Banking on volatility

While the dust still hasn’t settled on the cycle of economic crises that have marked recent years, discussion as to what went wrong is ongoing. Andrew Haldane, a Bank of England economist, recently gave a speech on “Control rights (and wrongs)” in which he proposed a number interesting explanations for recent banking excesses.

We now have the other extreme of banks being owned by people whose liability is entirely limited to the value of their shareholding- Piers Allen

Up until the mid-19th century British savings institutions were primarily organised as either (unlimited liability partnership) banks or (mutually-owned co-operative) building societies. Unlimited-liability meant precisely that, and the partners were liable for every that penny owed to depositors. Whilst immensely reassuring, in practice this made banking a rather risky activity for the owners and the fear of losing their fortune kept away many potential partners. Banks mitigated this risk by operating with low levels of gearing, however overall this only acted to further restrict businesses’ access to credit choking off economic growth.

After many reforms, banks have emerged primarily as limited liability joint-stock companies. From the extreme of unlimited liability we now have the other extreme of banks being owned by people whose liability is entirely limited to the value of their shareholding. While makes it easier for banks to raise capital, it has also distorted banks’ risk profile. The point is that banks’ owners are no longer terrified of losing their shirts from “instability”, but instead now profit most from a highly volatile share price with big swings upwards (and downwards if they are “short”).

Presuming that the owners incentivise management to maximise share price, the Bank of England suggests that bank managers can be motivated to indulge in high risk investment strategies with higher levels of assets relative to the shareholder’s equity (i.e. leverage or gearing). Indeed, to support this they point out that leverage has increased from around three to four around the mid 19th century, to around 20 at the end of the 20th century, and to around 30 in only the first few years of the 21st century. This leverage ties into the other argument advanced which is that, generally, while the interest paid on debt is tax-deductible from profits, the equity costs of financing are not, further motivating companies to raise finance through debt as opposed to equity.

Another point is that at the beginning of the 20th century Britain’s largest three banks had assets representing seven per cent of Britain’s GDP at the time. By the end of the 20th century this had reached 75 per cent, and by 2007 this had reached an incredible 200 per cent. Creditors should impose discipline on debtor banks, either by raising the price of debt or by limiting access to further credit. However increasingly, since perhaps the mid 1980s, researchers have found it difficult to see that creditors have been pricing in the riskiness of a particular bank’s strategy into the price of its debt.

The reason for this is that the banks have become too big to fail and banks, regulators and creditors all know it. Effectively, governments have been subsidising their banks with free debt default insurance: this makes it cheaper for banks to borrow and feeds directly into their profits. Estimates of the value of this subsidy for UK banks, between 2007 and 2010, range from an average of many tens of billions of US dollars to a few hundreds of billions. For global banks the figures range from a few hundreds of billions to more than a trillion US dollars.

In his speech, Mr Haldane summarises the overall situation rather succinctly: “Ownership and control rights for banks are vested in agents comprising less than five per cent of the balance sheet. To boost equity returns, there are strong incentives for owners to increase volatility. Those risk-taking flames have been fanned by tax and state aid.”

There is more to the story: since the 1990s return-on-equity has increasingly been used to set targets for the performance of banks and their managers. Unfortunately, bankers can boost returns on equity by increasing the volatility of assets, or by increasing gearing. Therefore the use of return-on-equity incentives has rather had the effect of amplifying, over a short-space of time, volatile and risky behaviour on the part of banks.

And this short-termism is further reflected in bank ownership where, in 1998, shareholders, on average, held their stock of UK and US banks for around three years, but by 2008 this was down to a rather ephemeral three months as investors speculated on the upward and downward swings of the underlying stock.

The danger is that modern banking has become a thrill-seeking volatility loving business instead of the economy’s foundation of solid, earthy, long-termism. The challenge for regulators, governments, creditors and savers is to establish exactly what service it is that we want from our bank manager.

Mr Allen has worked internationally in the technology sector, earning his first masters qualification in engineering from the University of Durham. For his second masters (in business administration, again from Durham) he researched the Maltese financial sector.