The Bear’s Lair: Towards a better banking system

It is likely that the over-leverage of the last decade and the lack of true reform in the banking system will lead to another financial crisis, in which taxpayers will once again be strong-armed to bail out the banking system. To prevent this from happening yet again in ten years’ time, I propose a novel banking structure, following a road taken two centuries ago and separating the deposit function of banks from their lending function. Only by such separation can we achieve a sound economy.

Modern Keynesian and development-economist theories of banking have a fundamental flaw: they assume the primary function of a bank is to make loans. This is far from being the case. While loans are necessary to any modern economy, over-indulgence in them is economically very damaging. Furthermore, as hedge funds, securitization and Internet P2P lenders are demonstrating, it is not necessary to be a bank to make loans satisfactorily.

Keynesians want banks to make loans, because they are favor all kinds of artificial stimulus to the economy – loans are just another way to provide money that has not been earned to produce extra economic activity, productive or not. However, in real life and away from the Keynesian ivory towers, sound businesses are relatively limited users of leverage, mostly for working capital. If they need additional capital for sound long-term projects, there is always the bond market or better still the stock market. Businesses in the early Industrial Revolution financed themselves primarily with retained earnings, holding cash but very little debt. Long-term borrowing should be a last resort, forming a very limited part of the capital structure of a truly sound business. Share repurchases are a rip-off of retail shareholders and should be prohibited.

Conversely, collecting capital from savers and providing them with secure access to their money is a vitally important financial function. Without savings, small businesses, the lifeblood of any well-functioning economy, cannot be formed. It therefore follows that, to ensure economic stability and growth, providing an attractive mechanism for collecting and nurturing those savings is the most important of all financial functions. Contrary to Keynes’ belief, the rentier is central to the economy’s proper function, and should be nurtured not euthanized.

Mixing the banking functions of collecting deposits and lending has proven itself over repeated financial crises to be unsound. In a deep financial crisis, unexpectedly large volumes of loans go bad, and, more important, become completely illiquid. In such circumstances, the bank is unable to repay its deposits, which are mostly short-term, and the threat of this can cause a run on the deposits. Deposit insurance, the solution to this since the Great Depression, does not really work. It prevents runs on banks, but the deposit insurance fund can quickly become insolvent in a downturn. Also, to provide a further cushion against losses of value on the assets, regulators generally require banks to hold large amounts of capital.

The solution to this problem was identified with its usual perspicacity in economic matters by the government of Robert Banks Jenkinson, second Earl of Liverpool, with the Savings Bank Act of 1817. This established what were to be known in Britain until their amalgamation and effective abolition in the 1980s as the Trustee Savings Banks. The Act provided for savings banks administered by unpaid trustees, which would be forced by law to invest their money only in government securities or deposits at the Bank of England. Provided government securities traded close to par (which they could be relied upon to do once the British government returned to the Gold Standard in 1819) this made the savings risk-free and meant that small savers did not have to risk their money in the hundreds of private banks lending to business and against real estate, which were by no means secure.

The first savings bank had been set up by the Rev. Henry Duncan, at Ruthwell in Dumfriesshire in 1810. Duncan publicised the scheme widely, and the 1817 Act was introduced by George Rose, the aged Treasurer of the Navy who had managed the 1784 election for Pitt but was also close to Liverpool. Its official sanction was shown by the readiness with which it became law on May 23, and by a necessary amending Act the following year being introduced by Chancellor of the Exchequer Nicholas Vansittart

The Savings Bank Act was over the long-term one of the Liverpool government’s most important pieces of legislation. Even by 1825, only eight years after the Act, savings bank deposits had grown to £13.3 million, 27% of the share capital of the Stock Exchange, and more than the total of outstanding country bank notes, default on which caused such hardship in the crash of that year. Trustee savings banks were to be an important feature of the British financial landscape for the next century, their growth only being restricted by Gladstone’s 1861 creation of an unnecessary public-sector competitor with the Post Office Savings Bank.

The central principle, that savings banks could only buy government bonds, gave working-class savers complete security of their holdings and separated the capital accumulation and protection function of these financial institutions from any lending function.

Returning reluctantly to the 21st Century (yes, modern dentistry does indeed make up for the loss of the rotten boroughs, but only just!) the main problem with Liverpool’s savings bank structure today is that there are now no risk-free assets. In his day, at least once Britain returned to gold in 1819, savings invested in Consols were completely secure as far as interest was concerned and almost completely safe for principal. Consols prices fluctuated, but except at the worst point of major wars (they hit 50% of par in 1797) you could always be sure that, in the long run, principal would be preserved. Only after Britain went off the Gold Standard in 1931 did Consols prices sink – and indeed after 1945 the Trustee Savings Banks ran into difficulties, as one would have expected.

No such assurance is possible now. Government bonds have both a credit risk and a substantial price risk. There can be no assurance on say a 20-year view that the U.S. or British governments will not face a liquidity crisis in which they cannot roll over debt, or that the dollar or sterling in which those debts are denominated will be worth anything. Hence for the savings bank structure to work, budgetary and monetary policy reforms must be implemented, with a balanced budget amendment and either a Gold Standard or a statutory requirement on the Fed to manage monetary policy with regard to inflation only (and a minimum interest rate of say 2%, to prevent the savings banks descending into losses). With those reforms in place, a savings bank structure would be possible.

There would be three major advantages to a savings bank structure. First, savings banks would need very little capital; with depositors assured of repayment and no risk on the asset side, a capital buffer would be unnecessary except to pay for the bank’s fixed assets. Second, there would be no need for deposit insurance, or for substantial savings bank regulation; the legal requirement to keep all assets in government bonds would be sufficient. Third, savers would be completely assured of getting their money back; there would thus be no possibility of a run on the bank in hard times.

There then only remains the problem of sourcing corporate and personal loans. Fortunately, modern technology has invented a way to do this: securitization. In the economy we have, there are far more ways of sourcing loans than we need, one of the reasons (along with low interest rates) for excess leverage in the system. Without conventional banks, we will have one less source of loans, but we will still have Internet P2P lending, securitization and the bond markets, junk and otherwise. All these methods will require the lender to take the credit risk of the borrower directly, obviating the need for extra capital to be deployed. Probably specialist junk lenders will also appear, using wholesale markets to fund themselves and forbidden to take consumer deposits, but they will be a small part of the market. Loans will continue to be readily available; the only difference will be that consumer deposits will no longer be used to fund them.

An economy without banks as we know them will be less leveraged and give more secure returns to savers. There is really no reason why consumers’ hard-earned deposits should be used to finance the high-risk games in the corporate and personal loan markets. By separating the banking functions in the way, we are inventing a sounder banking system, as Liverpool attempted to do in 1817. It has taken 200 years, but after the next financial crisis we will finally have the opportunity to get the financial system’s structure right at last.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)