September 5, 2018 / 2:30 PM / 20 days ago

Breakingviews - Hadas: The paradox of risk-free finance

LONDON (Reuters Breakingviews) - Charles Calomiris has a new twist on his old theory about what’s wrong with banking. Unfortunately, the Columbia Business School professor is not pushing his valuable insight in the right direction. 

Office blocks of Citi, Barclays, and HSBC banks seen at dusk in the Canary Wharf financial district in London, Britain November 16, 2017. REUTERS/Toby Melville

In 2014, Calomiris and Stanford University political scientist Stephen Haber published “Fragile by Design: The Political Origins of Banking Crises and Scarce Credit”. The book’s subtitle clearly reflects its thesis. The outcome of the “game of bank bargains” determines the solidity of financial systems. Banks get into trouble when politicians force them to be reckless.

That conclusion should not have been surprising, except perhaps to economists besotted with the virtues of competitive financial markets. But it raises two big questions. What sorts of political bargains invite crises? And what features of the banking system are warning signs?

“Fragile by Design” tried to answer the first question by recounting the history of several nations’ banks. Those stories are complicated, though, especially as the bargains were almost never written out in so many words. Historians have many potential culprits to choose from.

In their choices, Calomiris and Haber showed a strong bias against active government guidance. A typical judgement – in this case on the United Kingdom - is that “banks expect to be protected and are thus able to undertake risk at the taxpayers’ expense”.

Calomiris’s latest paper, written with Sophia Chen of the International Monetary Fund, is on the same wavelength. It deals with the second question, about dangerous features. Once again, the title tells all: “The Spread of Deposit Insurance and the Global Rise in Bank Asset Risk since the 1970s”. A complex statistical analysis concludes that the introduction of government-mandated deposit insurance caused banks to behave more recklessly.

The case is not necessarily persuasive, if only because deposit guarantees often just formalised implicit promises. Besides the study’s numbers are not overwhelming. The conclusion is that increases in mortgage lending were more likely to be a harbinger of crisis than protecting savers.

In any case, the paper is an odd reading of history. The rise of deposit insurance was just one part of an integrated regulatory approach to banking and finance. Written guarantees were supposed to reduce the chances of mass panic by depositors, while better risk management would make the world safe for increased leverage, massive cross-border movements of capital and endless financial engineering. Calomiris and Chen focus on the only item on that list which involves more government. But the others all basically reduced the role of the state.

Still, Calomiris’s basic instinct is right. Banks are asked to do too much. Their business mix is always potentially toxic because it combines public service with the search for private gain.

On one side, banks provide two utility-like functions for the general public. They run payment systems and take care of most money creation. Also, as “Fragile by Design” points out, lenders often promote some government agenda, whether helping local industry or supporting home ownership.

On the other side, banks try to maximise returns for their shareholders. They extract some money for doing the government’s bidding, but mostly take on as much risk as they think prudent. Guarantees on the government-endorsed parts of the business shift the border between prudent and hazardous. As the new paper puts it, banks use the state’s “enhanced protection” to extract “greater rents” from lending.

The modern banking system cannot simply separate insured deposits from risky loans. This puts governments in a quandary. It is politically unacceptable to put deposits at risk, especially in an increasingly cash-free economy where wages are automatically paid into bank accounts. Also, guarantees do serve an economic purpose, even if Calomiris does not like to admit it. The Great Depression taught that panicking depositors really are a menace.

So regulators are left to control bankers’ animal spirits. Unfortunately, the authorities have mixed feelings about holding them back. New loans serve an economic purpose – they are the prime way of putting new money into the economy. And since banks are pushed to run the payments system at a loss, for the sake of democracy, regulators cannot complain too much when financial institutions ramp up risky lending to help offset those costs.

There are potential solutions to this problem, but they are revolutionary. Suggestions include separating lending totally from payments processing, taking the responsibility for money-creation away from banks and eliminating the concept of “risk-free” lending.

Several such proposals have been made, but bankers are – unsurprisingly – far from keen. They point out that such dramatic changes are risky. True enough, but the current system has produced too many crises and too few ruined bankers to be satisfactory. 

Calomiris might want to think more radically. The best way to get the government out of banking might be to get the banks out of the governmental business of running the money system.

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