"Ah love, could thou and I with Fate conspire
To grasp this sorry scheme of things entire,
Would we not shatter it to bits, and then
Rebuild it closer to the heart's desire?"
Fitzgerald, Rubaiyat of Omar Khayyam
It seems to me that all the activity of the last three years by banks, governments and supra-national organisations such as the IMF has been aimed at one thing only - preventing the collapse of the international financial system. To prevent that collapse governments have wrecked their economies and sacrificed the future of an entire generation. Yet as I write, the financial system seems to be in no better shape than it was three years ago. In fact if anything it is worse.
I have been arguing for some time now that propping up failed institutions only makes matters worse. If an institution is not viable, it will fail eventually whatever steps are taken to prop it up. The problem is that when it does fail, it brings a lot of others down with it. The larger and more interconnected the failing institutions, the greater the risk they pose to the world economy - and the louder the cries of people who depend on those institutions that governments should act to prevent their failure.
If the international financial system is so fragile that it can only survive with constant infusion of mammoth amounts of public money, then IT IS ALREADY IN A STATE OF COLLAPSE. And as any mining engineer knows, propping it up is not only expensive, it is dangerous.
I would like to suggest that the international financial system should be ALLOWED to collapse. That doesn't mean that governments should abandon their responsibility to protect the people affected and as far as possible prevent long-term damage to the economy. On the contrary, governments should be actively involved in managing the collapse of the current unsustainable system and the building of a new system that meets our needs better.
But that requires a mindset change on the part of global leadership, and particularly central banks and the IMF. At present they think only of maintaining the status quo. And while they continue to think and behave only in terms of keeping the ship afloat, the greater the risk to the world economy. When the inevitable collapse happens, they will not be prepared for it and the world economy could indeed suffer serious damage. But that's not necessary. Planning for and managing the inevitable demise of an outmoded form of banking has to be the best way forward.
Why do I say it is outmoded? Consider this.
1. The lifeblood of our economy is payments. But there is no particular reason why payments should be made only via banks. Mobile phone companies have the technology to perform electronic funds transfers and are beginning to do so in a limited way. As we move away from paper-based transactions such as cheques, the need for back-office banking diminishes and the front end increasingly becomes electronic. And even paper-based transactions don't have to be handled by banks, anyway. A friend of mine runs an independent cheque processing company. At present the actual payments side can only be done through a clearing bank, but why shouldn't his company have direct access to BACS, CHAPS and the like?
2. The other key financial component of our economy is lending. Without bank lending, nothing moves. Banks have a complete stranglehold on the economy because they alone create the money that we use to buy goods and services. And because our economy is so dependent on bank lending it is prone to credit bubbles and credit crunches. When banks are feeling good about things, they lend - far too much, at too low a rate to the wrong people. The result is a credit bubble. Credit bubbles cause overspending in the economy, consequent overproduction (or importing) and eventually inflation. Then banks realise they have overstretched themselves - some of them get into trouble and have to be bailed out by governments - so they stop lending to ANYONE except those who don't need it. The result is a credit crunch. Credit crunches cause rapid deflation and recession. All of it is caused by the propensity of banks to over-lend in good times and under-lend in bad times. And in the background are governments which have no real control of their economies. Do we really want our lives controlled by banks? Surely there must be ways in which people and companies can borrow the money they need without messing up the economy?
3. But, people argue, banks can't possibly over-lend because they only lend out an agreed multiple of what they receive in deposits, don't they? Wrong. Banks don't actually need deposits in order to lend, so they don't seek to attract them and they don't offer a good deal to savers. Banks can obtain the money they need to settle lending by borrowing from other banks (particularly investment banks), issuing securities or borrowing from the central bank. Deposits are an optional extra. So the whole premise of "fractional reserve banking", that banks lend out a multiple of the deposits they receive, is fundamentally wrong. Modern bank lending doesn't rely on deposits at all. Which is just as well, because....
4. Bank deposit and savings accounts no longer hold people's life savings. Most savings are invested through managed funds in the investment banking sector. Retail banks simply act as a "front end" for selling those products to the customer. Yes, people still deposit funds in bank accounts, but generally those are EXCESS savings which people put aside for a short period of time and draw down as and when needed. The level of savings in bank accounts, as opposed to pensions, endowments and other forms of long-term investment, has dropped catastrophically since the 1960s. Loan to deposit ratios in retail banks are at an all time low. Do we really need traditional bank deposit accounts at all, any more? And if we do, how do we make them sufficiently important to banks for banks to offer a decent rate of return?
