Felix Salmon

Shrinking banks

By Felix Salmon
August 26, 2009

I was high when I gave my presentation on risk to the Zermatt symposium this morning — 8,471 feet above sea level, to be precise, in an idyllic place called Riffelberg. Who needs wifi when you have views like that. In any event, it went quite well: after all the high empirical seriousness of the past couple of days, I think that the attendees enjoyed me blowing off steam by telling them that we had to do something which of course we won’t do at all: abolish the tax-deductibility of interest, move in general from a world of debt finance to a world of equity finance, and, insofar as there is credit in the world, encourage that credit to be in the form of loans rather than bonds.

“I wondered where you were going there,” said Princeton’s Harold James after I was done, adding that he thought for a while that I was going to propose moving, essentially, to a world of Islamic finance. Doesn’t Islam essentially prescribe from a religious perspective exactly what I was prescribing from a practical perspective?

Yes, it does. One of the themes of my talk was that it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution, with an attendant surge in demand for triple-A-rated bonds. Investors didn’t want risk, and investment banks made billions of dollars, during the boom, by waving their magic securitization wands and seemingly making that risk disappear. In Islam, high religious authorities are tasked with looking at complex structures designed to circumvent the prohibition on paying interest; in western finance, the ratings agencies played a similar role, blessing highly complex structures (CPDOs, anyone?) which otherwise investors would never have touched.

There followed lunch, and a spectacular walk even higher, to the Gornergrat (10,210 feet) before we descended back to Zermatt on the famous railway to hear Professor James give his presentation, which was very good. James quoted Mervyn King, the governor of the Bank of England, as saying that “the behemoths of global finance have been global in life, but national in death”, and said this posed a problem for small, open countries, including Switzerland, which in general did well during the boom. Such countries just aren’t big enough, he said, to cope with a domestic banking crisis and embark upon a major Keynsian counter-cyclical spending spree at the same time, especially when such spending has to be financed abroad.

More generally, James sees big banks splitting up, becoming increasingly regional and/or national, and the sheer number of banks falling substantially, not least in the US, which has a huge assortment of small banks. The happy medium, he said, is somewhere like Canada, which has a manageable number of large, boring banks which in general don’t venture too far abroad. That sounds right to me, and I suspect that the upshot might be felt very keenly in Mexico, nearly all of whose banks are foreign-owned. Given (a) that the Spanish government has neither the inclination nor the ability to conduct a bank rescue in Mexico; (b) that there are questions over the health of BBVA, the owner of the largest bank in Mexico; and (c) that bank failures are managed by the regulators in the parent country, I can see moves afoot to pressure BBVA into selling Bancomer. The story could be repeated in Brazil and Chile for Santander.

James also raised an intriguing hypothetical, a propos the new nationalism which he sees emerging in the banking industry — how might the world look instead had Dick Fuld sold Lehman Brothers to the Koreans? It’s fascinating to wonder whether that one failed deal might have made an absolutely enormous difference in the future of global banking, between continued globalization and the beginning of deglobalization, if that is indeed what we’re now embarking on.

12 comments so far | RSS Comments RSS

I like the idea of eliminating bonds and moving towards loans.

However, how would this differ from Japan’s financial system of 90′s, which also caused a giant real estate bubble?

Posted by Chris | Report as abusive

Felix, is there a way to get a copy of Prof. James’s presentation, like a conference website or something?

Posted by DaveS | Report as abusive

“encourage that credit to be in the form of loans rather than bonds.”
-umm.. im guessing this has something to do with short term borrowing vs long term financing /fixed vs floating idk??

“move in general from a world of debt finance to a world of equity finance”
-0% interest rates don’t help your cause much

“abolish the tax-deductibility of interest”
-what is it with you and your love for tax revenue?

Posted by dvictr | Report as abusive

You just shifted a couple of loosely held paradigms in my head.

“…it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution with an attendant surge in demand for triple-A-rated bonds”

…which might not have been as high a demand had they been labeled “toxic-salami-from-Hell bonds”.

Posted by Mark Beauchamp | Report as abusive

I’m also curious about your push for loans over bonds. What’s the big benefit there?

Is it simply the fact that loans are less liquid and held mainly by underwriters (encouraging more stringent underwriting)?

Posted by ab | Report as abusive

I didn’t buy more than I can afford. The consequence was of course owning very little. No house,, used car,, shabby furnishings. My method would have worked had not the banks, government and employers conspired to keep me paying out every nickel I made. Between the supression of wages, the banks charging shameful fees to have access to my own money and a government which treats working men and women like sources of income. (much like livestock) How is the typical American expected to prop up these edifices of excess without any hope of being allowed inside?

Posted by RH Pyle | Report as abusive

Once again we get a left-handed compliment to the Canadian banks. Is it really so painful for Americans to admit that Canadian banks are exceptionally solid performers? Each of the ‘Big Six’ was earning between $1-2b per quarter, and is now still earning between $500m-1b per quarter. They each have a market-cap between $40-50b. We had only one quarter with bank losses form all this worldwide meltdown, and they were in the low hundred millions. So, we are smaller, manage to create stable and sustainable strong profits, and the best you can say is boring? How about saying “It’s the way banking should be, instead of robbing people and government blind with voodoo accounting and mislabelling securities!”

Posted by the Shah | Report as abusive

Speaking of Canadian Banks, there’s a post and a paper over at VoXEU that I think is a must read. I think it relates very well to your point about banks having to become “boring”. In other words, for the sake of stability, banks will need to rely more on simple deposits, instead of exotic finance. I guess that’s the old 3-6-3 model.

Posted by jg | Report as abusive


“Boring”, as I understand Felix, isn’t used in a pejorative sense here.

Posted by Mark Beauchamp | Report as abusive

DaveS, no, there was no written presentation that I know of, although it can’t hurt to email him to ask for a copy of his notes.

ab, yes, loans have stricter underwriting than bonds. They also have covenants.

And Shah/jg/Mark, yes, I was trying to pay a compliment to the Canadian banks. Boring is what every bank wants to be, these days.

Posted by Felix Salmon | Report as abusive

One non deal makes the difference between globalization and deglobalization? Redunkulous.

If the Koreans had bought Lehman, that would have merely delayed the crisis of highly leveraged, speculative institutions, but how in the world could the deal have prevented it? That buys the bullshit that it was a liquidity issue.

Posted by Joe P | Report as abusive

Felix –

Your oft-repeated thesis that “it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution, with an attendant surge in demand for triple-A-rated bonds” deserves an award as one of the best insights of our time.

It seems to me that a large part of this ‘overcaution’ is really due to central banks, sovereign funds, insurance and pension funds, and other large pools that have a very limited mandate as to how they can invest. These large pools and their limited mandates haven’t changed much at all through this crisis.

Meanwhile, the big reliable AAA credit remaining is sovereign debt, now available in abundance. If in our brave new world, non-economic bond players are the planets that control the tides, then bond vigilantism may be out of the picture. In the present case, central banks are not getting good market signals. Instead of a healthy rise in yields when too much stimulus is given, they are getting no response. At some point in the not-so-distant future, it will be suddenly found that the non-economic bond buyers simply have insufficient funds to meet the supply of bonds offered by central banks. Sovereign bond offerings may simply fail. Interest rates may spike more sharply than we have ever seen and we will wonder, where was the market signal?

Looking at global sovereign debt loaded into the budgetary pipeline, this spike event may not be far off, it will be global, and then what will the banks do?

Posted by Daniel Hess | Report as abusive

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