This week is a big week for the banks in Australia being the annual reporting time when they are forced to disclose the remuneration packages that they pay out to their management. The banks have been under attack – again – for gouging their customers with spurious arguments about rising costs and falling margins. While some of their costs may have risen from the rock-bottom levels before the crisis, the evidence does not support the narrative that the banks are now presenting to the public as a precursor to further gouging. The big debate though – which is simmering – is about the purpose of banking in a monetary economy. Essentially, banks are public institutions given they are guaranteed by the government. But there is a tension between their public nature and the fact that the management of the banks claim their loyalty lies to their shareholders (and their own salaries). This tension has led to the global financial crisis and its very destructive aftermath. However, while the real economy still languishes in various states of decay, the financial sector has bounced back under the safety net of the government’s socialisation of their losses. How long will all of us citizens tolerate this? The solution to the tension is to socialise both the gains and losses of the banking sector. In that sense, nationalisation of the banking system is a sound principle to aim for. This would eliminate the dysfunctional, anti-social pursuit of private profit and ensure these special “public” institutions serve public purpose at all times.
I have noted in recent weeks the claim emerging that the leading proponents of Modern Monetary Theory (MMT) appear to adopt contradictory positions in terms of the juxtaposition between the responsibilities they ascribe to government (full employment, public purpose etc) and the fact we do not advocate curtailing the capacity of banks to create loans (out of thin air).
I have found that a curious argument and also one that reflects a less than complete reading of our body of work. But as a teacher I should always realise that if someone is not “getting it” then the first question I have to ask is whether I have explained it clearly enough. Then I have to ensure I have provided enough reference material to support the pedagogy and if all that fails and I am sure that I have communicated clearly then I will conclude that the student is the problem.
So this blog is about banking. Not a complete story (given I am short of time today) but an account of what I think should happen to banks and banking. Note that this account is interpretative rather than a statement of MMT principles. It reflects my preferences based on my understanding of those principles. But equally, someone with a similar understanding might choose a different policy path.
At the outset let’s cut to the chase – I would nationalise all private banks.
In doing so I would be eliminating the largely unresolvable tension that exists in the current system where banks occupy a special protected place and are not really allowed to fail by dint of government support (implicit or otherwise) yet at the same time behave just like risk-taking entrepreneurial firms, paying exorbitant executive salaries and skewing their operations to the interests of their shareholders.
The tension between the public nature of banking and the intrinsic social role they play and the greedy pursuit of private profit – or the privatisation of profit and the socialisation of loss – is palpable and unsustainable.
Socialisation the profits and loss and steering the activities of banks 100 per cent towards the advancement of public purpose would go a long way towards eliminating the worst features of the banking system which culminated in the global financial crisis.
The crazies will argue that this is the first step towards communism. Perhaps it could be but the nationalisation of banks doesn’t imply that at all. It just means that a key social institution is serving only one master – the public rather than compromising its public charter to line the coffers of their private owners.
An Australian government tried to nationalise the banking system in 1948 but the legislation was challenged by the Bank of New South Wales. The challenge – Bank of New South Wales v The Commonwealth (1948) 76 CLR 1 – which was also known as the Bank Nationalisation Case was decided upon by the High Court in Australia. The court ruled that the Government’s plans were unconstitutional.
The High Court ruled that the nationalisation of private banking would violate an individual right to engage in particular types of trading and commercial activity. Under section 92 of the Constitution, there is deemed to be constitutional freedom of interstate trade and commerce. The Court ruled that the banks had a right to engage in interstate banking which would be lost if there was nationalisation.
Interestingly, this interpretation of section 92 of the Constitution has now been overturned in the Cole v Whitfield case in 1988. So the old grounds for opposing bank nationalisation are now no longer available.
The High Court also ruled that there was a failure in the proposed legislation to provide “just terms” for compensation to the private owners. This was deemed to be in violation of section 51(xxxi) of the Constitution which says that government would provide adequate compensation for compulsory property acquisitions. So this finding did not find that nationalisation violating any principle – it was just a case that the specific legislation was not generous enough.
You can read the full decision of the High Court HERE.
So it is entirely possible from a constitutional perspective for the national government to nationalise the private banks. I recommend it. I also note that many banks in other nations have effectively been nationalised as a result of the crisis. It is clear that once the banks can trade profitably again the government will allow them to privatise the gains after bailing them out of the losses. I find that an obscene aspect of the government intervention.
A classic demonstration of how the commercial banks in Australia work against public purpose is to be seen in the current debate over mortgage rates. Traditionally, the banks have passed on the policy rate changes proportionately. In recent months, the banks broke that tradition and hiked their rates more quickly, citing rising funding costs.
The evidence does not support their claim and rather supports the fact that these government guaranteed institutions are gouging their customers. There is a long history of prohibitive charging by the banks following deregulation.
Indeed there is a huge class action underway at the moment which seeks to make the banks repay all the fees they have illegally deducted over the last six years, plus interest. The case is likely to succeed. I am part of that class action along with 230,354 other account holders.
There was an excellent article in the Sydney Morning Herald last weekend (October 23, 2010) by Ian Verrender – Other side of big banks’ sob story doesn’t add up – which challenged the notion that the banks are nothing more than bloodsucking institutions that do little to advance public purpose.
Verrender (who is a financial commentator) demonstrated why the bank’s claimed “need to raise mortgage rates over and above the Reserve Bank official cash rate” which is based on the alleged higher funding costs from offshore borrowing is flawed. He notes that only “half their funding comes from Australian sources” which is thus exposed to the higher domestic rates and cannot then justify increasing rates above the RBA hikes.
The other way of looking at it is that by passing on the full rate rise they actually are gouging the hell out of their customers. By passing on the full 0.25 percentage points they are more than making up for any increase in offshore funding costs.
He also cites research by the Treasury and the Reserve Bank (RBA) which shows that bank margins are “the healthiest they’ve been in years” and that the banks aren’t “telling the truth at all about their funding costs and the supposed need to raise rates”.
He cited evidence provided to Senate Estimates last week (Economics Committee) by a Treasury official (one Jim Murphy). Murphy noted that he thought the GFC had reduced competition in the Australian financial services sector with the Commonwealth guarantee providing advantages to the big four banks. The financial services industry was cast as an oligopoly.
Murphy’s Treasury off-sider told Senate Estimates:
We saw the exit of some key players, particularly foreign players in the market; securitisation froze over which made it more difficult for smaller players to come into the market and compete with the larger banks.
From page E141 of Hansard you can read the conversation turned to whether the banks were behaving themselves given their market power. Murphy said that while statements made by the Treasurer “about the banks justifying their actions” were “not welcome” by the banks but did exert “some form of discipline on the banks and their actions”.
But it remained that the banks had been making statements recently (claims by the CEOs of the leading banks that rates had to go up because of increased funding costs) which Murphy said:
I think they are testing the water on how the public would react to above rate rises. The difficulty in the whole thing is a dispute as to the real facts of the situation.
The following exchange between one senator and Murphy followed:
Senator BUSHBY—In terms of the costs of their funds and things like that.
Mr Murphy—Yes. The Reserve Bank and Treasury do not believe the view put by the banks that they still need to put up mortgage rates higher than the movement in the cash rate, to recover funds—to recover the past losses.
Senator BUSHBY—Presumably, Treasury is aware of the power, in section 50 of the Banking Act 1959, to control interest rates by way of conferral upon the RBA—a power to promulgate regulations with the Treasurer’s approval?
First, the government (Reserve Bank and Treasury) think the banks are lying about their need to push rates higher.
Second, once again you see the claim that there is central bank independence in Australia is a contrivance. There is no independence. The elected government can overall the central bank board whenever it see fits. The central bank is, in fact, part of the consolidated government sector and its transactions with the non-government sector are equivalent in their impact on net financial asset positions as treasury transactions.
Third, what the Treasury officials didn’t tell the hearing was that the big four are reaping in the profits at the moment as a result of the appreciating Australian dollar. Around one-third of their funding comes from medium-term foreign sources (three and five-year notes) and given the AUD has moved from the mid US60c to nearly parity in the last few years then it doesn’t take much to work out that this will work in the bank’s favour.
Even taking into account that funds are now probably being priced more accurately (and hence more expensive given that the risk is being reflected more reasonably than before the crisis), the appreciating dollar is a major cost saving for the banks and this is not being reflected in the rates that the banks are charging local citizens.
The Reserve Bank also considers the claims by the private banks that their rising funding costs are forcing them to hike interest rates above that indicated by the cash rate changes to be exagerated.
In the March 2010 RBA Bulletin article – Recent Developments in Banks’ Funding Costs and Lending Rates – the RBA say:
Most of the increase in banks’ lending rates over the cash rate since mid 2007 has been due to their higher funding costs. For the major banks, however, there has also been an increase in their net interest margins (NIMs), which in late 2009 were about 20–25 basis points above pre-crisis levels. The major banks’ higher NIMs have supported their return on equity, partly offsetting the negative effects of the cyclical increase in their bad debts expense and the additional equity that they raised during the downturn.
The conversation in the Senate Estimates hearing sought to clarify the question of bank costs. A senator noted that the annual reports of the banks showed they avoided the financial crisis and have increased their profitability. He asked:
Does Treasury concede that it is the right of the banks to maintain their profits and their margins at the expense of other businesses and individuals — Australians generally — or is it happy to allow the banks to wear the consequences of implementing monetary policy, rather than the RBA? In some circumstances, when the RBA is considering increasing the cash rate, if the banks have been independently increasing their rates at a faster level it may well negate the need for some adjustment in the cash rate. Is it about allowing the banks to do a little bit of monetary policy? Are you quite happy to sit back and allow them to get away with it rather than wearing the consequences of an RBA decision which may reflect on government?
The Reserve Bank has said in its minutes of past meetings this year that one reason it has not kept pushing rates up is because the private banks have hiked their mortgage rates disproportionately (breaking historical precedents). In that sense, the private banks are now running monetary policy.
The Treasury official (Murphy) replied that the banks now claim “that their mortgage rates are not keyed off the cash rate; they are keyed off the cost of their funds”. He then said in response to a question that the “Treasury and the RBA do not necessarily agree with that”:
No, what I said was that the RBA and Treasury do not agree that the banks’ cost of funds has reached a stage whereby they need to increase their margins to, in effect, pay for moneys that they have paid out previously on more expensive funding … They are arguing that their
funding rates have gone up and that now they have to reconstitute that funding and recover their funding costs. We question that … If there are increased costs, should … [the banks] … be absorbing them at this time? Everyone else had to face the global financial crisis … They are operating in the community and they are largely operating with the goodwill of the Australian public. They have to take note of that. That is what the Treasurer is trying to stress. They are accountable to the public; they are not just accountable to themselves or their shareholders.
The last point the Treasury official made is telling. Banks occupy a special place in society and cannot be considered as purely private profit-seeking institutions. This is why the neo-liberal push to deregulate their activities which led to the crisis (in part) is a denial of the essential nature of banking.
Verrender takes up this issue and rejects the recent claims by populist politicians that the government should seek to control all interest rates. Verrender says:
Instead, the debate should be about the role of our banks in society. Given they are now a protected species, unique in that they will never be allowed to fail, should they be allowed to behave like risk-taking entrepreneurial ventures, trying to conquer the world and deliver fabulous returns to shareholders and executives?[The government] … now underwrite their activities. We guaranteed their offshore borrowing. We guaranteed their deposits. We banned some forms of selling in bank stocks. We stood behind them and declared that banks will never fail.
