What should banks do?

michaels

(I know another thread that will sink like a stone as the OP is too long but I feel I have this one 'in me' especially after reading some of the BBC HYS responses recently)

Bank bashing is the current national sport and it is generally 'casino banking' that is condemned and that banks should just do 'the basics' but what are those basics and are they really risk free?

I would suggest that the core requirements of banks in decling order are:

1) Keeping money safe. Imagine a cash only economy, most would still not want to keep it all their money in a safe/under the mattress and would want in effect a safety deposit box service for their money.

Obviously providing such a service would cost the bank money and as they would not be putting the deposited funds to any use this would have to be charged back to the customer - may be at least £100 pa?

2) Transaction / payment service
Another extremely useful one: employer can pay you without physically handing over money, you can make purchases without carrying arround large sums of money, included is probably cash machine access.

Note still no money to be made by banks here, they are keeping 1 for 1 cover in their vaults for each pound deposited so further charges needed to maintain the IT etc. May be £1 per transaction?

3) Interest on Term Savings
Now we are moving in to the risky world. Interest on savings implies the bank puts the money to use elsewhere, may be through a loan. Note we are not suggesting anything like maturity transformation yet. The bank offers term savings account offering a return to the depositor for giving up instant access to their money and charging the borrower to cover this payment to the depositor plus an extra amount to cover admin, risk of default and profit.

Note the bank is now in a position where if enough borrowers default the bank could be unable to repay all depositors - even without doing anything 'casino' like at all:eek:

4) Interest on current accounts/free banking
Now the bank puts the deposits from providing secure money storage and transaction services to use too, allowing it to offer the services for free and even pay interest. Of course to do this the bank has to lend out funds that could in theory all be withdrawn instantly - thus there is now also a liquidity risk as well as the default risk. However this is typically what we think of as core banking, maturity transformation, borrowing short (from depositors) and lending long. There is normally profit in this as the rate charged for longer borrowing is typically higher than for shorter loans and also more than is paid on demand deposits.

So far banks are doing nothing beyond bog standard deposits/savings/loans and already there is both default and liquidity risk and even such 'simple' banks can and have in the past needed bailing out.:eek:

5) I guess beyond that 'there be the dragons'.

One line I think that can (should be able to) be drawn is when banks start trading on their own account. Banks will hold 'capital reserves' to persuade depositors and lenders they have buffers against default (and illiquidity). This capital is expensive as it typical earns very low returns but it used to be possible to leverage this capital (basically the banks credit worthiness) to allow the bank to take speculative positions on its own behalf. However the JP Morgan recent losses show how difficult it is to say what is hedging of the risk the bank is already running (for example of more than expected borrower defaults) and what is running a position on the markets....

Anyone still reading?
Any thoughts?
What should 'normal' banks be doing? All of 1-4 above or more?

If we limit banking to only those things we would be killing an industrry that over the last 20-30 year has provided lots of highly skilled, highly paid jobs and lots of tax revenue and may be brought in sundry high skill industries like accountancy, the law, consultancy etc.

grizzly1911

michaels wrote: »

(I know another thread that will sink like a stone as the OP is too long but I feel I have this one 'in me' especially after reading some of the BBC HYS responses recently)

Bank bashing is the current national sport and it is generally 'casino banking' that is condemned and that banks should just do 'the basics' but what are those basics and are they really risk free?

I would suggest that the core requirements of banks in decling order are:

1) Keeping money safe. Imagine a cash only economy, most would still not want to keep it all their money in a safe/under the mattress and would want in effect a safety deposit box service for their money.

Obviously providing such a service would cost the bank money and as they would not be putting the deposited funds to any use this would have to be charged back to the customer - may be at least £100 pa?

2) Transaction / payment service
Another extremely useful one: employer can pay you without physically handing over money, you can make purchases without carrying arround large sums of money, included is probably cash machine access.

Note still no money to be made by banks here, they are keeping 1 for 1 cover in their vaults for each pound deposited so further charges needed to maintain the IT etc. May be £1 per transaction?

3) Interest on Term Savings
Now we are moving in to the risky world. Interest on savings implies the bank puts the money to use elsewhere, may be through a loan. Note we are not suggesting anything like maturity transformation yet. The bank offers term savings account offering a return to the depositor for giving up instant access to their money and charging the borrower to cover this payment to the depositor plus an extra amount to cover admin, risk of default and profit.

Note the bank is now in a position where if enough borrowers default the bank could be unable to repay all depositors - even without doing anything 'casino' like at all:eek:

4) Interest on current accounts/free banking
Now the bank puts the deposits from providing secure money storage and transaction services to use too, allowing it to offer the services for free and even pay interest. Of course to do this the bank has to lend out funds that could in theory all be withdrawn instantly - thus there is now also a liquidity risk as well as the default risk. However this is typically what we think of as core banking, maturity transformation, borrowing short (from depositors) and lending long. There is normally profit in this as the rate charged for longer borrowing is typically higher than for shorter loans and also more than is paid on demand deposits.

So far banks are doing nothing beyond bog standard deposits/savings/loans and already there is both default and liquidity risk and even such 'simple' banks can and have in the past needed bailing out.:eek:

5) I guess beyond that 'there be the dragons'.

