Money and Banking

Banking, its Purpose, Risks and Rewards

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Misty times on Wall Street
Misty times on Wall Street

Banks are returning to profit. The new chief executive of the taxpayer-owned Royal Bank of Scotland complains that

We sometimes feel as if commentators variously want us to go back to over-lending, to operate on a ‘not-for-profit’ basis, to never entertain a client and to offer employment conditions that deter the best and brightest.

All the evidence is that the government is listening to him, and that the banks will soon re-acquire their independent status and carry on pretty much as before. And yet the complaints of Stephen Hester are somewhat undermined by the balance sheet changes that by his own admission are necessary to restore the bank (from its own point of view) to health and safety over the next 3 years. This involves doubling its ratio of the safest-rated assets from 4% to at least 8%, increasing its liquidity reserves from £90bn to £150bn, and reducing its wholesale funding reliance from £343bn to £150bn with a consequent reduction of its loan/deposit ratio from 156% to 100%. According to Hester, ‘those with accountability for past mistakes have gone.’ So the previous appalling state of the balance sheet should be regarded as a natural disaster of which the ‘the new RBS’ need hold no memory. This is clearly nonsense. No other bankers, Hester among them, were queuing up to denounce the Royal Bank’s balance sheet position before the crunch came. Nor would we expect them to do so. The problem with the banks was and is little to do with the errors of individuals. It isn’t much to do with their talent and inspiration either. The problem lies with a complete failure on the part of bankers and the government to understand banking and its social function.

Banks are not like other firms. They do not create goods or services that are directly of benefit to society. They are facilitators for other firms and for individuals to manage resource production and use over time. They do this by issuing guarantees to the acquisition of future output. These guarantees, by the interlocking of banks’ balance sheets with those of the state in the guise of the Bank of England, can be exchanged now for goods and labour that when combined go to create the ‘guaranteed’ future output. The form of these guarantees is money, in the form of electronically registered bank deposits.

Perhaps a good analogy for the difference in the roles of bankers and other entrepreneurs is that between anaesthetist and surgeon in a difficult and innovative operation for a desperately-ill patient. The surgeon, like the innovator of a new product or service, needs skill, vision and the courage to risk failure. If he does fail and the patient dies, little has been lost in terms of the expected outcome. The anaesthetist, without whom the surgeon cannot operate, draws on the other hand on his exhaustive training and long experience to respond consistently to deteriorating vital signs to minimise fluctuations in the patient’s condition. For him, the less he does the better. The latter role is surely that we want from our bankers. They are there to support entrepreneurs, preferably in new production of real social benefit, rather than being entrepreneurs themselves. This is particularly so, because banks’ role as creators of money leads to them being the administrators of its flows, and if they get into trouble these flows are disrupted. As we have seen this has serious consequences for every agent in the economy, whether they are direct recipients of bank guarantees as borrowers or not. The qualities that make a good banker are unlikely to be found in those flamboyant enough to reach the top of the wealth-motivated entrepreneurial tree, but in those who are strong on analysis of social costs and benefits and are dedicated to getting the job just right without fuss.

While we don’t want our banks to make losses (especially when they really are our banks) we should consider how much we want them to make profits. The role of profits for firms is much misunderstood. To make profits is not their primary social purpose – their primary social purpose is the combination of goods and labour in new and socially beneficial forms – but a monetary surplus is of secondary importance in providing an incentive to monetary investors, such as banks and shareholders, and as a source of capital for expanding the firm’s operations. Given the fact that the biggest monetary investor in the Royal of Bank of Scotland is now the taxpayer and we aren’t doing it for the monetary return, the former is moot. The facilitative rather than creative role of banks means that their expansion is only justified if the creative power of the economy is increasing at least in step. The truth is that if banks are making massive profits and are paying huge bonuses to their managers, this is not a sign of the health of the banks but a sign of the structural sickness of our economy.

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