The post-Lehman financial system is its own source of risk - so why put up with it?

The cost of credit to the financial system is now higher than it is for industrials. The financial system has become a source of autonomous risk. Why do we need it, then?

Tony Curzon Price
Tony Curzon Price
16 July 2012

What are banks for?

The other day, I was approached to see if I'd put some money in a risky venture. Actually, on a moment's reflection, it was an unbelievably risky venture. An acquaintance of an acquaintance was reputed to be a brilliant mechanic but had had some previous, unspecified brush with the law for which he was just ending time in prison. Would I like to put up £10k for him to start up a garage when he got out? The returns, I was assured, would be very healthy and the man was utterly trustworthy, whatever it was he was inside for.

It didn't take me long to come to the view that much as I'd like to help someone to restart their lives, the chances of seeing my £10k again were slight. Quite apart from the risk that the person in question was not indeed reformed, it can't be that simple to make an honest pound as a mechanic ... there's hardly a shortge ... And I don't have lots of sums of that size lying around ... so I quickly decided to pass.

But a local bank manager - were there still such people - might have given this particular entrepreneur a proper look. After all, if you back 10 garages, then the risk they all go belly up is reduced. You gather local knowledge, you assess the good character of your borrowers and you poll the risk. I'm not saying the bank manager would have invested. But he might have done. He might especially have done if one of those Tory policy favourites, the social impact bonds, could have complemented the returns on the assumption that a garage would have kept the mechanic out of trouble. So, in the old days, I might have put my £10k savings into the bank and that might have made its way into a spread of projects like the one that I was personally too risk-averse to try myself.

One feature of that simple business model is that the borrowing costs to banks will be lower than the borrowing costs to individual businesses. That essentially is the point of the pooling: the acquaintance of my acquaintance would have had to pay me a huge interest rate to overcome my skepticism, but a bank manager playing the averages could have got my deposit for much less. The function of a bank, if you want, is to act as an insurer of debts, an institution that averages out the vagueries of business and allows small savers to invest while clinging n to the sleep of the just.

The shocking thing is that ever since Lehman Brothers went bust, banks have been doing the opposite of this: they have been risk magnifiers. The remarkable graph (referred to in an excellent VoxEU piece by Manmohan Singh and Peter Stella) shows that for the first time in 3 decades - actually, for the first time since the 1930s I would guess - industrial companies have been able to raise money more cheaply than financial companies. 


The graph shows that the spread over the base rate of "decent" investment opportunities (BBB grade) for fianncial borrowers and for industrial borrowers. During the great deleveraging, from 1998 to 2007, financials found it cheaper to borrow than the industrials that they typically finance - however pathologically, they were fulfilling their "ordinary" role. Since autumn 2008, however, savers have had to be compensated for handing cash over to financials rather than the sorts of industrials that banks are meant to be lending to. In other words, banks are now injecting uncertainty into the system. (The VoxEU article is well worth a read to get a sense of why the current global financial system is quite so stuck).

The financial sector, in other words, has become an amplifier of risk - an automonous source of uncertainty. There is no better picture or proof of the casino nature of the modern financial system than this: it is cheaper to get credit from outside the system than inside it. Think of it this way: at the level of the global economy, it is now percevied to be safer for the individual saver to put money into corporate bonds - the equivalent of me lending my acquaintances's acquaintance £10k - than to put it into a savings account.

Can anyone remind me why we're so desperate to save these risk-amplifying institutions?

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