Sunday, 7 February 2010

Tighter than a gnat's chuff

Old skool banking meant borrowing money from savers (e.g. via a savings account) then lending it onto borrowers (e.g. via overdraft facilities). In this way old skool banks were intermediaries that facilitated the transfer of cash between those wanting to save and those wanting to borrow. Even better old skool bankers did a time transmogrification thingy as well; because they knew there’d always be cash sloshing about in a mix of savings and current accounts (Mr A has made a withdrawal? Who cares Mrs B has just had her salary paid in), they could borrow short-term and lend long.

The obvious point here is that the volume of deposits a bank has determines how much cash it has to lend i.e. a small deposit base is a constraint. The discovery of wholesale funding bypassed this , most obviously at Northern Rock, which was able to lend oodles and oodles because around three-quarters of its funding came from wholesale markets rather than depositors.

In fact am sure I can remember seeing some graph produced in 2008/2009 that ranked every big financial institution in Britain by the % of funding they derived from wholesale sources. Northern Rock was the clear outlier, but as you looked at who was second, then third and fourth in line you realised you were looking at which banks (lets be honest, which former building society) would be the next to go under.

The moral of this is pretty clear – any bank reliant on wholesale funding shouldn’t be let near any part of the retail banking market. Except, I’m having difficulty squaring this with John Kay’s proposals for “narrow banking”.

Originally, in a paper what he wrote in September 2009 he defined “narrow banking” as follows: “Only narrow banks specialising in these activities could describe themselves as banks. Only narrow banks could take deposits from the general public (deposits of less than a minimum amount, say £50,000). Only narrow banks could access the principal payments systems (CHAPS or BACS), or qualify for deposit protection.

Narrow banks might (but need not) engage in consumer lending, lend on mortgage, and lend to businesses, but would not enjoy a monopoly of these functions.”

This to my mind is all well and good. Except, listening in to a half decent Radio 4 “Analysis” programme broadcast this month yer man Professor Kay appeared to have redefined his definition somewhat judging by the transcript: “Professor Kay believes that because so much has changed since the 1930s what’s needed now is a variation on the Glass-Steagal theme. He calls his version “narrow banking”. He would limit the activities of retail banks to the most basic banking functions; looking after your money and making sure the payment system works. Narrow banks would only invest in government bonds, and the government would guarantee their deposits in return.

KAY: Now what I would do would be establish retail banks that take deposits and access the payment system, but the business of providing even consumer credit and mortgages and small and medium size loans would be done by specialist lenders. And some of them I think would be standalone organisations and others would probably be parts of bigger financial holding companies, which would run narrow banks but would also provide a range of other services to retail customers.”

The killer point here for me is the comment “only invest in government bonds”. Like where has the financial intermediation between private savers and private borrowers gone? Does this mean narrow banks wouldn't sell mortgages, credit cards or personal loans? Like is narrow banking simply about hoovering up retail deposits to pass on to government?

That’s not necessarily a bad thing to be honest, given it potentially minimises the imprtance of selling sovereign debt into international markets and all the rating agency shite that entails. But, if “narrow banks” only engage in retail deposit taking, who is going to lend to private individuals (e.g. sell you a mortgage) and, more importantly, how will they fund it, via wholesale markets in a Northern Rock style? Am confused rather than critical if honest, but my take on the latest definition of a “narrow bank” is that it appears so tight as to engender unnecessary risks.

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