Thursday, February 5, 2009


For economic growth we people to take risks by lending money.
For long term stability we need banks that don't go bankrupt.
Thus we need banks to pass on the default risk.

It seems that the word 'banker' sounds like a swear word more-so now then ever before. Banker bashing is a popular pursuit in blogs and newspapers. But seldom do we hear the view from the inside, so let me try to start to remedy that.

Banks are full of regular people, who can show kindness and compassion, particularly to friends and family. They will hold open the door open for a little old lady, but when it comes to large sums of money, they will be, for the most part, very selfish. It is reasonably rare for individuals or firms to give more than 1% in truly charitable donations and the giving that is done is often used as a form of relatively cheap PR work.

Overall I think it is fair to say that banks are selfish institutions, full of selfish individuals. People just like me. In our desire for money we are very much like other groups. In our defence I would say that we are perhaps more open about aims than some. For example politicians frequently claim that they are motivated by a desire to do go and to help others, but their actions are much more consistent with a group whose primary motivation is a lust for power.

In banks, the executive boards have some significant power, but it is not absolute. Ultimately they are accountable to share-holders, who do from time to time demand the sacking of the board.

Suppose, back in 2004, a board member of a major bank were to present to the board the suggestion that they seriously reduce the credit exposure of the bank, which would drastically reduce risk of bankruptcy and indeed the profit of the bank. The board would know well that if they were to take up this suggestion then the share-holders would have them all sacked. If their competitors are making billions by taking large risk, then they are very heavily pressurised to do the same.

Roughly speaking, businesses work for the benefit of the share-holders. They take risks to generate profit. Outside of banking, firms go bankrupt reasonably frequently. Only a tiny fraction of firms that were in operation in 1900 were still going in some shape or from in 2000, without having experienced a bankruptcy and bail-out at some stage.
It turns out that in fact banks have good longevity compared to pretty much any other industry.

However, if we want any form of economic growth, then we need there to be risk-takers. We need to allow firms the right to risk bankruptcy. However suppose we say that the collapse of a retail bank is too devastating for an economy for a government to allow, then we cannot let banks take much risk at all. Any time money is lent there is a risk. So, if we absolutely can't let the banks go bust, then we need to have other risk takers. One solution would be just to let the banks just be intermediaries, not wear-housing the default risk, but rather passing it on. Hedge funds have the potential to be very very helpful to an economy, if they can be encouraged to take credit risk. If they are paid enough of course they will.

Individuals with deposits in banks could also be paid to take on some additional risk. For example an investor could be offered the following:
Choice 1:
Lock away 100,000 Euro for 1 year in super-safe bank and you'll get 1% interest.

Choice 2:
Lock away 100,000 Euro for 1 year and you'll get 6% interest, subject to Ryanair not defaulting on any of its debts. If Ryanair defaults, the 100,000 Euro deposit will be converted into a Ryanair bond, with face-value 100,000 euro.

It is clear, it is simple and we can have safe-guards against mis-selling.

The benefits of offering choice 2 to investors are:
1: Ryanair, and companies like it, will be able to raise money more easily
2: Individuals can get better returns on their savings, by choosing to take some risk
3: The safe banks which the government won't let to bankrupt are exposed to much lower credit risk.

Choice 2 above is basically a 'credit default swap'. They are not very popular at the moment, but they have great potential to come back in future.


  1. In recent times it has been amusing to read articles in newspapers which quote people saying "how dare those banks lend all that money to property developers others" and then on the next page, they have an article where small business are complaining of the lack of credit being extented to them, they say, "how dare those banks not lend money".

  2. Ah yes, the only thing worse for an economy than having banks that lend money willy-nilly, is having banks that won't.

  3. The task of banks is to take risks, calculating potential costs for themselves. But they do not take into account the consequences of their losses for the economy as a whole.

    If banks make profits, then they keep those profits. If they make losses, then everyone else pays for much of those losses (via government bail-outs) because banks cannot be allowed to fail. So much of the risk is not born by the bank. In other words: risk is systematically underpriced. This is especially so for executives of the bank: if they make short-term profits, they get huge bonuses. If they make losses, they don’t lose much (or by the time they are fired they have made enough money that it hardly matters).

    Now, there may be no way to completely solve this problem: but if you have institutions that are structured like this then they need to be extremely carefully regulated. But the finance industry has spent the last two decades campaigning to reduce regulation and they succeeded in doing it – they claimed that they had scientific mathematical models which could measure risk, so there was no need for outside regulation. It turns out those models were about as scientific as tea-leave reading. They couldn’t even assess the risk to themselves, nevermind the rest of the economy.

    The Great Depression during the 30s resulted in massive reforms within the economy in order to stabilize it’s boom-bust cycles, and gave the state more control over financial markets. Overall, that was the right thing to do. And that’s what needs to be done now.

  4. I would dispute the claim that bankers are, on average, no more selfish than other people. I think that if you are a greedy, selfish bastard then you are more likely to be attracted to working in the financial services sector, than, for example, becoming a nurse or a teacher or a social worker. And within a bank, the greediest most selfish people are the ones who are most likely to rise to positions of power. So I think that banks contain a disproportionate number of of greedy, selfish bastards (and I speak as someone who used to work in an investment bank!)

    “It turns out that in fact banks have good longevity compared to pretty much any other industry.”. I agree. That’s because they get bailed out when they screw up!

    “If their competitors are making billions by taking large risk, then they are very heavily pressurised to do the same”. I agree. That’s why they need to be regulated to prevent them underpricing risk, or overly exposing themselves to too much risk in order to make short-term profits.

  5. At the following link, there is an interesting article from an AIG employee: