Retail banks aren’t safe: Politicians fool themselves to think otherwise

Dr Piotr Konwicki
YESTERDAY, RBS’s chief executive Stephen Hester appeared before the Parliamentary Commission on Banking Standards, just days after his bank’s £390m fine for involvement in Libor manipulation. In the face of scandals like these, the political debate about structural banking reform has intensified. Last week, George Osborne committed to forcibly breaking up banks if they do not ringfence “risky” investment arms from their “safe” retail divisions.

But this debate is based on a misnomer. In an article in City A.M. last week, Frances Coppola looked at one aspect of bank safety – whether “safe” retail deposits supported “high-risk” derivatives trading on the international capital markets. She correctly pointed out that retail banks have long been dependent on capital markets to fund ordinary lending. At the time of the financial crisis, the average loan-to-deposit ratio in UK banks was 137 per cent, meaning 37 per cent of retail lending was not funded by deposits. It was not investment banks taking risks.

It’s important to take this argument further, and discuss the myth that retail lending – and retail banking by implication – is safe at all. As former vice president of New York’s Fed Ernest Patrikis said in 1996, “don’t focus on derivatives. One of the most dangerous activities of banking is lending.”

Why is lending so risky? Simple analysis of a bank’s function as a financial intermediary provides part of the answer. The social role of banks is to transfer a surplus of liquidity (from savers) to potential investors. This surplus is deposited with banks. From an accounting point of view, a deposit is a liability – money that the bank must pay back on request.

If we look at the typical period of these deposits, however, we immediately notice how short-term they tend to be. Analysis by Rabobank in 2012 showed that almost 63 per cent of retail banking deposits were for a period of 12 months or less. And deposits have become increasingly difficult to find. According to the Bank of England, between 1969 and 2009, retail deposits (the vast majority short-term) became a smaller percentage of UK retail banks’ total liabilities – declining from 88 per cent to less than 40 per cent.

These liabilities are then used to finance lending (such as mortgages). Loans are part of a bank’s assets, for the purpose of accounting. And the majority of these loans are mid or long-term. This simple juxtaposition shows that banks have always faced the fundamental problem of matching short-term liabilities with long-term assets. No regulation can ever solve this dilemma. If anything, regulation increases a retail bank’s propensity to take risks.

It all started with well-meaning deposit insurance schemes, aimed at protecting small depositors from losses caused by the failure of their bank. But this regulation had two unintended consequences: it lowered the incentive for depositors to discriminate against weaker banks (interest rates became the main factor attracting depositors), and increased banks’ willingness to take risky investment decisions. The first country to introduce the national deposit guarantee was the US in 1933, and President Franklin Roosevelt was one its strongest opponents. He saw deposit insurance as undesirable special interest legislation.

Research by Gayle DeLong and Anthony Saunders of Stern Business School, based on a study of 60 financial institutions, shows Roosevelt’s reservations were justified. Banks and trusts became more risky after the introduction of deposit insurance. The regulation removed depositors’ incentives to monitor and discipline banks.

Analysis of the number of US retail bank failures between 1934 and 2012 confirms this. There were only two years in which no bank failed – 2005 and 2006. There has never been another two year period since 1934 with no retail bank failures. And although the 1950s and 1960s saw relative stability, this was an aberration. It reflected the fact that deposit insurance was limited and the macroeconomic background was unusually stable.

There is no such thing as a safe bank, despite the efforts of politicians to portray retail banks as such. Maybe it is a failure of us academics to convey this message strongly enough in our teaching. It is easy to forget Friedrich Hayek’s famous words: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

Dr Piotr Konwicki is principal finance lecturer at BPP Business School, and a former senior investment banker at Lazard Freres and Deutsche Bank.