The Problem with Banks

Volume 4 Issue 3 October-December 2012

Abhay Kumar

Lena Rethel and Timothy J. Sinclair (2012), The Problem with Banks, Zed Books Publishing House London & New
York, Price Rs. 1091, pages- 147, ISBN: 9781848139398.
About the Authors It was expected that self regulating free market will
bring well-being and overall development but financial
Lena Rethel is Assistant Professor of International
crisis has proved it wrong. Recent financial crisis was
Political Economy at the University of Warwick and her
a result of the profit making lust that was linked to risk
research work includes mainly Capital market
taking. Compensation was based on risk taking, therefore
development, the emergence and challenges of Islamic
identification, calculation, pricing and packaging of
finance and the relationship of finance, debt and
risk was at the heart of modern financial market. Banks
development.
have become speculator with others' money without
Timothy J. Sinclair is Associate Professors of any accountability and liability. Banks' attitude towards
International Political Economy at the University of risk has changed. Risks of banks have increased many
Warwick and his research focuses on politics of global folds as they have started taking higher risk for making
finance and theories of global governance. more money. Authors are of the opinion that the
government not only regulates banks but also creates
About the book
and shapes their behavior and role. According to the
Over the last five years a lot has been written about book, government debt has increased by 86% during
problems of the banking sector. This book offers a the three years following the sub-prime crisis. Various
thoughtful contribution to the debate on various strict domestic and global regulations could not prevent
problems banks face before and after the sub-prime banks from global financial crisis that has eaten away
crisis. The authors argue that banks are very troublesome tax payer's money in bailout packages. Finally the book
institutions, they borrow short and lend long. They look gives an overview of what is happening in financial
for short term and ignore long term benefits of the markets. The book is divided into six chapters to explore
society. They don't take any decision in public interest various dimensions to understand the problem of banks,
but when they fail they are bailed out with public and suggests solutions.
money. US sub-prime crisis bailout has cost the public Chapter 1 describes how the evolution of banking sector/
over $5 trillion. The book draws the reader's attention financial institutions and framing of regulations by
towards political and economic issues. The authors government have systematically influenced the sector.
have tried to seek answers to some of the central The evolution of bank-like financial institutions can be
questions. What is the Problem with Banks? Why do traced back to around 2000 BC in Babylonia where
they seem to be at the center of economic and financial lenders were based in temples doing transactions of
turmoil down through ages? What is the difference accepting deposits and sanctioning loans. First financial
about the most recent banking crisis? Deeper information instability was witnessed during 33 AD when lenders
is catered with the help of large number of referenced were losing confidence in the institution. The then Roman
academic studies to support the arguments that make Emperor Tiberius stepped in as a lender of last resort
the book interesting. and brought the confidence back. Europe is linked with
many banking and financial crises historically. The
Review
growth of industrialization brought frequent banking
The book explains the circumstances that have driven crises such as the collapse of BCCI and Barings in Britain
the banks towards self regulation. in mid 1990s. These collapses have compelled the state
to develop tools necessary to regulate the financial