Should they be out there taking on bigger risks by expanding into Asia and trying to push more loans into Australia when almost everyone agrees that companies and individuals should lighten their debt loads?
He also notes that while Australia is “in the midst of the biggest resources boom in history” the CEO of one of the “world’s biggest miners” is paid considerably less than the CEO of the Commonwealth Bank of Australia who has shocked the nation with his “$16 million-plus salary”.
Verrender says that “(t)hat should tell you everything there is to know about Australian banking at the moment”.
By evading their public purpose charter the banks are able to justify pushing ever more credit onto the population so as to increase revenue and profits. But at the same time the increased risk involved in this greedy push is socialised. This makes the banks special. Verrender says that:
There needs to be a debate about the role they play in our community and about redressing the balance of power they hold. They’ve essentially become utilities – government guaranteed utilities at that. Perhaps it’s time banks became boring.
In this article (April 6, 2010) – Let’s see the flip side of bank funding costs – an Australian banking academic who also has connections with the Indian central bank challenges the bank’s claims about the impact of funding costs in international wholesale money markets on their margins.
The writer Milind Sathye says:
Nothing could be further from the truth. International wholesale funding constitutes only about 26 per cent of total bank funding. The cost of this funding has in fact declined below pre-crisis levels.
He produces various statistics to demonstrate his case. For example, he shows that the spread between the London interbank offer rate (LIBOR), “which is based on the rate banks charge other banks to borrow money without security, to the overnight indexed swap (OIS) rate, which is derived from the central-bank-defined overnight rate” fell “below pre-crisis levels” at the same time the banks were claiming increasing funding costs.
He also shows that the total “interest paid by banks on deposits declined from $74 billion (June 2008) to $70 billion (June 2009)” while “outstanding bank deposits rose from $1.4 trillion (June 2008) to $1.6 trillion (June 2009)”.
He says that (of the period that the bank’s were claiming funding problems):
… the best indicator of overall cost of funding is what banks actually pay for wholesale borrowing. The overall cost of funding measured by the proportion of total interest expenses to total liabilities fell from 5.29 per cent to 4.30 per cent, using statistics published by APRA. And the Reserve Bank study on bank funding costs, published in its June 2009 bulletin, has a graph of major banks’ average funding costs that shows a clear decline in overall funding cost.
The stark reality in Australian banking is that the banks under the watchful support of the Australian government concentrated their market power – largely because the smaller banks were disadvantaged by the crisis and did not enjoy the benefits of the bank guarantee introduced by the federal government introduced to save the banks as the crisis unfolded.
As a result of reduced competition, the commercial banks have been busily gouging their customers and reaping increased bank profits as a result at a time when the world was in crisis.
Milind Sathye shows that while bank profits soared their efficiency did not (the “ratio of operating expenses to total assets … remained unchanged” over the last two years). These profits were a direct result of the bank guarantee.
One option that has been suggested recently which does not involve nationalisation would aim to beat the big banks at their own game. Someone said the other day that the Australian government just has to utter two words – Australia Post. See this article (October 23, 2010) – One sure way to knock the banks into line – for more discussion on that idea.
Australia Post is still a government agency and has offices in every neighbourhood. It could easily be transformed to offer banking services which would force some competition on the big four private banks.
In this Melbourne Age article such a plan is discussed. It would “inject competition into banking, as well as providing an alternative future for Australia Post branches as their traditional postal business declined”.
One element opposing this option is that “If [Australia Post] becomes a bank, it then becomes a government-owned bank and the government would have to capitalise it”. So what? The Australian government could always ensure there is enough capital for its bank. The reality is that the Government stands by to guarantee the private banks anyway – no major financial institution in Australia will be allowed to collapse.
