I spoke at an investment conference recently where the opening speaker referred to banks as parasites. For me, the word parasite conjures the image of a tapeworm slowly eating my insides (backpacking in Southeast Asia comes to mind), but the word is used derogatively to depict elements of capitalism. The Oxford dictionary provides the derogative meaning of the word as “a person who habitually relies on or exploits others and gives nothing in return”. The speaker was arguing that banks do not produce anything, they simply feed off our money.
Demonisation of Banks….
Banks have been demonised since the financial crisis and this type of rhetoric has become popular. But does a comment referring to banks as “parasites” have any substance? This is something I have been meaning to write on for a while, but the challenge has been where to start. Study the origins of banking and you’ll find yourself going down many a rabbit hole. The history of “usury”, the practice of charging interest on loans, banned by the Christian church in medieval Europe and later repealed in the Western world, is an interesting context for how banks are perceived today.
The evolution of lending from being an illicit activity, largely carried out by the Jewish community, into our modern day banking system, spearheaded by powerful banking families – names like Rothschild, Warburg, Rockefeller – provides the fuel for many a conspiracy theory on who the real man behind the curtain is, the secret power brokers of the new world. You’ll find YouTube videos, blogs and books dedicated to ‘exposing the truth’ of an international banking cartel that is calling the shots. Whatever you choose to believe, there is no getting away from the fact that finance and power are inextricably linked.
The Role of Banks….
Still, referring to banks as parasites runs deeper than this link, it implies that banks provide no value to the economy and its stakeholders: individuals, households, businesses, financial institutions and governments. Banks play an invaluable role in the smooth functioning of an economy, acting as intermediary between savers/investors and borrowers, enabling the efficient allocation of money (capital) throughout the economy. They also provide clearing and settlement services, the importance of which is often overlooked, facilitating trade – the exchange of goods and services – and the safekeeping of cash. The cash under the mattress option is not a realistic alternative to keeping your money on deposit at a bank.
In a very simple world, banks borrow and lend money. While the commodity a cattle farmer trades is cows, the commodity a bank trades is money. Some market participants have excess funds (savings) while others are in need of funds (loans). Banks channel these surplus funds from savers to borrowers. An individual may need funds to purchase a car or house, or a business might need capital to expand. Banks assess the creditworthiness of borrowers, and where approved for a new loan the borrower is charged an interest rate to reflect the risk of default and the quality of the collateral provided, if any. For this and the ongoing servicing and monitoring of loans, banks earn a spread between the cost of money and the rates charged to borrowers. This does not make them parasites.
The role of banks is even more crucial in Europe, which operates a bank-based financial system, accounting for around 80% of financial intermediation. This compares to the US, where banks account for around 20%, with their much more developed capital markets shouldering the responsibility of allocating capital throughout the economy. There is no agreement on what the appropriate balance should be between banks and the capital markets, in terms of fulfilling the intermediary function. However, there is some suggestion that a market-based financial system recovers quicker from an economic crisis.
The Failure of Banks and Increased Regulation….
Unfortunately, the banking industry has repeatedly failed to live up to their responsibility in providing a solid foundation for the global economy. The billions in fines banks have incurred for the manipulation of the forex and interest rate markets as well as the mis-selling of securities and products is testament to their failings. While this behaviour is inexcusable, it does not take away from the important role that banks play in the financial intermediation process.
As banks shifted from plain vanilla bank lending into other areas of finance, insurance and investments, they became increasingly complex, making them more difficult to manage and regulate. Many banks are now reversing this process, returning to their core business of lending. While the costs associated with complying with regulation has now become more onerous, the banks have only themselves to blame. They proved that self-regulation, the so-called ‘light touch regulation’ does not work. They took advantage of a good thing, as is often the case with human nature in general.
Ireland: Banks are Public Enemy Number One….
In Ireland, banks are public enemy number one. The bailout of the banks by the Irish State has left us all carrying the financial burden through higher income taxes, universal social charges, property taxes, pension levies, and the infamous water charges. The same banks are still failing to meet the needs of expanding SMEs, charging some of the highest mortgage rates in Europe, and are in the process of repossessing thousands of homes. It is not surprising that banks are disliked, hated in some instances.However, the current situation is the legacy of poor decision making across the spectrum of stakeholders involved.
Governments incentivised real estate speculation and individuals bought into the dream with little care for affordability. Banks facilitated the bubble, continually rolling the dice on property values going higher, ignoring long term valuation and lending metrics. Meanwhile, the Central Bank and the Financial Services Regulatory Authority, tasked with protecting the financial system and ensuring financial stability, brought a whole new meaning to light touch regulation. Again, while banks must bear a large share of the blame for the economic collapse in Ireland, there is no doubt that we need a well-capitalised banking system to support the economic recovery. Of course, if those in charge at all levels were held accountable, rather than walking away with handsome pensions, then perhaps it would be a little easier for people to appreciate the importance of banks to our economy.
Public or Private Ownership….
Since banks play such a crucial role in the economy, it could be argued that banking is a public good. This raises the question of whether banks should be state run for the good of the people. In other words, if banks are parasites for earning a spread for their intermediation services, could state run banks provide this service for free? The answer is no. The reality is that if banking was nationalised, lending would become politically motivated, and capital allocation would become even less efficient. We are seeing first-hand how difficult it is proving to repair the banking system in Ireland, given the political influence that has come with the bailout.
In theory, the profit motive at the heart of private ownership is intended to negate poor lending practice. However, the reality is that short termism and the incentive systems in banks don’t always align with creating real long term value for shareholders and the other stakeholders in the economy. If banks operated long term business plans, conducted responsible and diversified lending, then they would be much more stable over time. Also, if investors are conducting appropriate due diligence, which was clearly not the case in the years leading up to the global financial crisis, the best run banks will be rewarded over time in the form of lower funding costs.
It is popular to blame everything on the banks, but the sooner the Irish banking system is repaired, the more it can contribute to the economic development of the country. The two biggest challenges facing our domestic banks is the huge portfolio of non-performing loans and the short term maturity of their liabilities. Greater than 50% of domestic bank funding has a maturity of less than one month, leaving it susceptible to a sudden change in the market environment. Of course, the difficulty at a micro level in terms of real banking reform, is that these banks are still staffed with the same people with the same mind-set.
Above all, there is one important lesson from the Irish banking crisis. Lending money out is easy, any fool can do that, the skill is getting the money back. On this front the Irish banks have failed miserably, but that does not mean they are parasites. Incompetent beyond belief, yes, but they are not parasites.