In praise of smaller banks, less volatility
– James Saft is a Reuters columnist. The opinions expressed are his own. –
If we want a world with safer banks, we need to be prepared for the consequences; lower growth over a painful medium term but the promise of making it up over the long run as we suffer less devastating financial blowups.
A banking system forced to operate with more capital and a higher proportion of safe, liquid assets is one that will shrink and charge more for credit, potentially retarding growth as we transition to a different mix of financing.
This may also imply better returns to credit investors outside of banks, but perhaps lower returns for equity.
The prize for most thought-provoking speech by a central banker of 2009 quite possibly goes to David Miles, of the Bank of England, who this week delivered an address considering the implications for the economy and monetary policy of changes in the financial landscape.
“The result of pursuing policies that significantly reduce the chances of another banking crisis like the one we have seen is likely to be a smaller banking sector,” Miles said.
“That is something that creates transitional problems, but it is not something we should seek to avoid.”
There is, of course, very great doubt that the reforms we end up with are effective in reducing the chances of another binge and bust, but let’s pretend for a moment that banks are forced to operate with fewer sails unfurled.
First off, it is important to understand how profound have been the recent changes to how banks operate; how they fund themselves, what they own and how they lend.
Miles estimates that, excluding international business, the British banking system went into the crisis holding about half the capital relative to assets that it had 50 years earlier, and just a third of the capital of a century ago. To amplify matters British banks held far less highly liquid assets, such as claims on the central bank or government debt, about one third the level of 50 years ago. So long as asset prices play along this is recipe for great profits and great growth, and that is just what happened; even excluding overseas business British banks grew to five times their size relative to the economy in the past 34 years.
A GENTLY SLOPING LANDSCAPE
Miles argues that tighter regulation and more conservatively managed banks will mean bigger spreads between bank lending and borrowing rates, less interest for savers and higher relative rates for borrowers. This would better compensate banks for the risks they had been running all along. His three main implications I quote directly below:
1. Less saving through banks and quite possibly less overall saving.
2. Less investment financed by banks and quite probably less aggregate investment.
3. Less credit to households and potentially a lower owner occupation rate and lower house prices.
He argues that this does not imply lower economic growth over the longer run, but lower yearly growth made more palatable by less volatility of growth. If you don’t lose 10 percent of GDP every 50 years or so in a banking crisis, you won’t miss fractionally lower annual growth due to higher lending rates and less credit.
From a central bank’s point of view this implies that the natural policy rate may be lower. Central banks will actually have more control over the economy via interest rate policy but would need to keep rates lower to compensate for higher effective borrowing rates due to fatter spreads.
From an investor’s point of view, a world with a smaller banking system and more expensive credit is challenging, but with interesting opportunities.
Credit investors should get better relative unleveraged returns — after all there will be less competition. An interesting question is whose credit analysis they will depend upon: the ratings agencies, the banks, or perhaps their own?
All three, as we have seen, have costs and disadvantages.
My guess is that a world in which we all do our own credit analysis is as likely and undesirable as a world in which we all raise our own food.
For equities, a world with more expensive debt should mean a world with less debt and lower returns. Even if the tax advantages of debt survive, borrowing will be less attractive for companies. Debt, as we know, amplifies returns.
The silver lining for equities may be that, though returns are lower they are more reliable, prompting investors to place a higher value on them.
It is unclear too what role global imbalances will play in valuation. Don’t be surprised if the universe of emerging market securities grows at a much faster relative rate, siphoning off some of the Asian savings which fueled the western bubble.
If, on the other hand, meaningful reform does not happen, successful investing will be all about boarding the bus early and getting off just before it plunges from the road.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)