Why our banking system is still broken
by Josh Ryan-Collins | @jryancollins
Ten years after the collapse of Lehman Brothers triggered the greatest financial crisis in history, our banking system poses something of a paradox. On the one hand, banks are ‘stronger’ and ‘safer’, with large banks now holding considerably more capital than they did in 2007. On the other hand, our economies remain vulnerable, with global debt across all sectors higher than 2007, sluggish wage growth and flatlining productivity.
To understand this paradox, it is necessary to think about how banks actually contribute to economic growth and take a longer view.
The primary function of the banking system is the creation and allocation of credit and money via their lending activity. For most of the post-war period, bank lending was to a greater or lesser extent directed towards productive sectors of the economy, typically manufacturing and exports. This was through a combination of central bank credit controls, a large role for state-owned investment banks and active industrial and fiscal policy.
The problems that led to Lehman’s collapse had been building since the 1980s when the U.S. and U.K. began liberalising and deregulating their banking systems. Economists and conservative politicians became convinced that a free market in credit would lead to a more efficient and productive economy, and also saw a way of funding activity whilst simultaneously cutting taxes. The inflations of the 1970s were blamed on excessive government spending, and it was argued that the state should step back and central banks should concentrate on price stability above and beyond economic policy objectives.
The result was banks gradually transformed from their textbook model of primarily lending to firms for production to lending against existing assets, in particular real estate assets (mortgages) and financial assets (e.g. lending that enables companies to buy financial assets like shares).
In the 1990s the financial sector exploded in size and demonstrated remarkable abilities to innovate to get round any remaining national and international regulations designed to constrain it. In the lead up the crisis, banks created complex new instruments that enabled mortgage loans of various risk to be packaged up and sold to investors across the world. We all know what happened next.
For the UK this process is shown in stark terms in the figure below. Total bank credit expanded from about 80% of GDP in 1990 to 180% by 2008 but only about 10% of this was due to an expansion in business lending — the rest was loans to households and the financial sector.
Figure 1: UK bank lending since 1990
Not all credit is equal in terms of its macroeconomic effects. Mortgage credit, unlike business credit used for investment, does not create an increased flow of income from the production of goods and services. This means it does not tend to support sustainable economic growth that enables debt to be reduced over time.
Instead, in developed economies where desirable land for new homes is in limited supply, such lending mainly increases land and house prices, making home owners better off but doing little for the long-term health of the economy. Unfortunately this phenomenon is not unique to the UK but rather common across the majority of advanced economies, as I describe in a new book coming out next month.
Post-crisis reform has failed to address the lack of productive lending
The post-crisis reform agenda has largely focused on making the existing banking sector safer, rather than questioning whether we have the right kinds of financial institutions doing the right kind of lending in the first place. Some central banks, including in the UK, have put in place measures to reign in the ‘wrong type’ of lending at a country-level. Macroprudential policy tools enable regulators to force banks to hold more capital against real estate loans for example. This is welcome but it doesn’t address the lack of credit for productive investment.
Taking the UK as our test case again, since the crisis, all forms of lending have reduced as a percentage of GDP, in particular lending to the financial sector as show in the figure above. However, business lending has fallen faster than household lending, indeed it only went in to positive territory in 2016. Today bank lending that supports businesses makes up around 20% of GDP, the same as in 1990 (and even less if you subtract commercial real estate lending which makes up around 1/3rd of business lending). Meanwhile lending against mortgages and to the financial sector makes up a combined total of 90% of GDP, much higher than the 1990s.
What then should policy makers be doing to create a banking system that supports sustainable economic growth?
Firstly, State Investment Banks can play not only an important counter-cyclical role, supporting the economy when the market contracts, but also play an important role in stimulating innovation and growth. IIPP research shows that they have played a key role in financing innovation in the renewable energy sector for example, ‘crowding in’ private sector investment by providing early stage, high-risk R&D financing.
Second, the evidence suggests that publicly owned or cooperative or regional banks (‘stakeholder banks’) tend lend more, as proportion of their total balance sheets, to non-financial firms that shareholder owned banks. This is because they develop long-term relationships with firms, meaning they keep lending even during downturns when larger banks cut off business lending. They also tend to play an important financial inclusion role, being less likely to close branches for example in order to cut costs.
And thirdly, there is a case for central banks better coordinating their monetary policy and financial regulation with government economic and industrial policy and the need to transition to a low-carbon economy. Adjustments to interest rates are too blunt a tool to stimulate business lending with the low rates and Quantitative Easing policies since the crisis mainly acting to reinforce the demand for lending against real estate and financial assets. Instead, central banks should be examining credit allocation policies — widely used in the East Asian economies for decades — to support economic growth.
Ten years on from Lehman, our banking system remains dysfunctional. Until we face up to the need for new kinds of financial institutions focussed on public purpose rather than short-term profits, our economies will remain locked in a debt-led growth regime inherently vulnerable to the next crisis.
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