Day after day more and more scandals erupt from our banks, RBS the state owned bank, has been fined £390m for involvement in interest rate manipulation. In the face of scandals like these, the political debate about structural banking reform has intensified. Last week, George Osborne committed to forcibly breaking up banks if they do not ring fence “risky” investment arms from their “safe” retail divisions.
But this debate is based on a confusion or maybe a purposeful illusion. The narrative has been that it was weapons of financial mass destruction that was to blame for our current economic malaise “safe” retail deposits supported “high-risk” derivatives trading on the international capital markets.
Retail banks have long been dependent on capital markets to fund ordinary lending to us in the form of mortgages and car loans. At the time of the financial crisis, the average loan-to-deposit ratio in UK banks was 137 per cent, meaning 37 per cent of retail lending was not funded by deposits.
It’s important to take this argument further, and discuss the myth that retail lending – and retail banking by implication – is safe at all. Why is lending so risky? A simple analysis of a bank’s function as a financial intermediary provides part of the answer.
The social role of banks is meant to transfer a surplus of cash (from savers) to potential borrowers sometimes called investors. This surplus is deposited with banks.
From an accounting point of view, a deposit is a liability, your wages go into your bank – that money the bank must pay back on your request.
According to the Bank of England, between 1969 and 2009, retail deposits (the vast majority short-term) became a smaller percentage of UK retail banks’ total liabilities – declining from 88 per cent to less than 40 per cent.
These liabilities are then used to finance lending (such as mortgages). Loans are part of a bank’s assets, for the purpose of accounting.
And the majority of these loans are mid or long-term. This simple problem shows that banks have always faced the fundamental problem of matching short-term liabilities with long-term assets. No regulation can ever solve this dilemma.
On top of this dangerous situation of not enough support for long term loans when they go bad, mass mortgage defaults in a recession, we allow banks to create money out of thin air, also when they make loans.
Most people think when they ask a bank for a loan, money paid in by one person is paid on to them. That’s not true. Not true at all, in fact.
Instead what the bank does is a conjuring trick. They agree to give you a loan. They do it by opening two accounts for you. One is a current account (for ease, let’s assume you haven’t already got one).
The other is a loan account. If you borrow £10,000 they mark your current account as having £10,000 in it. You’re now free to spend that however you like.
They also mark your loan account as having £10,000 in it. You now owe that to the bank.
Add the two together and they add up to nothing. One you apparently own (the current account) and one you apparently owe (the loan account). But if you decided to cancel the deal you could straight away repay the loan using the current account and there would be nothing left. Which is why I mean they add up to nothing.
Note there’s no cash involved in this process at all. It’s just an accounting trick. Nothing more.
And now the bank charge you interest for the benefit of having created that money. Even though there is no money as such, even though you think there is, because you can spend what is in the current account as if it were money.
Which is what we mean about the banks creating that money. You can see why they make so much profit, cant you?
They make money out of nothing and then charge you to use it.
In fact... "The process by which banks create money is so simple that the mind is repelled" (John K. Galbraith, in Money: Whence it came, where it went, p. 29.)
He was right, because it’s true: the process is so simple that we are repelled by the idea that we pay for it. So the moral is there is no such thing as a safe bank, despite the efforts of politicians to portray retail banks as such, and we pay for that over and over again.