It's Not Just the Bonuses What's wrong with banks, and what should be done? Copyright David H Smith 2012

What's wrong Contempt for customers Cheating the shareholders and investors Privatising profits and nationalising losses Dislocating the economy

What's wrong – Contempt for customers 'Stuffing the stickies' Failure to explain risks of complex loan products. Mis-selling of PPI. Chip and pin implemented on the cheap – unlike on the continent. Banks fail to take elementary measures to prevent direct debit fraud.

What's wrong – Cheating Shareholders and investors Shareholders are cheated by perverse incentives, short termism and excessive risk. Other investors, such as pension funds, ('principals') are cheated by 'agents' such as fund managers, who have better information and different objectives.

What's wrong – privatising profits and nationalising losses 'Moral hazard' arising from: Bank bailouts Deposit guarantees

What's wrong – Dislocating the Economy In the good times banks create too much money. Banks lend too much for investment in existing assets and not enough to business. In the bad times banks lend too little. Bank crashes destroy confidence.

The Core Issue - Money and Debt Excessive debt is blamed as a major cause of the banking crash. 97% of our money is created as credit. Credit and debt are two sides of the same coin. But most economic models ignore debt.

Debt – acc. to Morgan Stanley

Debt 2009 – acc. to McKinsey

UK Banks and Bldng Socs in 1964 and 2007

UK Debt Figures by Year - McKinsey

UK Broad Money: GDP Ratio

How can the money supply increase faster than GDP? Fisher Equation of exchange: P x Q = GDP = M x V Why has the velocity of money been falling?

How Money is Created 97% of our money is created by commercial banks as credit in exchange for a loan agreement, such as a mortgage. The bank does not need a customer deposit in advance of extending the loan. Banks determine the purposes for which credit is extended: consumption, productive investment or purchase of existing assets.

House Purchase Example - Effect on buyer's bank's balance sheet.

Asset Price Bubble

Saving the Banks Balance sheet problems: bank becomes insolvent because its assets become 'toxic', and can never be sold for full value. Assets have to be revalued downwards, but this takes time and effort. Bailout needed. Liquidity problems: Banks need liquid assets. Loans cannot be sold quickly except at a considerable loss. QE indicated.

Bank Bailouts This has to be done by government. It has to borrow to fund bailouts. Two ways: a. Buy toxic assets for more than they are worth. e.g. US 'TARP' program. b. Subscribe to new shares. - e.g. UK bought new shares in RBS etc.

Quantitative Easing (QE) This is done by central banks. The central bank buys up loan assets from commercial banks at fair value, with credit issued as part of the transaction. Thus the central bank is creating money, and is sometimes inaccurately said to be 'printing money'.

Putting Things Right Respect for Customers Relationship with shareholders Relationship with investors Eliminate Moral Hazard Creating stability

Eliminating Moral Hazard Objective: to allow banks to fail whilst protecting the payments system. Means: Narrow banking / ring fencing Full reserve banking

Creating Stability This involves controlling the rate of credit extension by: Direct control on the rate of credit extension by commercial banks (Richard Werner), or Full Reserve banking: only the central bank creates money as credit, and issues to government.

Full Reserve Banking - The central bank creates money as credit, and issues to government. - Customers' current ('transaction') accounts are formally accounts with the BoE. - All banking transactions have to involved transaction accounts, and therefore commercial banks cannot create credit, but become financial intermediaries.

Full Reserve Banking - benefits More stable financial system Less debt. Smaller banks Avoids asset price bubbles

Making it happen – discussion points Why did the Vickers commission summarily dismiss both Full Reserve Banking and Werner's plan? Why was no current member of MPC, BoE or FSA on the commission? Will the next crash come before we get reform?