IMJ 107 Abhay Kumar

markets. The concept of central bank emerged during and other participants have made banking like a musical
the late seventeenth century, when the Bank of England chair game, everybody (citizen, business and
was incorporated in 1694 by royal charter as a private government) dances while music plays and runs towards
company. United States too has witnessed a number of a chair when the music stops. But the regulator
financial crises; in 1792 Bank of New York had witnessed understands that chairs are not sufficient for everybody,
a bank run, followed by bank failure in 1818-19 and so they try to keep the music playing. Once confidence
financial crisis during great depression of 1930's. Further is lost (as happened in 1930s and 2007-09) bank runs
US also faced a saving and loan crisis in the late 1980's occur which may lead to financial paralysis. To maintain
and the sub-prime crisis early in the twenty-first century. confidence at times of crisis, state always stands ready
as a lender of the last resort. Banks' balance depends
The Great depression of 1930's made banks to split on
upon confidence; those institutions not doing well would
the basis of types of operation after enactment of Glass-
have different values than those doing well.
Steagall Act, 1933. The Act has not proved effective in
making the banks "Crisis Proof". A series of bank failures Chapter 3 focuses on the impact of financial
and success of European style universal banking model disintermediation on banking. Disintermediation and
compelled repeal of the Glass-Steagall Act in 1999. After financial innovation have taken place in banking sector
Europe and USA it was the turn of Asia to be hit by post 1990s. Because of disintermediation, banks have
various financial crises. Banking crisis of Japan in 1927 to compete with efficient and cost effective capital
affected its colonial dependency. Another big financial markets. Liberalization and deregulation during this
crisis in Asia started in Japan during 1990s. This crisis period have encouraged borrowers to seek alternative
spread wider across the East Asia region and continued forms of finance by borrowing directly from the market.
till 1997-98, and demonstrated how financial instability Disintermediation, which is the process of eliminating
in one country can affect other interlinked countries. the middlemen, has benefitted both borrowers and
These banking crises in all continents shaped the lenders. Borrowers can obtain funds from outside at a
boundaries of future financial arrangements and gave lesser cost and lenders can earn more than what they
way to the government to step in as a regulator to earn from banks. The cost of bank intermediated loan
protect the savings of people. The development of is always more as banks need to maintain a certain ratio
democratic setup has also pressurized the government of reserve assets to loan outstanding, and they also
to avoid cost of future bailouts. charge for infrastructure cost as well as for NPA of
funds. Bond market has flourished because of its cost
Chapter 2 provides a glimpse of what exactly banks are.
effectiveness and got further boost from Asian financial
What is the nature of the banks? In reality banks are
crisis of 1997-98; this development has led to significant
not strong rooms or counting houses. They don't store
decline in the share of banks' lending over the last
money safely for their customers. Banks have to pay
decade. So what is the way out for banks? Should banks
interest on the deposits so they lend most of the fund
give away the traditional role of intermediation and
in the market and earn interest on it. They keep
become active as market participants? Now they have
approximately 10percent reserve to meet customers'
a new role to play i.e. trade, securitize the loans and
requirements. Most of the deposits accepted by banks
device new types of financial products. This process has
are lend out but problem arises when they borrow for
forced the banks to give up their role as a gatekeeper
short term and lend for long term. This creates maturity
in the financial market and made them to reduce the
mismatch and increases doubt on the bank's ability to
margin approximately from 2.5 percent to 1.5 percent.
cover demand on depositor's funds. Sometimes banks
lend more than they borrow which creates additional Repeal of Glass-Steagall act provided the much needed
pressure on the banking system. Confidence on the support, banks moved into the market with full speed
banks could not be built based on its efficiency of by strengthening their investment banking business.
operation but state participation alters the rule. State For example: Deutsche Bank acquired Banker's Trust

