WHY BANKING IS STRUCTURALLY INCAPABLE OF EFFICIENCY / THE FINANCIAL TIMES ( RECOMMENDED READING )

Why banking is structurally incapable of efficiency


By Tony Jackson

Published: October 17 2010 20:43


The latest banking mini-crisis, involving foreclosures in US home mortgages, reminds us of this industry’s power to astonish.


We read of so-called “robo-signers” – junior employees signing off 500 foreclosure documents a day without having read them. We hear how the big banks have had to suspend foreclosures nationwide – partly because having passed the original mortgages through the sausage machine of securitisation, they could scarcely trace the relevant documentation if they wanted to.


That may be a bureaucratic glitch. More likely, it points to a deeper malaise.


The wider context was set out in a lecture last week at the London School of Economics by Professor Amar Bhidé of Tufts University. If we define the elements which make the US economy successful, Prof Bhidé argued, the banking system over the past two decades has been going in the opposite direction.


Most economic activities work best if people on the ground are free to make decisions. In banking, by contrast, decisions have been sucked into the centre. The result is huge inefficiency and misallocation of capital.


His starting text is a 1945 paper by Friedrich Hayek entitled The Use of Knowledge in Society. Intended mainly as a blast against Soviet-style central planning, it also bears directly on how firms are organised. Since human knowledge is necessarily imperfect, Hayek says, the question is how it can best be communicated on a constant basis. Some kinds of knowledge – in the physical sciences, for instance – can be managed by a central team of experts.


But other kinds are specific to time and place. The local trader knows what is selling on his patch that week and plans accordingly. A central authority cannot duplicate that.

The complicating factor, though, is economies of scale. These are always tempting and the trick is to know when the gains they offer are illusory.


The head of Intel, for instance, can run an empire of semiconductor plants, because the product is centrally determined and raw materials consistent. But can the head of a big bank run an empire of bank branches in the same way?


Plainly not, Prof Bhidé says. Issuing a mortgage or a small business loan involves precisely the kind of on-the-spot knowledge and judgment Hayek described. But the banks have centralised those judgments. Why is that?


Because that is where the growth is. Proper banking requires an army of trained workers. That slows things down. But if you reduce everything to mechanistic models and harness them to modern computing, it goes turbocharged.

The result, for Prof Bhidé, is pathological. So are some of the innovations to which it gave rise, such as asset-backed securities.


There is a profound paradox here. It is precisely in times of innovation that local judgment matters most, that being the only way to measure the effects on the ground. But if you convert everything into centralised backward-looking data, you deprive yourself of knowledge when you most need it.


Misallocation of capital, meanwhile, is inevitable. Capital goes to sectors that can be mechanised. Mortgages qualify, so resources are poured into housing. Small business loans are less amenable, so small business lending shrivels.


There is internal misallocation, too. As experience has shown, when it comes to mortgages the model cannot distinguish between a schoolteacher in steady employment and a car worker whose plant is about to be closed. Which brings us back to the foreclosure crisis. Robo-signing, Prof Bhidé observes, is a natural consequence of “the robotic extension of mass-produced mortgage loans”.


Thus, mass production led to securitisation, which in turn meant the servicing of the loans was concentrated in a few hands. So when all those bad loans turned into a flood of foreclosures, lack of staff made robo-signing the only option.


What is to be done about all this? Prof Bhidé has much in common here with fellow economist (and Financial Times columnist) John Kay. The basic functions of banking – lending, deposit-taking and so on – should be separate and they alone should enjoy taxpayer guarantees.


Their regulation should be appropriately local. Each branch should once more possess a loan book, open to inspection. Activities should be limited to what a college-educated regulator can understand.


But merely to state that is to lower the spirits. The banks have so far fended off structural reform. The idea of letting the big investment banks fail in the next crisis is simply not credible. Indeed, Prof Bhidé himself describes his ideas as quixotic. But truth will out and is worth hammering home for as long as it takes.


Copyright The Financial Times Limited 2010.