The social role of banks is banking

Since fox-hunting became illegal, banker bashing has become a new blood sport. Not only is the typical banker portrayed as being greedy, much of what he produces is said to be ‘socially useless’. The behaviour of our bankers, it is argued, needs to be reined in and the economy should be rebalanced so that we have fewer bankers and more people ‘making things’.

It would be highly desirable if bankers did rein in their excesses, of course. In my view, this is best done by the market mechanisms of punishing failure and ensuring the bankruptcy of failed institutions. Some of the reforms proposed in the wake of the crisis will improve matters in this respect, though I am sceptical about many of the measures being proposed by the ICB.

But what about the more general issue: is banking socially useless and should we be rebalancing our economy?

It is, in fact, difficult to imagine a modern economy without a large financial sector. The chattering classes and intellectuals often seem to think that it would be better
if much more of the British workforce were engaged in manufacturing and we had fewer money-men supervising superfluous transactions that have nothing to do with the real business of creating wealth.

But life would be intolerable without banks. Not only
do banks provide mechanisms to ensure that we can pay each other immediately for the goods and services we consume, they also provide crucial economic functions. These include screening risk, diversifying risk, reducing transaction costs and providing capital for businesses and credit for consumers. The flip side is that they also provide safe returns for savers. Without a modern financial system, retirement from work would be more-or-less impossible.

The costs and risks involved in investing, say, £10,000 without banks would be enormous. The lender would have
to seek out potential borrowers. The lender would then
have to check their credit worthiness and the viability of the projects in which they want to invest. All but the very rich would have little chance of diversifying their risk between different borrowers. And, without the mechanisms that banks use to maintain liquidity, lenders would have to wait years to get their money back. With a developed banking sector I only have to find a reliable bank and it will provide all these services. The bank screens the risk, ensures that risk
is effectively diversified, reduces transaction costs and ensures that I can have my money back more or less when I like. There are corresponding benefits for borrowers, of course, who have cheaper and easier access to finance.

Indeed, saving, investment and the financing of transactions through the payments system would be more difficult without banks than trying to survive by growing your own food.

Banks are intrinsically social institutions. They make money by providing services that people want and which would be extraordinarily expensive to procure without banks. Supine corporate social responsibility (CSR) departments
do not have to justify the social role of banks by ensuring that they give part of their profits to charities – the social role
of banks is banking.

Would we be better off with a smaller banking sector and
a more diversified economy? Probably not. It is possible that, without the implicit taxpayer guarantee to banks, our banking sector would be smaller, but certainly we should not try to ‘rebalance’ our economy artificially. It makes no more sense for Britain to diversify its economy than it does for me to diversify my working week and work for a day in a butcher’s shop, a day stuffing teddy bears, a day as a nurse and a day teaching. In advanced economies we do what we are best at and trade with others who do what they are best at. Indeed, it is the export of services that allows us to enjoy manufactured goods in abundance. The UK had a £46 billion trade surplus on financial and professional services in 2009. Even if banking were socially useless, Britain seems to make a good living from exporting such services and using the money to buy manufactured imports.

It is about time those in the banking industry educated people about the fundamental economic value of banks. In my view, there is no room for taxpayer-funded bailouts in this or any other industry. Ensuring that we have a legal framework so that broken banks don’t break the taxpayer is an important step in winning the PR battle. But, until the banks are able
to justify their existence and explain their economic functions to the wider public, the left-leaning intellectual elite will have a field day from undermining banking and financial services. If they succeed, we will all be much poorer.

