What Do Banks Do? Adair Turner

This essay on Adair Turner’s essay ‘What Do Banks Do? Why Do Credit Booms and Busts Occur? What Can Public Policy Do About It?’ taken from the book ‘The Future of Finance – The LSE Report’

  • PART 1 – SUMMARY OF MODEL & ARGUMENTS
  • PART 2 – QUESTIONS ABOUT THE MODEL
  • PART 3 – WHAT MIGHT CAUSE THE MODEL TO NO LONGER BE TRUE?
  • PART 4 – APPLICATIONS/IMPLICATIONS OF THE MODEL

PART 1 – SUMMARY OF MODEL & ARGUMENTS

Overview

Turner’s argument is as follows

  1. First Principles: Turner lays out the theoretical roles of banks in the economy.
  2. Hypothesis tests: Then he establishes tests for measuring banking’s effectiveness at these roles.
  3. Statistics – Δ in x: Turner describes the massive developments in banking.
  4. Statistics – no Δ in y: But shows there is little evidence these changes are resulting in better economic outcomes.
  5. Null hypothesis false?: Turner questions whether the assumption that more banking is always better is true in several key areas.
  6. Solutions: Turner offers some possible solutions.

1. First Principles: Turner lays out the theoretical roles of banks in the economy

Four categories of financial system activities.

  1. Provision of payment services, both retail and wholesale.
  2. Pure insurance services.
  3. Creation of markets in spot/short-term futures instruments e.g. foreign exchange & commodities.
  4. Financial intermediation between providers of funds and users of funds, savers and borrowers, investors and businesses crucial for capital allocation.

Problems of crisis were with category 4, where intermediation of non-matching assets and liabilities entails four functions.

  1. Pooling of risks.
  2. Maturity transformation via balance-sheet intermediation – banks lend longer than they borrow. Risks are offset by the equity cushion.
  3. Maturity transformation via provision of market liquidity.
  4. Risk-return transformation – different mix of debt and equity investment options for savers than naturally arises from the liabilities of the borrowers.

2. Hypothesis tests: Then he establishes tests for measuring banking’s effectiveness at these roles.

This four transformation functions add value to the economy in three ways.

  1. Investment of pooled assets directly affects capital allocation. Although much capital allocation goes on within firms and their use of retained earnings.
  2. Maturity transformation means higher consumer welfare, particularly consumption smoothing because both savers and borrowers can get personalised maturity mix of assets and liabilities.
  3. All four factors mean individual household sector savers can hold a mix of assets different from the mix of liabilities owed by business users of the funds.

3. Statistics – Δ in x: Turner describes the massive developments in banking.

Financial intensification of the four transformation functions occurred through:

  1. Securitization pooled new assets groups e.g. mortgages.
  2. Transformed risk-return characteristics of assets through tranching.
  3. New forms of contractual balance-sheet maturity transformation through structured investment vehicles (SIVs), conduits and mutual funds which enabled short-term providers of funds to fund longer term credit extensions.
  4. Extensive trading in credit securities providing market liquidity.

Four trends in particular have occurred:

  1. Growth & changing mix of credit intermediation through UK bank balance sheets.
    • Significant financial deepening both loans and deposits as a percentage of GDP. UK balance sheet by 2007 was 500% of GDP compared to 34% in 1964.
    • Significant increases in income leverage of both household and corporate sectors.
    • Leverage growth dominated by increasing debt levels secured against assets in both household (mortgage lending 14% to 79% of GDP) and corporate sectors.
  2. Growth of complex securitization.
    • Over the last two decades the  rise of off bank balance sheet pooling and tranching.
  3. Difficulty in quantifying aggregate maturity transformation from first two changes.
    • Nonetheless undeniably increase in scale and complexity of intra-financial system claims.
  4. Growth in financial trading activity.
    • Value of foreign exchange traded from 11x global trade value in 1980 to 73x today.
    • Interest rate derivates grown from 0 in 1980 to $390 trillion in mid 2009.

4. Statistics – no Δ in y: Shows there is little evidence these changes are resulting in better economic outcomes.

Fundamental problem is volatility in the supply of credit to the real economy and biases in the sectoral mix of that credit. It is assumed that there is a trade-off between capital requirements and credit extension, risk of financial recessions and productive investment.

Bank Credit Extension

  • However, fixed capital formation in building and structures is around 6% of GDP, the same as 1964 when total lending to real estate developers was much lower and without the risk of credit and asset price cycles.
  • Gross plant, machinery, vehicles, ships and aircraft has fallen from more than 9% in the 1960s to less than 6% today.

Complex Securitized Credit

  • No data?