Given the Australia government is sovereign in its own currency it faces no financial constraints in either respect. The question is not whether the government can afford to bail out or underwrite private banking but rather whether it should.
Financial stability as a public good
To advance the case for bank nationalisation I note that the fundamental responsibility of government macroeconomic policy is to maximise real national output in a way that is sustainable (social, economic and environmental). In a monetary economy this requires aggregate spending levels such that all those who wish to work have that opportunity.
Further, the population demands price stability as a matter of fairness and thus accept it as a legitimate political goal.
The political priorities of the Australian government in the post World War II period are listed in the Reserve Bank of Australia (RBA) Act 1959. Section 10, Subsection 2 says:
It is the duty of the Reserve Bank Board … to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and … will best contribute to:
(a) the stability of the currency of Australia;
(b) the maintenance of full employment in Australia; and
(c) the economic prosperity and welfare of the people of Australia.
These economic goals fit with my conception of public purpose. I thus consider the banking system in terms of how it promotes the achievement of these macroeconomic public policy goals.
The current financial system is linked to the real economy via its credit provision role. Both households and business firms benefit from stable access to credit.
An economy’s financial system is stable if its key financial institutions and markets function “normally”. To achieve financial stability two broad requirements must be met:
- The key financial institutions must be stable and engender confidence that they can meet their contractual obligations without interruption or external assistance.
- The key markets are stable and support transactions at prices that reflect fundamental forces. There should be no major short-term fluctuations when there have been no change in fundamentals.
So stability in our financial institutions requires that they can absorb shocks and avoid potential widespread economic losses.
Financial stability requires levels of price movement volatility that do not cause widespread economic damage. Prices can and should move to reflect changes in economic fundamentals. Financial instability arises when asset prices significantly depart from levels dictated by economic fundamentals and damage the real sector.
Collapses brought on by injudicious speculation that do not affect the real sector or that can be insulated from the real sector by appropriate liquidity provisions are not problematic.
The essential requirements of a stable financial system are:
- Clearly defined property rights.
- Central bank oversight of the payments system.
- Capital adequacy standards for financial institutions.
- Bank depositor protection.
- An institutional lender-of-last resort when private institutions refuse to lend to solvent borrowers in times of liquidity crisis.
- An institution to ameliorate coordination failure among private investors/creditors.
- The provision of exit strategies to insolvent institutions.
While some of these requirements can be provided by private institutions, all fall in the domain of government and its designated agents. As a consequence there is nothing intrinsically “private” that has to be present in the banking system for these requirements to be met.
Private goods are traded in markets where buyers and sellers exchange at prices that reflect the margin of their respective interests. At the agreed price, ownership of the good or service transfers from the seller to the buyer. A private good is ‘excludable’ (others cannot enjoy the consumption of it without being party to the transaction) and ‘rival’ (consuming the good or service specific to the transaction, denies other potential consumers its use).
Alternatively, a public good is non-excludable and non-rival in consumption. Private markets fail to provide socially optimal quantities of public goods because there is no private incentive to produce or to purchase them (the free rider problem). To ensure socially optimal provision, public goods must be produced or arranged by collective action or by government.
In my view financial system stability meets the definition of a public good and is the legitimate responsibility of government.
While advocating bank nationalisation, I do not support 100-percent reserve banking. I discuss that debate in full in this blog – 100-percent reserve banking and state banks.
If you have a mixed economy (government and non-government enterprise) then I think it is important the business firms can gain access to credit to expand their working capital.
I don’t support banks engaging in betting behaviour between themselves in pursuit of profit. My vision of banking does not include profit-seeking behaviour unless we are going to include broader social benefits as being part of our conception of “profits”.
In these blogs – Operational design arising from modern monetary theory and Asset bubbles and the conduct of banks – I introduce some of the reforms I would make to the financial system to ensure it served public purpose.
In terms of operational guidelines for banks, I offered the following ideas. I am working on a paper at present which aims to flesh these out some more.
