Should Banks Take Their Losses Through Free Market Mechanisms.

Some business owners tell me that they believe the mainstream financial sector has convinced an entire generation to buy and hold because it suits their business model that is asset-driven rather than performance-driven. 

Are the bulk of financial institutions simply regulatory oligopolies with asset-harvesting business models more concerned with fees and proprietary speculative activities than with providing any useful services to savers and retail investors? Is this a true reading of the finance industry?

My husband was a financial analyst for a broker dealer and they would only issue reports on buy or hold or sell because their brokerage would process the changes and charge a fee. That model has changed. Large financial firms in the USA appear to have an intrinsic institutional bias to be bullish. Where is their incentive to tell you not to invest in something, as they will usually be operating a fund in that area. This need to keep the investor invested is causing sophistry as being "underweight" unattractive asset classes rather than encouraging selling.  The investment insight is too often: sit tight, everything will go up in the long-run. These conversations about concern over stock performances are becoming common and there is an increasing noise. Most of these entrepreneurs are not critics of the financial sector, and neither am I. They appreciate their role. So what is the problem? Has the sector become too large? Did the corporate finance whiz kids take the reins from the bankers and change the race too much?

Here are the questions I have heard from business owners over the past few years:

Question 1: What is the Profitability of Banks?

Corporate profits attributable to the US finance sector were effectively stable from the 1950s to the early 1980s from 5% to 15%, then as the growth in the money supply turned sharply higher on a sustained basis in the 1980s they peaked at 40% in the early 2000s and still remain around 30% - substantially higher than long term averages. 

On an asset basis the numbers tell a similar story. The 20 largest banks in the US have combined assets of approximately 90% of GDP. The five largest banks - JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, and Goldman Sachs - have combined assets of approximately 60% of GDP. These numbers are roughly 3 times what they were in the 1990s.

Canada's leading bank, TD which is now in the USA, had a thoughtful look at this very issue. The CEO asks why the bank executives should make more than the business owners. He said that if the bank is making more than those who create the wealth, that will have a long term impact on the Canadian economy. That is fantastic leadership and probably why TD is the still the leading bank in Canada and on the list of top 20 banks in the world.

The concern is the appearance of the American finance sector's intimate relationship with government and central banks. It is not surprising that it grows faster than the underlying economy. Newly printed money flows into and through the finance sector acting as a wholesale subsidy that drives corporate profits, compensation and speculation. Despite widespread belief to the contrary, government intervention into broad swathes of the financial sector to support "too big to fail" banks or, more accurately, to prevent capital destroying business activity from being eliminated to the benefit of the entire economy is not a positive for future growth.  When it is funded via expansionary monetary policy, business owners know this and see it is laying the groundwork for stagflation.

Question 2: What is the Long Term Impact of Government Bailouts?

I was fortunate to be at a speech by Stephen Roach, Economist for Goldman Sachs, who once suggested taking a bat to Paul Krugman, and I am paraphrasing:

Whatever you subsidize you actually encourage. By subsidizing failure we are ensuring bigger failures in the future and worst of all penalizing well-run businesses. He said that the firms that were prudently managed leading up to the crisis should have benefited from the demise of their poorly-run, profit over customer service, riskier competitors.  In a free economy, capital would have flowed to the profitable businesses rather than the loss making ones. The fact that this didn't happen creates a perverse "if you can't beat'em, join'em" mentality with respect to risky and imprudent business practices.  

 I worked for a bank as the corporate strategist, and it was owned by the founders and a wide pool of banks executives, then it went on the stock market. They kept their good banking practices at a cost to their bottom line growth. During the 2000s, they did not want to do high risk swaps and derivatives or risky deals and they were asked, "Are you in business or not?" Why should they now get penalized again? They lost out money on the upside and they lost out money on the downside. 

Did you see the documentary on the bail outs with the few bank heads seated around a table with George Bush and the candidate Obama and McCain? It seemed so cozy. I know it was a terrible time with the whole US economy ready to go down the chute and no one really knew what to do. Yet, the business owner I worked with at the same time period, did not have cozy talks with government leaders. Is that too much power in a few hands or is that good management? We learned later that bankers picked Obama as the Presidential candidate of choice, and fed him information (and money) not given to McCain. Is that crony capitalism? 

Question 3: Who Really Gets Helped By Low Interest Rates?

Another question asked by entrepreneurs and owner-operators dealing with banks is, What exactly is the primary purpose of low interest rate?"

We are told it is to save the economy, but is it really it is to save the American banks? It gives them time to get their house in order.

Owner-operators are getting denied loans. The CFOs understand why. After all, would you loan $10M to a business during this economic climate at a low interest rate? No. You would put it into commodity stocks or gold because for a way lower risk, you are getting a similar return. 

 Question 4: What are the Bank’s Housing Losses Doing to the Economy?

Stephen Roach actually gave me the answer. He thought the banks would be asked to eat their loans and take the hit via the free market. So far, that does not seem to have happened. 

Low interest rates are simply a case of robbing Peter to pay Paul as capital is being "strip-mined" from savers via low interest rates and in effect "donated" to the financial sector. Roach argued that the enormous size of the American and financial sector coupled with the American Bank's current insolvency, which the constant bail-outs are attempting to disguise, will be a drag on growth for years unless losses are allowed to take place via free market mechanisms.