Banks and the state: insufferable but inseparable

We want them to be closely watched by the state – but not actually be run by the state. Banks need to be able to say to us: “I will always be here, looking after your money with care and financing your society and the investments it needs”. We want solidity, permanence and competence. We also want competition, choice and efficiency.

Banks cannot provide all this without the state, but the state and society want plenty in return.

Prudent regulation, banking profits and economic stimulation don’t always sit well together, and this is why:

If that sounds weird, imagine what would happen if you borrowed £100 from your bank and gave it to your brother, who deposited it at the same bank: the bank has created £100 of money.

In times of recession, society will demand that banks use this magic power to boost the economy.

This means that they must charge enough margin on loans to make up for the inevitable customer defaults and manage the riskiness of their loan portfolios. But this can mean high loan rates or refusal of credit for elements of politically sympathetic elements of society that rely on access to credit: small businesses, struggling consumers, and environmental projects, for example.

If banks chose not to use bailiffs, there would be no mortgage system. But it puts banks into conflict with the societies they serve. Societies want cheap, plentiful loans but no foreclosures.

Systemic banking crises cause severe damage to economic wellbeing. The IMF noted in its April 2009 “World Economic Outlook” that recessions associated with financial crises tend to be unusually severe and followed by slow recoveries.

So the state imposes prudential regulations and close supervision, to limit bank risk to the acceptable, not the excessive. But trying to limit bank risk creates friction with the banks, and creates the moral hazard at the root of the "too big to fail" conundrum. When the state tells banks what risks to take on, the market assumes the state is standing behind the banks.

Sometimes, risk management has to play second fiddle to economic growth. The state overrides its financial stability mandate with a “boost the economy” goal. If this is done via a direct subsidy, as in the UK’s funding for lending” scheme, then at least it’s clear to see.

But a relaxation of prudential capital rules (as in the reduction of the risk-weights of SME lending by European banks by applying a factor, bizarrely, of 0.7619) sends a confusing message.

Who is bearing the risk that such politically or economically motivated lending creates?

Capital flows most efficiently to the right purpose when its owners have a profit motive. Unlike privately-run monopolies – the UK’s air traffic control system, for example – this is not about the operational efficiency of the private sector. It is about allowing a moderately competitive banking sector to set the cost of capital for the various sectors of the economy through open market mechanisms.

Why only “moderately” competitive? Because an oligopoly appears to be the most stable and valuable form for a banking industry.

But if they are private sector, how should banks deal with credits that are unprofitable on a standalone basis, but may make sense when other factors, like environment benefit, are taken into account? The state also needs to worry about banks in the private sector –  are the returns from banking asymmetrical, with bank shareholders and staff taking the gains on the upside when times are good, but society bearing the brunt of financial crises?

State endorsement is not sufficient for banks to operate successfully. They are service companies, not just passive conduits for the flow of capital. Customers want to feel that they can choose from a variety of competing offerings. Customers have a great deal of loyalty towards their bank, most of which is genuine commitment rather than mere inertia.

Customer commitment improves their brand perceptions of their bank. The “hot money” in rate-chasing internet deposits makes up a small part of the deposit market, and acts unusually – most customers stay with their bank for years.

Most customers expect that their trust and commitment mirrors, and is mirrored by, their bank’s solidity and permanence. And their loyalty indicates a competence at the bank (real or imagined) that reinforces the positive brand values of the bank.

New, funky bank brands think they will snap up dissatisfied deposit-holders in droves, by offering something fresh – dog biscuits, or better call centres – but they’ll find that they still need to retain conservative anchor values.

Regulated status matters for the vast majority of customers; a deposit guarantee is essential for most retail depositors.

Customers also expect that they are dealing with a pillar of society. It is not by chance that most countries have successful mutual and co-operative banking models.

Even shareholder-owned banks seek affinity with charities, sports clubs and consumer brands. It is not an accident that bank branches were historically imposing buildings – rather like government offices!

What appears to be a regulatory "burden" is a core feature of a functioning, modern, stable banking industry.

When banks say supporting the economy through lending out funds is their social purpose (as many now do), it is not mere lip-service: it is a genuine strategic and naturally ethical stance, a kind of quid pro quo for their inherent state-sponsored nature.

Banks are not faceless state utilities — but nor are they unbridled Randian corporations living in a laissez faire world.

Unfortunately, it took a brutal banking crisis to alert us to their dual nature.

The FIG Idea is an occasional column taking an offbeat look at the weird world of banks. It is written by a market professional with more than 20 years involvement in the FIG market.