This article originally appeared in the Autumn 2011 edition of Balance, the magazine of the British Bankers' Association

There's a lot of sense in this article, of course. However, when Philip Booth says "Indeed, it is the export of services that allows us to enjoy manufactured goods in abundance. The UK had a £46 billion trade surplus on financial and professional services in 2009." he really isn't correct, or a least he is only partially so. The biggest export earner by far is still the manufacturing sector (about half our exports) - financial services are, by comparison, a relatively small (but not insubstantial) export earner. So manufacturing exports, more than anything else, allow us to import imported manufactured goods - plus, of course, the trade deficit. My point is that there is no real prospect of strong recovery without a substantial increase in exports - and this will primarily mean an increase in manufactured goods exports (as happened after the early 90s recession). Like Philip Booth, I don't think that manufacturing should be specially favoured, but we could do with a reversal of the situation of recent years where the banking sector has been treated more favourably and where more and more of our national resources have been funnelled by government into the public sector which, unlike the manufacturing sector, isn't exposed to international competition.
HJ - what you say is true. I tend to take the view that (though it is a general equilibrium problem to use the jargon) the big driver of the trade deficit (ie the broadly exogenous variables) are domestic saving relative to domestic investment and government borrowing. Unless domestic saving increases (and the welfare state must have something to do with that) and/or government borrowing decreases then we will have a trade deficit. The high level of government spending/borrowing is especially detrimental to manufacturing because it affects the traded goods sector more than the non-traded goods sector and also government spending is concentrated in areas of the country that might otherwise specialise in manufacturing. I think that is a long-winded and jargon-ridden agreement with you!
I'm the CEO of Zopa. The costs and risks of investing say £10,000 without banks would NOT be enormous via an established P2P lending site such as Zopa. The transaction costs are lower than doing so via a bank as witnessed by the fact that both sides (lenders and borrowers) get a better deal than they would through a bank. Risky? Our credit performance has been miles better than any bank over the last 6 years, with default rates below 0.9%, below the figure forecasted to lenders at the outset to allow them to set their rates. Lenders can be diversified while only lending £500 so it is hardly for the very rich. We can also provide liquidity to lenders (or savers) by allowing them to sell on their interests to others in a highly liquid marketplace, without adding structural risk into the system through leverage. Seems a better model to me and criticism of bankers perfectly fair.
the main premise of this article is to suggest that because they serve society, they must be of social benefit. That is intrinsically flawed. Surely its silly to suggest that society would suffer if the current banks weren't there. Surely history has shown that society - like nature - abhors a vacuum and all that would happen is that an equivalent would take over? Given that we live in an increasingly socially moderated world, its fair to assume that any such new order would be socially regulated rather than legally; that we would lend to each other and pay each other directly rather than pay a bank and then go cap in hand to try to squeeze some (of our) money out? We should look to P2P Banking like Zopa for our future - then ask ourselves "who is holding this back?" The answer will come as no surprise. Its the current banks and the regulatory systems they themselves designed and manipulate. Social banking? Bring it on.
Ah the left-leaning intellectual elite... And what of our fore-fathers the bank founding philanthropists, good Quakers all (I should know I am descended from many of them) Lloyds, Barclays - social indeed in their supine CSR, building housing, schools and churches even (how mindful of others' beliefs was that?)... There are countless savers in this country who would disagree with you that banks provide safe returns for savers, and pension holders who see their retirement on an increasingly distant horizon, not to mention those who dispute the banks' creation of wealth as far back as Frederick Soddy. How very good of you to engage your debate with the intellectual elite. Oddly, if you accorded the same respect to the British workforce who have been literate for some time - in large part thanks to the aforementioned philanthropists - you would find them quite articulate in demanding more from our banks. I respect your view that tax-payer funded bailouts should not be accorded to any industry, but they have been given the banks and the ROI is not forthcoming. Banks should not underestimate the power of consumers. Market forces cannot exist without them. Banks social role must now be to listen rather than to assume a need to educate.