If you think about these guidelines (constraints) you can hardly conclude that I advocate bloodsucking or irresponsible behaviour from the banks.
Remember also that I advocate using fiscal policy (taxation and social housing provision) to discipline housing markets. I don’t see it is an effective policy response to attempt to choke specific asset class price movements using movements in the policy (cash) rate. The bluntness of the instrument is a problem as is the uncertainty of its outcome.
I have also noted before that the distributional issues involved in interest rate transmission mechanisms (the way the rate changes influence aggregate spending) are too uncertain. Creditors gain from a rise in rates, borrowers lose – net effect?
Reflecting on our conception of a bank – the only useful function that a bank should perform is to facilitate a payments system and provide loans to credit-worthy customers. Attention should always be focused on what is a reasonable credit risk. In part, the aim should be to avoid some of the Minskian fluctuations in credit availability over the business cycle.
How might we begin to regulate the commercial banks to ensure their operations more closely satisfy our conception of social/public purpose?
First, they should only be permitted to lend directly to borrowers. All loans would have to be shown and kept on their balance sheets. This would stop all third-party commission deals which might involve banks acting as “brokers” and on-selling loans or other financial assets for profit.
It is in this area of banking that the current financial crisis has emerged and it is costly and difficult to regulate. Banks should go back to what they were – providing financial intermediation. Banks should not be permitted to speculate as counter-parties with other banks.
Second, banks should not be allowed to accept any financial asset as collateral to support loans. The collateral should be the estimated value of the income stream on the asset for which the loan is being advanced. This will force banks to appraise the credit risk more fully. One of the factors that led to the financial crisis was the increasing inability of the banks to appraise this risk properly.
Further, the foreclosure scandal unfolding in the US at present would not have occurred if these stipulations were in place.
Third, banks should be prevented from having “off-balance sheet” assets, such as finance company arms which can evade regulation.
Fourth, banks should never be allowed to trade in credit default insurance. This is related to whom should price risk.
Fifth, banks should be restricted to the facilitation of loans and not engage in any other commercial activity.
Sixth, banks should not be allowed to contract in foreign interest rates nor issue foreign-currency denominated loans. There is no public sense achieved in allowing them to do this.
The upshot of these suggestions would be to render a huge raft of transactions that are currently considered part of normal banking these days illegal.
The libertarians will scream state control. But if you think about it we succumb to micro management of our daily affairs by the state in the name of public purpose and largely agree with that because we can more easily see the consequences of a failure of state regulation. For example, only the most extreme rev-heads will not support speed limits on our roads. In most cities, the speed limits are even getting more stringent (which is good for our natural environment by the way). We can easily see that excessive speed causes carnage and wrecks lives.
I could document a myriad of such laws where the state prevents us from doing things which we readily understand to be injurious of others or ourselves. The level of comprehension of the consequences allows us to accept the state intervention. The articulation of public good or public purpose is easy for us to make in these cases.
I thus consider nationalisation to be the best option. But I would also restructure their management to include representatives of the community and their workforces (similar to the community banks now in Australia). The operations of the nationalised banking system should not replicate the profit-seeking model of the private banks.
The “market” and what can be gouged out of it should not determine how the banking system allocates credit. Instead social and environmental criteria would become central along with job quotient and considerations of the working conditions that business borrowers provide their workforces. Yes, a new world.
Given that financial stability is a public good, the structural changes that I advocate for the banking system are probably best achieved by outright nationalisation. It is clear that they could also be achieved with the private banks being maintained.
But the essential advantage of nationalisation is that the tension between public purpose and private profits is resolved. At present, that tension has pushed the banks into very anti-social behaviour which has generated the financial crisis. A properly regulated system of state banks would not allow such a crisis to emerge in the first place.
As Ian Verrender says:
Perhaps it’s time banks became boring.
I am travelling today and so have run out of time. Must fly!
That will have to be enough for today!