Banking StandardsWritten evidence from Prof. Jagjit S. Chadha

1. Properly functioning banks and financial institutions allow individuals and firms to separate in time and space the generation of their income and the pattern of their expenditures. In this sense, financial institutions transform the maturity of money because they fund themselves by accepting short-term deposits, which we can think of as savings from current income, and then plan to return these with interest at some future point when they are required. Returns on deposits are generated by making loans to individuals and firms, who we can think of as requiring funding, and this activity typically involves screening loan applicants, monitoring their performance, seeking collateral, deciding on an appropriate interest rate spread over funding costs, as well as loan maturity. In this sense, banks manufacture returns from the raw materials of deposits by selecting assets into which that money is placed at a return sufficient to cover their costs and provide a return for holders of bank liabilities, which are both deposits and equity in the bank. Such activity is essential to the development of a market economy as it allows intertemporal trade in expenditure units and ought to act to smooth expenditure patterns and so ultimately the business cycle and hence benefit society.

2. The key weakness of the banking system, which has been exposed so thoroughly since 2007, flows from the very reason for its existence, because banks transform the maturity of their funding, they are vulnerable to sharp deteriorations in the confidence of their funders, or depositors, which may quickly lead to insolvency. Such a deterioration in confidence may be triggered from the revelation of actual business conditions or simply emerge from the sky, from what economists call a sunspot, as a sudden decision by depositors to withdraw deposits. But it now seems well established that the ongoing financial crisis not only resulted from excessive leveraging by many banks and the employment of fragile funding models but also because the systemic risks of individual bank behaviour were not properly monitored by the regulatory authorities. And while it might be the case that with sufficient maintenance of professional behaviour confidence may have been bolstered, this does seem rather marginal compared to the actual business models employed and encouraged by the authorities. In the event individual banks, and the system as a whole, has contributed to rather than attenuated the volatility of the economic cycle by first helping to prolong the economic expansion and enabling economic imbalances to be funded by financial intermediation and, following the crash of 2007–8, creating a legacy of undercapitalised banks with many poorly performing assets and a restriction of funding channels. This legacy acts to constrain current and future activity as banks reign in their lending activities. And so while it is clear that banks have not delivered on their main objective of helping to smooth the paths of aggregate expenditure and income over time, the difficult question facing this Commission is the extent to which Standards in Banking have played a role in this failure.

3. One possible analysis is that the banking system played a rather cynical game of chicken with the authorities and managed a Pyrrhic victory. The regulatory regime that was adopted from the 1980s onwards involved light touch, which implied that banks could mostly run their own books subject to limited controls on capital and informal liquidity requirements. The carrot was the promise of returns to the shareholders and employees with taxes collected by the state. The stick was that if a bank was poorly run, the authorities would let it fold. In this sense, like any private sector industry the market would be able to select and promote success and punish failure, so that capital and labour could be re-employed. Banks on the other hand gambled with the proposition that even if they took on excessive risk, the systemic implications would be so great that the stick would not in the end be wielded and the state would step in to provide support. The Run on the Rock and the partial nationalisation of UK banks following the collapse of Lehman Brothers, as well as a host of other measures to bolster financial sector liquidity, tells a tale of state support and intervention rather than market determination and a gambit won by the banks. The extensive nature of this state support has placed public finances under strain and we have therefore discovered that there is a significant degree of mutual risk-taking by the banking sector and state, which implies an ongoing case for some greater regulatory constraints to be placed on banking. The obvious issue here though is not to impose extensive controls on banks such that we re-enter the postwar period of capital and lending constraints that led to significant financial repression and yet ensure that the business of banking continues and resumes its basic role of smoothing the economic cycle.

4. A number of further analytical problems have also been highlighted by this crisis, which have exacerbated these issues: (i) risk transfer, or shifting, whereby financial market participants only bear the positive return from any investment or trade and not the loss, can artificially bid up asset prices—this concept has applications as diverse as the question bankers’ bonuses to the development of new instruments eg CDOs and to the implications for fiscal sustainability; (ii) herding behaviour in which similar operating practices by individual banks in the sector not only raises overall risk but also leads to the incomplete transfer of information from the private to the public sector—under these circumstances some heterogeneity is to be encouraged; (iii) opaque bank balance sheets, which are not sufficiently transparent in real-time and may not capture the extent of all contingent claims, and so do not allow holders of bank liabilities to draw up a full picture of a bank’s riskiness, or indeed that of the whole sector; (iv) internal governance in banks, though rightly concerned with profitability, did not necessarily consider reputational or systemic issues and tended to act in a manner that obstructed attempts to tighten regulation; and (v) indifference from the regulatory and monetary policy makers to the problems of an exuberant financial sector, which is currently being addressed with the development of so-called macro-prudential instruments.1

5. The academic debate has suggested the design of a number of optimal contracts between agents that may alleviate some of these banking problems, which we might think of as negative social externalities, and in general these require some limitations to be placed on bank behaviour—in terms of holding more capital and liquidity as a buffer stock, or even in a time-varying manner over the business cycle; possibly by placing limits on exposure to certain fast growing sectors; or in deciding to what extent deposit contracts can be paid out and the scale of deposit insurance. These contracts are designed to ensure that risk-sharing is properly allocated across individual banks, the sector as a whole, the state and households in proportion to their likely returns, or possible gains. It makes little sense to allow banks to accrue excess returns and then lay-off risk to the state and the household sector in extremis. Much of any residual risk in a market economy, what we might call aggregate risk, is insured by the appropriate operation of monetary and fiscal policy—note that we have learnt in this crisis that even bank re-capitalisation tends to be an arm of monetary and fiscal policy. And so when considering new policy initiatives with respect to Standards,2 I would like to suggest a simple selection criterion: Does the proposed policy maintain the freedom of banks to structure their assets and liabilities in order to maximise profits subject to the constraint that economic risks to society have been properly accounted for in the calculations of any individual bank. I think the proper role of what we have called Standards in Banking is to ensure, as far as is practicable, that no enduring gap exists between private returns to the bank and social returns, which would of course be less than private returns in the presence of negative externalities. Put this way Standards are simply about getting the bank and the banking system to understand how to co-ordinate more formally its actions with those of society in general.

24 August 2012

1 See Chadha (2012) for evidence to the Treasury Committee on Macro-prudential Tools:

2 I would rather not comment on them one by one at this stage, though would be pleased to comment on specific proposals at some later date.

Prepared 19th June 2013