@giles, neil - I don't follow your point at all. You seem to be saying that because competition, whether resulting from the technological changes and entrepreneurship that fired zopa or otherwise, may provide alternative mechanisms of providing some of the services (though not, currently, on a widespread basis, payments systems) then banks do not provide a social function. I look with indifference to the future when Barclays may be the size of zopa and Zopa the size of Barclays. None of this means that banking itself does not have important social functions. I accept that some of the phraseology I used might have implied that these functions could not be provided any others way - which of course is not correct, money market mutual funds and securities markets more generally do so. @Emma - I am certainly not against philanthropy (indeed that is an understatement, I am a huge supporter of it and have written to that effect). However, the philanthropists you describe were, on the whole, owners spending their own money. That is not what modern CSR departments of publicly quoted companies do - and most of their effort is not, I am afraid, related to provision for charity either. Also, whether such activity is a good thing or not, what I am saying is that banks do not have to do that activity to be seen as providing a social function - their bread and butter business is social. I am not sure why you assume I do not afford the same respect to what you describe as the "British workforce" - though I prefer to see them as people rather than use a collective noun that makes them sound like an army - and I am also not sure why you think that savers have not had safe returns. Finally, I am also not sure why you drag in pensions which are not provided by banks. Indeed, the reasons for the poor returns people have received on their pensions are mainly 1. improved longevity 2. low interest rates at retirement and 3. very low equity returns. Certainly reduced profits for banks will not help 3 (though I would not support raising bank profits by impeding competition, by bailing out or by any other mechanism just to help pensioners). It is competition and not banks' CSR departments that will sharpen the social contribution of banks or lead that contribution to be provided by others - that is where Giles is completely right. I have a strong view that it is the owners of companies and not the managers who should make the charitable contributions.
@Philip – I wasn’t saying banks can’t or don’t provide a social function but arguing with the assertion in your original piece that there is no alternative to them, which you now accept was not correct. If competition drives banks to improve the value they offer to consumers or indeed their social contribution, that would be a good thing, but they will have to be dragged kicking and screaming.
@ Giles Andrews - Philip Booth's argument is not that there is no alternative to current banks, but that there is no alternative for the type of functions that banks perform. Clearly there is a demand for these functions, or people wouldn't pay for them. He's not saying that the market couldn't provide alternative methods and mechanisms for providing these functions - indeed, one of the wonders of a market system is that all sorts of providers of goods and services try their luck and only the most effective prevail. Perhaps the biggest problem with the current banking sector is that it really isn't a free market. It is highly (but in many ways ineffectively) regulated, providing large barriers to entry (how often do new banks enter the market? Almost never) and irresponsible behaviour is encouraged by taxpayer guarantees (as we have seen).
OK - we seem to be crystallising down to the lowest common denominator of banking that we have to have them because no one else can afford to create the back-end, core systems - payments and inter-bank transfers and I guess, ATM network. Well, fixing that is easy. And if the State and regulators is serious about promoting competition, all they have to do is take that back-end monopoly on these away from the banks. This would be useful in many other ways: Firstly, it would remove the principle barrier to entry of the banking market. Even MovenBank is being forced to use existing banks to process transactions, inflating their costs enormously. Secondly, by charging a true cost for delivery, any new bank would be able to find a niche for itself, allowing boutique banks to flourish on a level playing field to existing banks. Thirdly, it would be an opportunity to the existing players to show what they could do on that playing field. Could they compete without an artificial advantage? It would certain cause a breaking of their ranks and removal of the existing cartel. We might see them compete with each other! Anyone remember that Barclays once wanted to reduce cheque clearance to one day, but NatWest objected and it stayed at three? Fourthly, it would encourage those who have excelled in other markets (Ezibank, RyanBank, Googlebank?) to bring a breath of fresh air to a stuffy, suffocating sector, offering real choice and hopefully, innovation. All very well, you say, but who would provide these services? Well, I think we all need to accept that no core "utility" should ever be delivered on a profit basis. How can it when there is no choice? That's immoral. The services should be delivered by the Bank of England or some state franchise and charged at cost of delivery - maybe a North-South version for resilience and some competition for efficiency. Advantages? Many. High regulation. No illegal off-shoring of funds, no money laundering, full visibility. In other words, I'm suggesting a market full of specialist, boutique banks providing unique front-ends each serving their own market sector like mobile, high-street, mortgage, savings, business, credit finance, private all with the same cost of delivery through a state or franchised back-end delivery framework. Now, someone tell me why not?

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