunderstood. It’s a problem I found worryingly apparent when recently browsing a Chartered Bankers Institute textbook, and it’s also the main point behind the BoE Working Paper no.529 published at the end of May.
The paper articulates that banks do not simply lend out money deposited by savers, the so-called intermediation of loanable funds (ILF) model that most economic textbooks propound. Instead they create deposits when they make loans, effectively expanding the money supply. This creates most of the money in circulation, and is only limited by the bank's own assessment of the implications of new lending for their solvency and profitability. This is more generally referred to as the Financing through Money Creation (FMC) Model.
Whenever a bank makes a new loan to a non-bank customer X, it creates a new loan entry in the name of customer X on the asset side of its balance sheet, and it simultaneously creates a new and equal-sized deposit entry, also in the name of customer X, on the liability side of its balance sheet. The bank therefore creates its own funding, deposits, in the act of lending. And because both entries are in the name of customer X, there is no intermediation whatsoever at the moment when a new loan is made.
Central banks have limited control over how much money is pumped into the system in this way, and supply whatever reserves are required. The idea that commercial banks multiply money created by the central bank is plain wrong.
“Central banks are committed to supplying as many reserves (and cash) as banks demand” at the target rate of interest, in the interests of financial stability, the paper says. “The quantity of reserves is therefore a consequence, not a cause, of lending and money creation.” And in any event, banks cannot lend central bank money on to non-banks.
Of course there is a trade off here. Banks do not simply create money out of thin air- the asset side of a bank balance sheet is a debt for the customer. Too much credit, or inefficiently allocated credit is bad news, but responsible financing is a prerequisite for growth.
Things very recently are actually starting to look up. In the three months to June, BoE economic data is showing that people worked 0.2 per cent fewer hours, but the economy grew 0.7 per cent, implying workers became almost 1 per cent more productive. Correlation is clearly not causation, but it's certainly interesting that this is happening just as bank lending is picking up (see table below)
Central bank tools are blunt and ineffective instruments without the big lenders deciding to lend. A problem painfully apparent right now as the global economy stalls and the authorities have no possible response, given that interest rates are already zero across most of the developed world, debts levels are at or near record highs, and there is little scope for fiscal stimulus.
If you bash the banks in a way that impacts on their lending then you bash the growth. Maybe that’s a good thing — continual economic growth feels unnatural to me — but either way, we need everyone to understand the important role that banks play.