IMJ 108 Abhay Kumar

Corporation, merger between Chase Manhattan and JP performance linked bonus was left to the market forces.
Morgan in 2000 and acquisition of Bank America Most often, remuneration was linked to risk taking
Corporation by Nationals Bank. Banking has capacity of investment bankers. Bankers' focus shifted
transformed as a shadow banking system (investment towards taking more risks and earning more, rather
banks, hedge funds, money market funds and insurers) than safe keeping of deposits.
and started creating complex financial engineering that
US was first to adopt self regulation. Initially it was
was a main cause of the sub-prime crisis. Structured
slow in Europe, yet they implemented Basle accord of
finance in the form of security of package of debts
1988 in the second banking coordination directive in
(credit card borrowing, car loans & mortgage) started
1989. Further they have also adopted Basle II accord
selling like hot cakes in the financial market. The owner
in 2006. Basel II was based on three principles: a) Risk
of this security has a claim on the revenue of these debts.
weighted minimum capital requirement b) Periodic
This process of securitization helped in converting
supervision, and c) Market discipline. Basel II also
illiquid consumer debt into financial market assets.
pushed the idea that, bigger the bank the better equipped
These securities were then sent to credit rating agencies
they are to handle worst situations. Self regularization
for rating. Rating agencies rated the instruments (most
has helped Regulatory in decreasing their strength.
often "AAA") on the basis of their past performance
Federal hiring is reduced by 20%. Malaysian central
without having any clue towards future paying capacity.
bank has reduced the staff by 50%. Reduction in staff
Sub-prime crisis made Lehman Brothers bankrupt and
has reduced the regulatory check, and impact was visible
US government had to bailout by paying $182 billion
in the form of financial crisis. Market driven
to the insurance company, America International Group
remuneration system has further increased turnover of
(AIG). Further to revive the market, US Federal Reserve
the regulatory staff. They move towards private sector
followed easy money policy to keep the cost of borrowing
as they offer much more attractive compensation than
cheaper. This policy led to the decline in interest rates
the state owned regulatory authority. For example,
thereby reducing the margin of the banks. Naturally
Secretary of UK Treasury was drawing £.18 million
this made banks to look for products that can earn them
whereas CEO of Royal Bank of Scotland had drawn £4.2
higher returns.
million in the same year 2007.
Chapter 4 explains the impact of self regulation on the
Things were different in East Asia; policy makers were
behavior of the banks. Government has liberalized
pragmatic and things like credit control, capital control
regulations and has tried to push responsibility for
and variable reserve requirement were in force. In the
prudent behavior onto the institutions themselves. States
aftermath of financial crisis, South Korea, Thailand,
will intervene only in case of market failure. Banks'
Indonesia & Malaysia became much more proactive
regulation develops in the social and political
towards market disintermediation.
environment locality at contemporary periods.
Regulation related to banks and financial institutions Chapter 5 elaborates proposals of reforms in banking
have changed substantially over the last few decades sector and why these reforms are not solving the
since the collapse of Bretton Woods system. Financial problems of the banks. Three areas have been discussed
disintermediation took off in 1980s and regulation in detail: macro prudential policies, ban on proprietary
became external to market operation. Interference of trading and proposal about breaking up of the banks.
regulator has reduced drastically in the day to day As regard to macro prudential policy, the authors are
functioning of the market. Authorities allowed financial of the opinion that formation and implementation of
institutions to set, enact and adjudicate rules of game. regulation is not sufficient to get rid of the problems
Banks were allowed to decide the scope of their of the banks. Simply obeying the rule is not enough in
operation, risk taking capacity and own compensation a professional culture. Reforms can be achieved by
package. Decision of compensation which includes institutionalizing the profession of banker. Specified

IMJ 109 Abhay Kumar

education and training with certificate can make them Creation of a separate organization for safe keeping of
professional like any other professionals. Volcker rule deposits and the generations of funds for investment,
was implemented to ban proprietary trading by the who can take calculated risk, can help. Banks have been
banks. But the rule has failed to control risky behavior managing short term liabilities and long term assets,
of the banks. The bankers were not in favor of breaking and have been surviving. They have been under pressure
up of the banks. They thought bigger banks are better by cheaper and multiple sources of funding. Capital
as government will not allow big banks to fail. Bigger market and money market has also eaten up the business
the banks, bigger the systematic risk it poses considering of banks. To make good returns, banks also started
its potential collapse. Therefore there is more likelihood using capital market through proprietary trading. Banks
that it will be bailed out by the government. This possible have changed character and behavior. It has posed risks
bail out guarantee of government serves as a incentive for the financial system; therefore living with the current
to the banks to go for merger and acquisition to become arrangement is foolish.
bigger. Banks readily pay premium to become big. Banks
Finally, the authors have concluded that problems with
indulge in much more riskier activities as there is no
banks is not going away any time soon. Banks are rich,
fear of collapse, thinking "Too big to fail".
problematic and fast moving institutions to produce
Chapter 6 concludes with the authors' argument that maximum profits. Banks are under great depression.
banks are not ordered, sensible institutions as suggested States have helped them to perform better but systemic
by those who run and those who regulate. It has created risk caused by them can no longer be neglected. Banks
problem for borrowers and lenders many times. Even cannot work on serving their purpose at the cost of
after global financial crisis of 2007 very few people or society. Banks have to come forward to reduce their own
policymakers have realized it. Investigative reports and problems and cannot ignore the public rage that started
policy briefs produced by various agencies also do not after 2007. State, as a maker of the banks, has to play
deal with the problems of the banks though, they can the role of a re-maker.
help in dealing with some of the issues created by the
banks. They are of the opinion that more sharp changes
Abhay Kumar is an Assistant Professor in NMIMS
are needed in the banking institutions. A broad societal university, Mumbai. He can be contacted at
consensus and more creative solutions are required. [email protected].

A few heart whole, sincere men and women can do more in a year then a mob in
a century.

- Swami Vivekananda

IMJ 110 Abhay Kumar