WITH the thud of almost 1,000 pages, America’s main supervisory regulators have approved the Volcker Rule, which prevents banks from trading in securities such as shares and bonds for their own profit rather than on behalf of their clients. Its aim is to stop banks using deposits that are backed by taxpayers to gamble on markets. In Europe regulators too are drafting their own versions of laws intended to make banking safer. Britain’s version will enclose retail banks in a “ring-fence” to separate them from investment banking. In France and Germany regulators are looking instead at fencing off those bits of investment banking that they think are riskiest. Why are banks unstable and will these solutions help?
For many observers the source of instability comes from the “casino” or trading businesses of banks. In their view a simple division emerges between banking that serves society on the one hand by, for instance, lending people money to buy homes or lending businesses money to invest in productive machinery. On the other hand is banking that involves trading securities, writing derivatives and other sorts of risky activities that, in the words of Adair Turner, are socially useless. Yet this explanation fails to pass the common-sense test. Many of the banks that collapsed during the financial crisis (let alone during earlier ones such as the Savings & Loans crisis in America in the 1980s) were simple retail banks that provided loans to finance home-buying. In contrast, many “casino” banks did rather well.
There are two main reasons why banks are unstable. The first is that their main job is to turn short-term savings into long-term loans. The average person wants to be able to access their money whenever they need it, yet doesn’t want to take out a mortgage that might have to be repaid on demand by the bank. Banks get around this problem of maturity transformation by gambling that on the whole most people won’t want to withdraw all their cash at the same time. One way of helping ensure this is the case is by having government-backed deposit insurance so that people don’t start or join bank runs. A second cause of instability is that bank loans are used to finance assets such as housing that can fluctuate wildly in price, making it a risky investment for homeowners and a risky proposition for lenders.
Once one accepts that banking is inherently unstable then the solutions for dealing with it change from those aimed at removing risk from banking to ones intended to reduce both the risks and consequences of failure for banks. The first is to ensure that banks have more capital financing their loans to give them bigger buffers to absorb losses. A second is to ensure those losses fall on investors in the banks rather than on depositors or taxpayers. Lastly authorities need the tools to clean up after failing banks so that their collapse doesn’t cut people off from payment systems or firms off from access to credit. It is only by accepting that banking is inherently unstable that it can be made safer.
Source:l Economist.com