Sunday, January 15, 2012

The Role of Banks

“Cut out the middleman.” Facebook is more threatening than the “occupy” crowd.

Since the seasonal reference to “It’s a Wonderful Life” was late this year, perhaps a second reference is appropriate penitence. The last posting, “If the Plan is Right, Stick to It,” addressed personal financial management. It made the simple point that a financial plan that involves running around like a chicken with its head cut off isn’t the way to a wonderful life. Now it’s time to see what “It’s a Wonderful Life” says about banks.

First thing to note is that the Bailey’s are bankers throughout the movie (technically Bailey Building and Loan is an S&L, a distinction made obsolete years ago). Potter, by contrast, becomes a banker when he “takes-over” a bank during a run. The efforts of hedged funds and private equity funds to buy into banking during the recent crisis are similar to Potter’s “takeover.”

The parallels are interesting, but that was the 1930’s and 2008-2009, this is now. Does the movie say anything relevant to today? It says a lot that is timely. Look closely and the movie says a lot about what banks are and how much power they can have.

The first point is easy to miss. In the picture labeled Scene 1 Potter is describing George’s success at avoiding Potter’s control. It’s a meeting between two bankers. What is easy to miss is that Potter refused a telephone call in order to meet with George. Listen closely: he tells his secretary to “tell the congressman he’ll have to call back.” Potter, who craves power, has political contacts. George, by contrast, runs his bank without such contacts.

Scene 1

It’s telling that a bank isn’t enough for the one seeking power. He needs political contacts. Perhaps banks don’t have that much power. They may just be instruments the government uses. Regulation is simply the government trying to preserve its tool.

The situation represented in Scene 2 contains an obvious fact about banks that the media and political demagogues love to overlook. George is explaining banking to his customers. He is explaining that the bank doesn’t have piles of money “back in the vault.” It has assets. To paraphrase the terms in which George explains banking to a customer, “your money is in your neighbor’s house.”
Scene 2

It’s silly when the media and politicians (and embarrassingly, some economists) say banks are sitting on the money rather than lending it. How stupid can they be? The bank’s business is lending. Banks sit on money only to the extent they are required to in order to meet regulatory reserve requirements.

If you think banks aren’t lending as freely as they should (a belief not shared by The Hedged Economist), you should consider this quote from the March 3, 2010 posting “Regulatory capital and who’s got the money?”
“What we know about reserves is that people lower them in good times and raise them in bad times. We also know this aggravates the cycle. Well, surprise, surprise, governments are people; they do the same thing. Unfortunately, the government has a long history of changing capital requirements in the wrong direction over the business cycle.”

Similarly, if you believe banks lend to the wrong people, look closely at the risk factors assigned to various types of loans (the risk factors determine how big the reserves banks have to hold will be). It shouldn’t be a surprise that a bank that lends to the government doesn’t have to hold as much in reserves as one that actually lends to people.

The picture in Scene 3 was used in “If the Plan is Right, Stick to It” to illustrate a point about George’s situation. But, it has broader implications because it is easy to misinterpret. In fact, George is guilty of the misinterpretation.

Scene 3

While pleading with Potter, George expresses a belief that Potter is the only person with the kind of money (liquidity) George needs. Turns out, George is wrong.

Scene 4 and Scene 5 illustrate the truth about liquidity.

Scene 4

Scene 5

Scenes 4 and 5 make it quite clear that Potter, and, for that matter, George aren’t the source of liquidity. George’s comment regarding Potter should sound familiar to those who think banks have money. Yet, the happy ending to the story results from the fact that it’s people who create liquidity and all capital by not consuming everything they earn.

The image of villainous bankers deserves no more attention than the villainous merchant. Intermediaries are hardly powerful or the source of the merchandise they sell. That’s true whether the merchandise is a piece of apparel or a loan. Middlemen whether merchants or bankers have to justify themselves regularly.

The most obvious way to eliminate an intermediary is to just stop using their service. That is happening with banks to the extent that people stop borrowing. It’s even more dramatic when they pay off debts. This, of course, increases the overall savings rate when done with current income. However, if existing savings are used instead of debt or debt is paid off from existing savings, the use of banks can be reduced without much of an impact on the portion of current income the person has to save.

George’s experience raises an interesting issue. Potter, the impersonal investor, evaluates George as a borrower based on collateral. By contrast, the populace evaluates him as an individual. For most of history, the ability to evaluate an individual was the way banks justified their role as intermediaries. (Manual underwriting is the term often used to describe the process). It was a high cost way to allocate capital.

Much is made of the competition between community banks that can “know their customers” and large impersonal banks. The discussion overlooks the broader issue. Just as the populace didn’t need a bank to act as intermediary between them and George, there is always a risk of “eliminating the middleman” if the intermediary can’t justify itself. That is a risk faced by banks large and small.

Large banks depend on scale built around their access to large amount of capital at advantageous rates. In the corporate sector that justification was undermined by the corporate commercial paper market. The large banks have used the systems for consumer credit evaluation to gain the scale they need in consumer markets.

Credit scores, automated underwriting systems, risk models, and numerous other systems were designed to reduce the cost. Many of those systems failed during the financial crisis, but even if improved and refined, the systems represent a shift toward Potter’s model. They facilitate scale, but do it by undermining the traditional justification for the banks’ role as intermediary.

Interestingly, the Potter approach requires a legal system where there is clear title and contract law. In THE MYSTERY OF CAPITAL Hernado de Soto points out how these factors, so necessary for the Potter approach to work, are missing in many parts of the world. In those places, a system closer to the George’s model may develop. However, its cost would always be a limit on the availability of credit to a large segment of the population.
The real threat to banks is technology, not the investment risks the banks take. Using technology, and integrating with Facebook, has developed a community approach based on George’s reliance on character while offering the potential for scale. Their website describes the approach as “By combining community-based micro-lending techniques with social media endorsements, Lenddo is the first credit scoring platform optimized for emerging markets; specifically, markets where traditional credit scores and collateral frameworks may not exist.”

Lending was once based on character and relationship. Social networks have the potential to restore the sound lending practices of the past. And it looks like it already is starting to happen.

Facebook’s COO Sheryl Sandberg said this weekend in the WSJ interview “We would like everyone who builds products to use Facebook. Our vision is that industries get disrupted and [they get] rebuilt with people at the center. The gaming industry has been really impacted by these social gaming companies like Zynga and Playdom. By putting people at the center, they took a totally different approach to games. We think this will happen to every industry.”

Or, as Facebook CEO Mark Zuckerberg said in 2010, “If you look five years out, every industry is going to be rethought in a social way.”

Social lending has caught on with the Lenddo community in places like the Philippines, but if Mark is right a social approach has the potential for radical improvement over the way US and Western European banks traditionally do consumer banking, which has global implications. Thus, it shouldn’t be surprising then that The Hedged Economist is long

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