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Work and prosperity
22 July 2013

High risk and low reward, we shouldn’t pretend that banking can ever be safe

Repairing things normally involves putting the pieces back together. But when it comes to fixing the banks, the opposite applies – it’s all about the separation of one part of the system (retail banking) from the other part (investment banking).

Though probably a good idea, the policy is underpinned by a misconception, which is that the riskier aspects of banking somehow represent a modern deviation from historical norms. As James Greiff explains in a comment piece for Bloomberg, this is far from being the case:

  • “...by their nature, banks engage in a very dicey practice. They take a dollar from one person, with a promise to return it at any time, and give it to another person. They hope to get that money back at some point in the uncertain future. For all their troubles, they get a few extra cents with their returned dollar, assuming everything goes well.
  • “If it doesn't, the consequences are brutal. Imagine a bank that lends someone $100 and, after paying interest to the depositor, has a net profit of $2. Suppose the borrower stops paying interest and can't repay the loan. To make up the $100 loss, 50 other similar loans have to keep paying off.”

Banking, therefore, has always operated on a knife edge:

  • “All it takes for a bank to go bust is for a small percentage of its loans to go bad. A rule of thumb, a bank that has 3 percent or 4 percent of its loans in default is in serious trouble; a bank with a 7 percent default rate is dead.”

Greiff goes on to argue that it was this ever-present danger that instilled habits of extreme caution on the part of the banking profession as it used to be  – habits that were subsequently undone by government intervention.

It is sometimes half-joked that the best way to make motorists drive more carefully would be to manufacture cars that had a deadly spike projecting out of every steering column. In the banking industry of old, the constant threat of bank runs provided the equivalent of the spike, persuading bankers of the wisdom of high capital ratios and sound investments. Government guarantees effectively took the spike away (or rather pointed it elsewhere) thereby allowing the boy-racers of the banking world to take over, with consequences we’re all too familiar with today. 

To put it another way, the state has inverted the high-risk, low reward nature of banking:

  • “What is disturbing… is that... the risk-reward equation has been flipped. Because of the government's implicit guarantee to rescue banks deemed too big to fail, the risk is low. Meanwhile, the marriage of commercial banks with investment banks has created a compensation environment with high rewards. Much of the fear that should be part of banking has been wrung out of the system.”

Thus when politicians speak of “making banking boring again”, Greiff counters that they’ve got it backwards and that instead they should “make it scary again – for bankers and their shareholders”.

But what about the rest of us? If ordinary savers have to put up with ultra low interest rates, then at least they want certainty that their money won’t disappear overnight. Terrifying the bankers into playing safe with our cash might just work, but most people would rather have a direct guarantee from the state.

Perhaps, instead of pretending that banking can be free of risk, it’s time to take these guaranteed accounts out of banking.


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