Wall Street Journal’s Greg Ip Makes Counterfactual Arguments to Defend Bloated Banking Industry

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.

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  1. TheCatSaid

    Thank you Yves for an exceptionally clear exposé of the falsehoods that continue to dominate MSM financial writing.

  2. Bambino

    Dear Yves,

    Pay attention on what is going on in the UK. Terrible days for them as they are discovering the truth about the Brexit.


    1. Colonel Smithers

      Thank you. One would think that the rules will be tightened up to preserve stability as the big EU banks, including my employer which is the biggest branch in the world, will be third country firms after hard Brexit, but the UK needs the business / investment, so the network of EU branches will be allowed to carry on.

    2. Synoia

      Terrible economic forecasts. We all know how accurate is crystal ball gazing.

      The eventuality could well be very different.

      Please be precise in your use of assertions.

    3. Vedant Desai

      Dear Ciao,
      Please also pay attention to what RBS has done in UK. Terrible days for them as people are discovering the truth about how thousands of business and jobs associated with them were destroyed by RBS despite many business being perfectly solvent and even paying installments.


  3. Chauncey Gardiner

    Wow! Great post!

    Unfortunately, Ip’s position is reflective of the cognitive capture of an entire class of professionals. This is not rocket science and, as we have repeatedly seen, senior bank managers are far from rocket scientists. These financial intermediaries should be broken up and the FDIC-insured portions formally converted to public utilities. The Glass-Steagall Act should be reinstated and the primary role of banks in the nation’s payments system and depository institutions restored.

    Speculation in derivatives and markets by or booked in FDIC-insured banks should be disallowed, legislation passed to stop the recidivist looting and control frauds, and criminal prosecution of criminal behavior required. If individuals at these institutions want to continue to speculate, they can do so with their own money and that of their bondholders and shareholders; rather than that of government (taxpayers), the central bank, and bank depositors.

  4. diptherio

    I believe it was Proudhon who calculated the amount of interest on loans that a bank run for the public benefit would need in order to cover its costs, i.e. the socially legitimate cost of credit. IIRC, he figured about .4% would be plenty. Point four percent. Of course, that was in 18th century France…we could probably do it much cheaper today.

  5. KPL

    The biggest issue is bailing out of the banks by the Fed. If banks are allowed to fail (or rescued to avoid a break down of the financial system and then closing it down) and if individuals at the bank are jailed and compensation and pensions put in limbo, the banks propensity to take risk will automatically diminish and ensure that banksters do not turn out to be speculators. Instead their backs are covered, they are bailed out by the Fed, let off with a slap of the wrist and no one goes to jail.

    This is plain and easy to see for everyone but not people like Greg Ip and his ilk.

  6. shinola

    Way back when banks were still regulated, a V.P. from one of the larger regional banks taught the Money & Banking course at UMKC’s night school. I remember he stated flatly:

    “A bank is a money making machine. The only way for a bank to lose money is through (internal) fraud or extreme ineptitude.”

    We’ve come a long way since then; but is it progress?

  7. Tim

    I’m reminded of 2 ads.

    1 where Exxon or one of the other oil majors lists as a societal benefit that it is increasing access to energy for developing parts of the world.

    2 The Bank add for the social benefit of mobile banking brink a bank anywhere a smart phone can go, bringing banking to the masses (rural farmers in india was what was shown).

    Rent extractors have a different way of viewing progress than the rest of us.

  8. Vedant Desai

    This Greg fellow very conveniently doesn’t mention that a large part of banks’s revenue and profit doesn’t comes from giving loans but from speculation in stock market and the so called financial services.And that the banks are not earning profit despite record high stock prices. He further misguids by giving false idea that it is the reputational risk businesses such as international fund transfer are the one which makes banks do illegal activities. While in reality illegal activities are due to very low level of ethical standard maintained by the banks. As far as banks continue to maintain the same level of ethical standard and internal control gaps ,scams will keep coming out and investors must continue to expect multibillion dollar fine, it will not matter whether banks are in business with reputational risk or has exited from it.

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