How Banks Became Parasites

The banking sector should have shrunk after 1970. But it didn't...

I HAVE been having a number of interesting discussions with a friend who works for a very large international bank, the sort that some call "Too Big To Fail". His opinion is that most of today's banking and financial system is basically unnecessary, and, consequently, parasitic in nature, writes Nathan Lewis at New World Economics.

What are banks' role in society today? First, they operate a payments system. These are your checking accounts and so forth. Second, they are conduits of capital, making loans mostly to small entities like households and small businesses. In the US in particular, businesses of any considerable size use direct corporate bond finance instead. In Europe and Asia, banks still have a role providing loans to large businesses.

In effect, banks take many small loans, such as mortgages or small business loans, and transmute them into a simple generic product, a bank deposit or bank debt. Banks were highly regulated, so that they wouldn't get into trouble.

"Banks," broadly considered, also includes various Wall Street activities. Traditionally, this consists of offerings of equity and debt – the corporate bonds mentioned earlier, and new offerings of equity. In other words, Wall Street raises capital for corporations. The brokers also maintain a secondary market in issued equity and debt. These are your Ameritrade accounts and so forth, and their institutional equivalents.

Banks, in themselves, provide no useful goods and services to society. However, by facilitating the flow of capital to worthy companies, they help those companies provide useful goods and services.

This is roughly what the US financial system looked like in the 1960s. By all appearances, it worked fine: growth was high, non-financial industries were healthy, unemployment was low, debt was manageable, and the US middle class steadily became wealthier.

Like any business, the banking industry wanted to grow. However, its natural business was shrinking. As mentioned, their mainstay corporate lending business was shrinking, because corporations were raising capital directly through bond offerings. In the early 1970s, brokerage commissions were deregulated, and have today fallen to very low levels. The investment bankers still get paid well for offerings of equity, but simple bond offerings, for corporations, municipals and the like, have become a low-profit commodity business.

Statistics on corporate bonds show the process of disintermediation that has occurred. In the US, corporations have $4,967 billion of corporate bonds outstanding, and $1,395 billion of bank loans. This compares to the eurozone, where corporations have €4,761 billion of bank loans, and €882 billion of bonds. In 1968, US corporations had $139 billion of bonds and $105 billion of bank loans.

If anything, the financial industry should have shrunk between 1970 and today. Like many businesses, over time banks have found ways to get the job done with fewer and fewer people. This increases productivity, and frees up people to contribute other things to society. As former Federal Reserve chairman Paul Volcker said in 2009, the greatest financial innovation of the past twenty years was the automatic teller machine. The financial industry should have been like the agriculture industry, which manages to produce more and more food with fewer and fewer people.

Volcker's comment was, in my opinion, not just a joke. It was a realization, from his lifetime of involvement in the financial industry at the highest level, that virtually all of the "financial innovation" of the past three decades produces no positive social benefit. "I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth – one shred of evidence," Volcker lamented.

Most of the useful functions of the financial system – the payments system, and loans to individuals and small businesses – are accomplished quite readily by thousands of regional and local banks. Europe and Asia still have some need for giant banks, to make giant loans to giant corporations, but in the US in particular, relatively small banks are capable of virtually any necessary banking functions.

A shrinking industry naturally leads to consolidation. My friend says that, as the brokers and investment bankers saw their business shrinking, they naturally wanted to get into commercial banking, thinking that's where the money was. As the commercial banks saw their business shrinking, they naturally wanted to get into broking and investment banking, thinking that's where the money was. Both discovered that the other guy's business was also shrinking.

Faced with this fundamental problem, the banks engaged in a variety of new activities which, inherently, did not produce a positive outcome for society. However, the banks were able to channel greater and greater resources toward themselves. In old terminology, they became "rentiers." I would say that they have become parasites, which means the same thing.

One such activity was "proprietary trading," which emerged in the 1970s. Brokers discovered that they had access to information regarding investment flows, investor holdings, orders, and so forth that allowed them a unique and exploitable advantage. Of course, any money that the brokers make in this fashion is money that is lost by other investors.

Instead of simply maintaining the secondary market in securities, and charging a small fee for transactions, they became parasites upon it, sucking out a steady flow of resources from the rest of society. In some recent quarters, Goldman Sachs declared that they made a profit on every single trading day, a feat that no hedge fund – not even those operated by Goldman Sachs – has ever replicated. Why is that? Eventually, they found that they had become influential enough to affect the markets themselves, at least in the short and sometimes medium term, thus gaining another advantage.

Another such activity was the huge expansion in consumption-oriented lending since 1970. Credit cards were rare in 1970. Aggressive promotion of credit cards, loans for car finance, vacations, second mortgages, education and so forth – considered disrespectable in the 1960s — have left many US households buried under a mountain of obligations.

Ideally, lending goes to finance some project which produces a new asset. The asset should be worth more than the value of the loan, and ideally should be able to pay off the loan. A loan to buy a house can fall under this category, as often the house rises in value and the mortgage payment is simply a substitute for existing rent expenditures. An investment in education can be productive, if the result is higher skills and higher income to pay off the loan. However, a loan to finance a vacation or other such consumption does not create a new productive assert.

As many have observed, the availability of loans to finance houses or education has led to much higher prices for houses and education. Although it may seem that the availability of mortgage lending in the US helps to promote homeownership, in fact that may not be the case at all. In Mexico, where incomes are much lower and home mortgages were not available until the last few years, the home ownership rate is 80%. The highest point reached recently in the US was 69.0% in 2007, as the home lending bubble reached its apex. Only 13% of homes in Mexico have a mortgage, compared to 70% in the US

India has a homeownership rate of 80%, and Tegucigalpa, Honduras, has a rate of 79%.

I will continue on our theme of what the financial system should look like, compared to how it looks today. In the meantime, you may wish to take a look at the work of Boston University professor Laurence Kotlikoff (kotlikoff.net), who has come to a similar conclusion.

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