5. Conversely, the investment banking sector is awash with funds - and contrary to popular opinion these are NOT provided by retail depositors but largely by pension and endowment investors. The volumes traded on international financial markets are HUGE and the frequency of trading is approaching warp speed. No longer are investors buying newly-issued securities and holding them long-term, generating returns from coupon payments and dividends. No, these days it's all about short-term returns. The "search for yield" - higher and higher rates of return for investors - was the key driver of Wall Street's excessive risk taking in the run-up to the global financial crisis. Very little of this activity gives real benefit to people through economic growth or decent returns on their investment: most of the return ends up in the pockets of the very rich.
6. There is a toxic link between retail lending and financial markets. Securitization allows over-extended retail banks to move loans they have already made off their balance sheets so that they can lend some more. They do this by packaging those loans up as securities and selling them on into the international financial marketplace. This would be fine if the risk of those loans was low. But it isn't. Securitization is routinely used in Japan and the US to remove non-performing loans from bank balance sheets. The reason these loans are non-performing is because the debtor is in trouble. They are risky by definition. Additionally, there is evidence that securitization encourages riskier lending. After all, if you can get rid of the loans, you don't have to worry about the risk, do you? But when sufficient numbers of securitized loans go bad, the result is DISASTROUS. The Global Financial Crisis of 2008 was primarily caused by failure of securitized retail loans.
I do want to make it clear that securitization itself is NOT the problem. Indeed, because capital markets are better able to price and manage risk than retail lenders, judicious use of securitization can enable lending to groups that otherwise might struggle to obtain finance. The problem is the moral hazard that that creates for lenders, and the fact that when lending is securitized large amounts of high-risk lending endangers the global financial system. I have written on this in another place.
7. And finally, there are practices in the investment banking sector that would be illegal if done anywhere else - insuring assets you don't own, pledging someone else's property as collateral for lending, ponzi schemes, mispricing and mis-selling. Complex maths and big words are used to hide the reality of what is really going on. If an investment banking practice or product is described in words of more than three syllables or priced using formulae containing Greek letters it's almost certainly dodgy.
I could go on to discuss the role of big banks in money laundering and international crime, the various scams that banks have inflicted on their customers (PPI, for example), the price fixing and cosy cartels, the advertising doublespeak that convinces people they are getting a good deal when they are really being scammed. But you've probably heard enough already. Do we REALLY want to preserve this? It's rotten to the core. Wouldn't we do better to allow the whole thing to implode? It is no longer working in the best interests of its customers - it is entirely self-serving, rapacious and greedy, bleeding people, companies and countries dry while it becomes ever more bloated and its main protagonists ever richer.
But how to manage the collapse of this monstrosity? First, we must stop feeding it. Ideally there should be NO MORE injections of public money. At present we are hearing demands for governments to provide liquidity (cash), increase bank capital (shares), and provide funds to countries to enable them to meet debt interest and refinancing obligations to banks. I agree that in order to manage collapse in such a way as to create a soft landing, it will probably be necessary to continue to provide some funding in the short-term. But the aim should be to withdraw all public financial support from the banking system, and it should be made clear to banks that if they get into difficulties because of the withdrawal of public funding - including debt payments - they will not be bailed out.
Secondly, there should be a programme of debt forgiveness for countries that have got themselves into serious trouble. Playing the blame game ("it's their fault, so they should suffer") doesn't help the people of those countries to rebuild their lives and revitalise their economies - which in the end is MUCH more important than paying off banks. Banks can and should take the hit for their irresponsible lending. After all, they received the returns on that lending in the good times.
Thirdly, it should be made plain to people and banks that deposit insurance is for PEOPLE not banks. Government should put in place through existing insurance schemes (and possibly new private insurance) measures to ensure that people's life savings, especially their pensions, are ADEQUATELY covered. And government should have ready emergency measures to enable payments to continue to be made in the event of failure of a major clearing bank, and to provide short-term financial support to people and companies whose money is temporarily inaccessible. Failing banks should go through a form of financial administration in which assets are sold and creditors paid off with the proceeds as far as possible. And if all our banks end up in landfill - well, we need replacements, don't we?
I don't think we need to worry about what would replace the present system. There are already businesses waiting in the wings for an opportunity to enter the financial marketplace - as this blog from Simon Cooke describes - who are being denied that opportunity by the dominance of the dinosaur banks. For the moment the dinosaurs are being kept alive by more and more artificial intervention to preserve their habitat. But when the asteroid of public debt default finally hits the dinosaurs will be wiped out, and a new breed of financial institutions will take their place. And this is what goverments should be planning for, not preservation of a corrupt and outdated system. The economic adjustment will be painful, and it is the job of government to protect the people who will be hurt and support the development of new forms of banking. But the result should be a more efficient, more stable and more effective financial system. It would be well worth it.