One line I think that can (should be able to) be drawn is when banks start trading on their own account. Banks will hold 'capital reserves' to persuade depositors and lenders they have buffers against default (and illiquidity). This capital is expensive as it typical earns very low returns but it used to be possible to leverage this capital (basically the banks credit worthiness) to allow the bank to take speculative positions on its own behalf. However the JP Morgan recent losses show how difficult it is to say what is hedging of the risk the bank is already running (for example of more than expected borrower defaults) and what is running a position on the markets....

Anyone still reading?
Any thoughts?
What should 'normal' banks be doing? All of 1-4 above or more?

If we limit banking to only those things we would be killing an industrry that over the last 20-30 year has provided lots of highly skilled, highly paid jobs and lots of tax revenue and may be brought in sundry high skill industries like accountancy, the law, consultancy etc.

30 years ago the Banks were making nice profits from 1-4. Not astronomic but sizeable and relatively stable with linear growth.

The risk of default/loss in 4 can be managed at a cost but remain lucrative.

They also employed large numbers of staff with good levels of pay generally but with the higher pay been spread out more. Higher earners tending to sensible balanced individuals rather than high risk takers. Those allowed to take more of a gamble were still retained but trusted, on a longer rope, due to long pedigree.

The Banks still had their riskier more flashy offshoots in Merchant Banks. There were less derivates and those that were used were more closely monitored for risk. The more exotic vehicles were also priced high. It is not just the complexity of the derivatives it also the sheer volume and transaction speed that adds to the risk.

Obviously IT systems, Operation Process Improvements and Automated Risk Processes changed the goalposts as cost /income ratios were targeted.

To progress in those days in the 1-4 Banking arena staff were expected to be qualified, they were more closely monitored and scrutinised to establish trust and integrity. They were also rewarded more for collective quality rather than individual sales/profit achievement.

At the end of the day to achieve exponential increases in profit corners have to be cut and greater risks taken.

HAMISH_MCTAVISH

What should banks do?

Lend.

It's their reason for existence.

Banks generate revenue primarily through lending out the money they have on deposit. Everything else, transaction fees, etc, is just icing on the cake.

There may be an argument that banks in recent times have made too much money through "merchant banking" activity, and not enough from traditional lending.

It would be good to see them focus 100% of their efforts on lending as much as possible into the economy, in order to make profits, rather than being able to compensate for lesser profits form lending via casino banking.

grizzly1911

HAMISH_MCTAVISH wrote: »

Lend.

It's their reason for existence.

.

As long as it can be repaid and risk/reward is priced sensibly.

HAMISH_MCTAVISH

grizzly1911 wrote: »

As long as it can be repaid and risk/reward is priced sensibly.

That has never been a problem for UK lending, on the whole.

What has been a problem is absurd bank profiteering since the credit crunch, as bank profit margins on lending have risen to all time record highs.

Generali

grizzly1911 wrote: »

As long as it can be repaid and risk/reward is priced sensibly.

That's too glib though. Nobody's going to underprice risk deliberately.

Part of the problems being faced by banks at the moment was that risks to the US housing market were misunderestimated.

pqrdef

michaels wrote: »

So far banks are doing nothing beyond bog standard deposits/savings/loans and already there is both default and liquidity risk and even such 'simple' banks can and have in the past needed bailing out.:eek:

In fact it's only a matter of time. Banks fail, sooner or later.

The basic job of banks is to manage the mismatch between depositors who want their cash back, and on the other side, borrowers who may not be able to repay and security that may not hold its cash value.

And the problem is that profits come from volume, since fixed overheads have to be covered, and this encourages banks to misunderestimate risks. Especially as it's not their own money they're lending.

Our favourite asset class is sovereign debt. We cheerfully lend to governments, directly or indirectly, knowing they will spend the money and yet believing they will pay it back.

But sovereign states have unrivalled access to resources to meet their obligations. Other borrowers don't. The puzzle is why we don't see bigger differentials in interest rates between gilts, corporate bonds and small business loans.

Part of the answer is that businesses cover long-term funding needs with cheaper short-term borrowing - even overdrafts. Lenders may look at the books and estimate prospects over a short term, but only Warren Buffett seems to have a crystal ball that sees further ahead. What lenders tend to ignore is that the business is blatantly gambling on being able to refinance.

And banks lending to businesses will connive at underestimating this risk along with all the other risks, because they want the business. The conflict is very obvious even with peer-to-peer lending - the "exchange" is itself a business, whose success depends on driving down interest rates to build borrowing volume.

So High Street deposit-taking needs to be dominated by mutuals who will look after the interests of the depositor/investor. (The UK government has some obvious opportunities.)

And if truly commercial lending to small businesses is only viable at prohibitive interest rates, then we need a new flexible model for financing small businesses. I would envisage mutual funds, traded like OEICs or maybe ETFs, but with a specific remit to invest in a particular local authority area. They would work closely with the firms they support and would be able to make loans or buy equity as appropriate. They would have a vested interest in the local economy in general, in the interests of their investors, and as well as selling units they would be able to raise support funds and guarantees from councils, government and the EU, and take donations, and reinvest the proceeds of profitable businesses, all of which would be used to close the gap between cheaper finance for businesses and smaller risks for investors.

TruckerT

Banks are supposed to 'oil the wheels of capitalism' - and in return they will be allowed to play an enormous part in the governance of capitalism, and also make huge profits

In recent times, banks have spectacularly failed in their responsibilities, but their benefits appear to be invincible

TruckerT