Market making

  • High profitability of market making/liquidity provision suggests 1) end customers value liquidity 2) market makers with market share + skill can use their knowledge valuably.
  • However, what optimal level of liquidity is is unclear.

5. Null hypothesis false?: Turner questions whether the assumption that more banking is always better is true in several key areas.

Bank Credit extension

  • Perhaps there is no trade-off between credit extension and capital requirements. You can have the latter without losing the former.

Complex Securitized Credit

  1. Market completion.
    • Although beneficial theoretically if complex structuring is for tax/capital arbitrage then it is socially useful.
    • Market completion is subject to diminishing marginal returns of increased tailoring.
  2. Increased credit extension.
    • Undoubtedly true, particularly the extension of credit to sub-prime borrowers.
    • However, lifecycle consumption smoothing benefits outweighed by credit + asset price bubbles.
  3. Better risk management.
    • Most compelling argument.
    • However two inherent problems.
      1. Maturity transformation makes financial system more vulnerable to shocks because much of the demand (perhaps half) long-term securities are funded by short-term demand (which disappeared in the crisis).
      2. Self-referential pricing leads to greater inherent instability. Particularly as credit spreads were so clearly incorrect.

Market making

  • Benefits
    1. Increased liquidity means trading at low bid-offer spreads.
    2. Lower costs per transaction mean more trading.
    3. Liquidity is valuable because it means market completion.
    4. High liquidity means efficient price discovery.
    5. Liquidity means reduced volatility because speculators are incentivized to profit from divergences in optimal price.
  • However benefits have limits
    1. Market liquidity, like market completion suffers from declining marginal utility.
    2. Speculation can lead to destablizing and harmful momentum effects.
    3. Active trading creates the same volatility which customers seek liquidity to protect themselves from.

6. Solutions: Turner offers some possible solutions.

Bank Credit Extension – 4 possible approaches.

  1. Interest rate policy takes account of credit/asset price cycles as well as CPI.Downside is cannot differentiate and knock-on effects.
  2. Countercyclical capital requirements. Downside is not varied by sector.
  3. Countercyclical capital requirements varied by sector. Downside is credit supply from foreign banks.
  4. Borrower-focused policies.

Complex Securitized credit.

  • Borrower focused constraints as well as lender policies in case bank balance sheet capital controls are evaded by going off balance sheet with securitized credit.
  • Need to develop macroprudential tools.

Market making

  1. Set trading-book capital requirements in favour of conservatism (over liquidity).
  2. Speculation (including non-bank) should be curtailed perhaps by leverage limits.
  3. Financial transaction taxes

Radical Reform – not sufficient.

  1. ‘Too big to fail’
    • Cost of bailing out banks is at most 2-3% of GDP. Real cost is the increase in public debt burdens by perhaps 50% of GDP because credit dries up.
    • Therefore futures banks should not be put into insolvency as this will lead to a sudden contraction of lending but instead impose losses on subordinated debt holders and senior creditors sufficient to ensure that the bank can maintain operations without tax payer support.
    • Also lots of small banks failing like in 1930-33 could be just as harmful as one large bank failing.
  2. Separating commercial from investment banking.
    • Separation is desirable because trading losses can lead to general credit supply constraints however legislated separation is neither straightforward or sufficient.
      1. Clear distinction between proprietary trading and market-making, customer facilitation and hedging is difficult.
      2. Just as large integrated banks (e.g. Citi, RBS and UBS) played a role so did pure commercial banks (HBOS, Northern Rock and IndyMac).
      3. Destablising interactions could still exist through the market e.g. commercial banks originating credit and non-banks buying it.
  3. Separating deposit banks from commercial banks.
    • John Kay’s proposal is that deposit banks would be 100% backed by the government.
    • Lending banks would by wholesale funds or uninsured retail/commercial deposits.
    • This would perhaps solve the moral hazard problem but not the procyclical, self-referential problem of volatile credit supply.
  4. Abolishing banks: 100% equity support for loans.
    • Kotlikoff’s proposal is that ;ending banks become mutual loan funds i.e. 100% equity funded.
    • Banks therefore would pool risks but not tranche them but this would again not solve the stable credit supply problem.

It is not just a structural problem with our institutions but a problem with liquid markets themselves.

  1. Higher capital and liquidity requirements.
  2. Countercylical macroprudential tools.

PART 2 – QUESTIONS ABOUT THE MODEL

  • Key question is allocation of capital. How do you measure efficiency particularly when it comes to new industries?
  • Liquidity is fundamentally exogenous shock risk.
  • banks work on hte assumption of indendpence but everything is connected so nothing is independent.

PART 3 – WHAT MIGHT CAUSE THE MODEL TO NO LONGER BE TRUE?

PART 4 – APPLICATIONS/IMPLICATIONS OF THE MODEL