Betting on the banks

Author John Legge Published 5 October 2009

The word “bank” covers three quite distinct types of institution.

There are merchant or investment banks, which profit from assembling finance for major deals (such as the creation of productive enterprises) but far more often through share market speculation. Their deals are inherently risky: not all speculations or attempts at productive investment will turn a profit. And when a merchant bank operates as a principal in such deals it can lose a lot of money in a very short time.

When a merchant bank loses a lot of money, the effects can be far reaching: we watched as the failure of Lehman Brothers in the USA precipitated the Global Financial Crisis, and we felt the effects of the failure of Babcock and Brown and pseudo banks such as Storm Financial Services here in Australia. But it is not just employees and investors who suffer losses: members of the public who entrusted money to them generally lose it. Historically the merchant bank and pseudo bank sector has been very lightly regulated, if at all.

There are also clearing banks, which function to facilitate transactions in business and consumer markets: they make advances against security and pay interest on deposits – creating money as they do so. By charging transaction fees and higher interest rates on advances than they pay on deposits clearing banks can be solidly profitable. Clearing banks are tightly regulated by the Reserve Bank in Australia and its equivalent in other countries, and are supposed to observe the Basel II rules to protect their depositors from loss.

Finally there are savings banks (now extinct in Australia) and building societies. These accept money from small depositors and lend it on the highest quality security, generally first mortgages over residential property. Savings banks were invented by Florence Nightingale, who observed that ordinary soldiers spent their money on bad drink and worse activities because there was nothing else to do with it. She persuaded regimental officers to become trustees of savings banks; and to their surprise but not to hers large numbers of soldiers had their pay directed into these Trustee Savings Banks.

Since the 1970s there has been ongoing agitation for deregulation of the banking sector. The major clearing banks, in particular, cast envious eyes over the aggregate deposits in savings banks and building societies and greedy ones over the profits made by merchant and pseudo banks. They successfully lobbied to have laws and regulations relaxed, allowing clearing banks to offer savings accounts and take over savings banks and building societies, and to get into wealth management and speculative lending in competition with merchant and pseudo banks.

Following the collapse of Lehman Brothers the five largest US banks and hundreds of smaller ones were rendered insolvent, as were two large British banks and several banks on the European continent. The world’s largest insurance company was also insolvent. Rather than let these institutions fail the relevant governments and central banks recapitalised them with hundreds of billions of dollars and changed the accounting rules to allow various worthless securities to be carried on their books as if they were valuable.

Australia suffered less than most, partly because Australia has had a longer but lower level series of crises – including the near-insolvency of at least one of the clearing banks in 1989, the Pyramid Building Society collapse of 1990 and the HIH collapse of 2001. Australian governments introduced tighter regulation and more supervision than either the US or British governments, and so the losses in Australia were measured in single digit rather than hundreds of billions.

The G20 summit has agreed that the global financial system must be re-regulated, but it is yet to agree on how it is to be done. Former Australian Treasurer and Prime Minister Paul Keating has his opinion on the subject: see http://www.abc.net.au/7.30/content/2009/s2694701.htm.

One of the most difficult questions will be what to do with bankers who speculate with and lose small depositors’ money. Since their annual incomes are equivalent to an ordinary person's lifetime income, mere sacking seems to be altogether too gentle. Bring back the stocks and pillory perhaps?