THOUGHTS ON THE TROUBLES OF BANKS / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( HIGHLY RECOMMENDED READING )

Thoughts on the troubles of banks

By Samuel Brittan

Published: August 12 2010 23:50

There are three alternative courses of action for a political economist to take when a crisis blows up in an area that is far from his speciality or range of interest, such as banking in my case. The first is to stay silent. The second is to bone up as quickly as possible on the new area and to talk plausibly about Basel I, Basel II, the looming Basel III, first and second tier capital and so on. The third is not to bluff one’s way into the technical discussion but to use the crisis to think about a few fundamentals. The third is the course that appeals to me.

Let us start with the question of why we need banks. They are first and foremost depositary institutions. Without them we would have to keep whatever we use as money under the mattress or in corporate storerooms. Following closely from this depositary function is the role of banks for transmission and clearing of payments. Instead of having to withdraw money every time we make a payment and deposit all our receipts as they come in, it is obviously convenient to use documents such as cheques or transfers that the banks can net out, and also to net out payments and receipts from different banks to each other, according to the flow of their customers’ business.

There is however a third function. Large corporations derive most of their investment funds from retained profits or issues on the capital market. Many small and medium-sized businesses want more for their investment needs than they can find from retained profits, but do not have easy access to the capital market. Their best course is to borrow directly from savers. And even major corporations may have short-term financing needs that do not justify a new issue. Moreover, the availability of banks is highly useful for small savers who can effortlessly spread their savings among many borrowers and who do not have to put all their eggs into one or two baskets. Bankers will say that their function is to bring such savers and companies, who need funds for physical investment (including stock building), together.

Here, however, is where trouble starts. One can imagine a market that brings together small savers and small investors directly. But this is not what happens. Banks have become the main source of credit for private or small business borrowers. But there is no direct link between what the banks feel able to lend and what their business customers feel they need to borrow. Many banks originated as goldsmiths who looked after their depositors’ supplies of precious metals (like Veit Pogner in Die Meistersinger). But it did not take long for them to discover that in normal times their customers would wish only to withdraw a limited proportion of their holdings each year, so they could safely lend out a multiple of their deposits, provided their IOUs were generally acceptable. In normal times the market rate of interest brings about a rough correspondence between new savings and physical investment.

But times are often not normal. Depositors may wish to withdraw more than the banks have available, as happened with Northern Rock in the UK. And the banks may not feel able to advance what is required to keep the economy going at a sustainable rate of activity. The reinforcement of bank deposit insurance and lender of last resort activities by central banks may have reduced the probability of bank runs such as that at Northern Rock. But the problem of supposedly inadequate lending to small and medium-sized businesses remains.

Here we come to a vicious circle. Bankers say that there is no shortage of bank credit, but a shortage of bankable propositions from the business side. But why is there such a shortage? In part at least because of recessionary conditions created by the earlier credit crunch. So in a sense the banks themselves have created the conditions of which they complain.

Things are not made easier when the same politicians and officials who urge the banks to lend more also insist they build up reserves in a cyclically adjusted way (if only we knew what that was) and abandon problematic investments of the kind that built up before the crisis.

The long run answer may well be the entry of new and smaller banks into a more competitive banking industry. But we know what Keynes said about the long run. If the state wants to speed up economic recovery there is a case for setting up one or more government banks, perhaps in conjunction with institutions such as the UK Post Office Savings Bank. One or two such institutions have already been established, but they are limited in their range.

I could easily write a speech decrying this idea. Once established, it would be difficult to run down or sell off such institutions. Meanwhile, they could be easily perverted for political purposes, as any visitor to Italy must know. And who are the paragons who will run them? Yet the best is so often the enemy of the good; and preservation of the benefits of a competitive private enterprise system may require some trimming at the margins. Or, as they say in a certain country, reculer pour mieux sauter.

Copyright The Financial Times Limited 2010.