We Need Complex Banks?

It would be nice to pick up a newspaper that did not have some reference to banking in it. How refreshing that would be. It would mark the end of the pernicious effect that the industry has had on our economy. Banks that are not newsworthy are, presumably, not destroying the economy. At least not as openly and wantonly as before.

As you know I am not a fan of the bank reform passed here in the US in recent years. It failed to deal with the one issue that I see as critical: the size of our biggest banks. Until our biggest banks are a lot smaller we will be easily held up to ransom every time one, or all, of them gets itself into a pickle. Since banks are regularly getting themselves into such circumstances, and with ever increasingly deleterious results, I see it as crucial public policy to cut they banks down in size. At least then we can let the supposed rigors of market forces slash away at the ineptitude of bank management. As things are now bankers are immune to such rigors since they are well aware we will bail them out whenever they threaten the economy. Which is about once a decade.

The Dallas Fed, hardly a bastion of leftist thinking, recently waded in on my side. It published a paper arguing that the size of our leading banks remains a major destabilizing force and an ongoing threat to social stability.

There is no news in this message.

And, predictably it engendered a furious response from our bankers.

Today’s Wall Street Journal has a letter from Frank Keating who is President of the American Bankers Association – the biggest banking trade group in the US. He manages in one short letter to encapsulate all the errors it is possible to make with respect to big banks.

The main thrust of his argument is that smaller banks cannot supply the necessarily complex products our modern economy needs, and certainly cannot supply the kind of products that our largest companies need. hence those companies would be forced into the arms of the biggest non-US banks, the US would lose its place of dominance in the financial industry, and our economy would begin to wither away.

OK he didn’t add that last part in those terms, but the implication is pretty clear.

Is he right?

No. Not at all.

We need to separate the complexity of the economy – by which I take to mean the interconnection of, technological dependence of, and scope of production, from the complexity of banking needs. Yes, indeed, our economy is far more complex than it used to be. That complexity is masterfully matched by the explosion in jargon used to describe it. For instance companies used to buy things from suppliers. Now they manage entire supply chains. It just sounds more complex to be managing a supply chain than to be purchasing stuff. But all this web of activity doesn’t necessarily require any more complex banking. The basics remain the same. Finance for inventory, finance for construction, finance for any other capital expenditure are the same no matter what the supply chain looks like. Trade finance remains trade finance. So does hedging against currency and commodity price shifts.

The activities and purposes of banking are exactly those we have seen for decades.

What has changed is the nature of the products and services offered to meet these standard needs. Most often, I would argue pretty much all, those new products and services have been designed not to match against some new need arising from growing complexity within the economy, but to match against the self-imposed needs of the banks themselves. With that need being to justify higher fees and profits in order to meet rising return on equity targets and, ultimately, larger bonus pools for bank executives. In other words the banks were not responding to anything in their market when they developed the host of products that bombed to create the crisis, but were driven instead by an internal need to create new streams of income.

The key point is that the bank’s products were not serving some new complex purpose, nor were they responding to demand from customers. They weren’t just creating demand. They were creating complexity. The cause and effect is precisely the opposite of that Keating wants us to consider.

Moreover: the complexity that the banks introduced was such that they were unable to manage it at all. They outfoxed themselves. They were palpably unable to comprehend, manage, and account for the products they designed. The epicenter of the crisis was in the portfolios of the complex products that the biggest banks created. It wasn’t in the balance sheets of the businesses supposedly asking for all those services. It was in bank-to-bank transactional activity. It was not in the bank-to-real economy flow.

If Keating is correct and only larger banks can create those complex products, then I take that as an ironclad argument calling for smaller banks. We need to cut banks down in size in order to stop them building things they cannot control, understand, and manage. The only people who need all that cornucopia of complexity are the big banks themselves. And they need it only to justify bonuses.

Smaller banks, smaller bonuses, and less complexity. This seems like a good idea to me. Especially given what we’ve just lived through.

Speaking of bonuses.

The tone deaf nature of our leading bankers can be astonishing. Take Bob Diamond, CEO of Barclays in the UK. He is getting a very large bonus – albeit not as high as previously – despite having led his bank through year of a falling share price, lower profits, and even lower expectations for next year. If bonuses reflect performance – what a joke that has become – then he deserves zero. Perhaps even less than zero. Clearly the bonus culture in banking is distorted. It is a kind of entitlement program where the top tier of executives scoops up the cash while being under no real pressure to perform. Meanwhile Barclay’s shareholders have a legitimate gripe: their share of the loot has dropped as a proportion of the whole. It used to be that they received about the same as the management, now they get about one third the amount that goes to the top executives.

That is catastrophic corporate governance. And it is a clear demonstration of the ongoing ills in banking.

We are nowhere near having fixed the banks. The Dallas Fed should be applauded for taking the stand it did. About time too.