Greg Ip clearly spends too much time with bankers.
In his new article, Future of Banking Looks Dark—Why That’s a Problem, he’s issued a big lament in the Wall Street Journal about why it’s so terrible that banking isn’t all that profitable these days and the result is the industry will need to shrink.
As we have been saying for years, we need a smaller banking industry. It would have been vastly better, in the wake of the crisis, to have done that much faster by writing down bad debts, in particular, giving viable mortgage borrowers who were in trouble principal modifications, and offset the impact of the losses with fiscal stimulus. The proximate cause of the crisis was too much private sector debt, in particular economically unproductive household debt.
A raft of recent economic studies have validated our point of view, consistently finding that large financial systems are a negative for growth. Other studies have taken a dim view of high levels of private debt, which also go hand in hand with overgrown banks. One of the most damning was a 2015 IMF study that found that the optimal level of financial development, in terms of growth, was represented by Poland.
It’s remarkable to see the mix of inaccuracies and omissions that Ip relies on in to sell his tale that it would be a terrible thing for banks not to grow or even shrink, and those meanie regulations are a big reason why.
Now in fairness to Ip, he’s relying on a study by Natasha Sarin and Larry Summers that relies on the market value of banks as the basis for his conclusion. The key paragraph:
They discovered that markets think banks are much more likely now to lose half their market value than before the crisis. They interpret this as a “decline in the franchise value of major financial institutions, caused at least in part by new regulations.” The counterintuitive implication: The bevy of rules designed to make banking safer may, by endangering their long-term viability, ultimately achieve the opposite.
This is a perverse interpretation. Since when should the status of banks, right before they would have destroyed the global economy absent extreme interventions by central banks and governments around the world, be considered a sound benchmark?
Moreover, Sarin and Summers, thanks to the strong bias in executive compensation for share price growth, have fallen for the canard that it is desirable or necessary for the health of a business. Normally, the logic of issuing common stock is to fund expansion (remember, I helped companies do this in a former life at Goldman). And common stock is not the preferred way to fund growth. Retained earning is first, and borrowing is second. So if the banking industry for broader societal reasons, needs to shrink or at least not grow, there’s no reason to be particularly worried about lackluster stock prices.
But that’s before we get to some even uglier truths that Ip omits from his account.
Banks enjoy such extensive subsidies that they should not be regarded as private institutions. Even though most banks are public, as we wrote in 2013, they are in fact not profitable in the absence of government subsidies. That means they should not be regarded as private institutions. Any returns to shareholders are in fact a stealth transfer from taxpayers. That means they should be regulated as utilities. As we wrote:
The point is that the banking industry has been profitable (at times, seemingly very profitable) only at the result of long standing government intervention to assure its profitability. It is no exaggeration to say that the banking industry enjoys so much public support that it can in no way be considered to be a private enterprise. But we’ve put in place the worst of all possible worlds: we’ve allowed an industry that couldn’t figure out how to operate profitably on its own to extract undeservedly large subsidies, with the result that financial services industry has become extractive. Its pay is wildly out of line with the social benefits it provides (indeed, many of its most predatory activities are also its best remunerated) and it has also grown disproportionately large, sucking resources away from better uses (we’d clearly be better off if math and physics grads were tackling real world problems rather than devising better HFT algorithms. And when you have bank branches displacing liquor stores, you know something is out of whack).
The cost of periodic financial crises is so great that the banking industry is value-destoying to society. Again, that means that measures that reduce the odds of a crisis are entirely justified. From a 2010 paper by the Bank of England’s Andrew Haldane calculated the cost of financial train wrecks:
….these losses are multiples of the static costs, lying anywhere between one and five times annual GDP. Put in money terms, that is an output loss equivalent to between $60 trillion and $200 trillion for the world economy and between £1.8 trillion and £7.4 trillion for the UK. As Nobel-prize winning physicist Richard Feynman observed, to call these numbers “astronomical” would be to do astronomy a disservice: there are only hundreds of billions of stars in the galaxy. “Economical” might be a better description.
It is clear that banks would not have deep enough pockets to foot this bill. Assuming that a crisis occurs every 20 years, the systemic levy needed to recoup these crisis costs would be in excess of $1.5 trillion per year. The total market capitalisation of the largest global banks is currently only around $1.2 trillion. Fully internalising the output costs of financial crises would risk putting banks on the same trajectory as the dinosaurs, with the levy playing the role of the meteorite.
Yves here. Haldane’s working estimate of costs of one times global GDP was criticized as high at the time; it now looks spot on.
So a banking industry that creates global crises is negative value added from a societal standpoint. It is purely extractive. Even though we have described its activities as looting (as in paying themselves so much that they bankrupt the business), the wider consequences are vastly worse than in textbook looting.
Ip’s defense of the role of banks is inaccurate. From Ip:
When central banks ease the supply of credit, they rely on banks to transmit the benefits to the broader economy by making loans, handling trades and moving money between people, companies and countries. Shrinking, unprofitable banks hobble that transmission channel.
This is the debunked “loanable funds” theory: that when money is on sale, businesses will go out and invest more. That theory was partially debunked by Keynes and dispatched by Kaldor, but zombie-like, still haunts the halls of central banks.
Businessmen see the cost of money as a possible constraint on growth, not a spur to it. They decide to invest in expansion if they see an opportunity in their market. The big exception? Businesses where the cost of funding is one of the biggest costs. What businesses are like that? Financial speculation.
And we’ve seen the failure of this tidy tale in the wake of the crisis. Providing super cheap money has not induced businessmen to run out and ramp up their operations. Instead, one of the biggest outcomes has been corporate financial speculation: issuing debt to buy back their own shares.
That isn’t to say that banks aren’t important. Payment systems are extremely important. But depicting banks as needing to have robust profits to play their role is not well founded. Japanese banks had razor thin profits in the years when Japan was going from strength to strength. And, what led them to ruin was rapid deregulation forced on them by the US in the 1980s (remember that Japan is a military protectorate of the US), not their profit levels.
Ip underplays the role of ZIRP, QE, and negative interest rates in the fall in bank profits. The measures that helped goose asset prices and forestalled a day of reckoning are now haunting banks and central bankers. In fact, the fact that QE and ZIRP have killed low-risk sources of profits like income from float and easy yield-curve profits likely has much more to do with the stock market’s dour take on banks than regulations. Mr. Market is well aware of the fact that central banks don’t seem to have the foggiest idea how to get themselves out of the super low interest rate corner they’ve painted themselves into.
Ip hates market discipline. One of the biggest problems with public companies is that shareholders seldom act as activists and force managements to address problems they see. It’s easier to sell your holdings and move on.
Yet here, we see the uncharacteristic outcome that investors really are worried that banks will do Bad Things and are avoiding banks that might do that, which in turn is leading banks to get out of dodgy businesses. Per Ip:
Indeed, investors must now discount the possibility that any bank could be one scandal away from indictment and a crippling, multibillion-dollar fine. Banks have responded by exiting or downsizing businesses that carry the most reputational risk, such as international money transfers and issuing mortgages to less creditworthy borrowers.
What Ip fails to mention is that investors also love institutions that can tell a tale, whether it is real or not, that they’ve are a better, smarter actor in a sector that others have pulled out of. In other words, the process at work looks like perfectly normal creative destruction. But the message is that banks are so special that they deserve a free pass.
The worst of this is that Ip, being full time on the banking beat, no doubt has seen the same studies I have, and more, that stress how hypertrophied banking systems are an economic negative. To see someone who should know better instead reveal that he is cognitively captured is, sadly, far from surprising.