Reforming banking

Economist Nicholas Gruen has posted a couple of interesting articles recently about reforming banking. Our central bank, the Reserve Bank RBA, lies at the heart of the banking system. Rethinking and adapting its role more in line with the internet age could easily put thousands of dollars into the pockets of Australian households and billions into government coffers he argues.

The first brief article brief was posted in December 2016 here 

The Saturday Paper April 15-17 edition had a longer article here . (Access may be a little difficult on line but I think one view per week is possible).

The gist of Gruen’s argument is that the RBA is the wholesaler in the banking system when it comes to creating loans and deposits. All the retailing is done by the private banks. Most profits accrue to them which is easy money given that most customers pose little or no risk.

One industry after another is being disrupted by wholesalers dealing directly with customers—airline tickets from airlines, newspaper directly on line. Why not settlement services from the RBA rather than via a bank? The internet age is such we don’t need banks as middlemen to help us settle payments. The RBA could provide us all with a settlement account.

Furthermore Gruen suggests the RBA providing super safe lending to households (up to 65% of valuation) and businesses( up to 45% of prime business real estate). If the RBA charged a margin of 0.5% above its cash rate (much lower than private banks charge) and it ended up with 50% of home lending an additional $11 billion would flow annually into government coffers even with current low rates. He puts the figure at $30 billion should the cash rate go to 4% from 1.5% (presumably the margin is a % of the cash rate?).

Banks wouldn’t be too keen on the proposal but Gruen throws in a figure of a 3% improvement to GDP (no detail is offered) which is considerably more than the current government’s GDP miniscule gains that are supposed to flow from the recently approved company tax cut.

Gruen’s proposal are not the first such proposal thrown on the table for consideration. A 2014 book by Jonathan McMillan goes even further explaining how we really don’t need banks to do the things they do. There are ways to take advantage of the digital revolution to largely replace what banks do with far less regulation and also significantly reducing the amount that banks drain from consumers and the real economy. Below is a Q&A with Jonathan McMillan about the book.

The End of Banking: Q&A with Jonathan McMillan

(Copied from here.)

What would a world without banking look like, and is it a vision worth exploring? Jonathan McMillan says yes. The pseudonym for two people—an investment banker and an economist—McMillan has a front row view of the international banking landscape, and he doesn’t like what he sees.

In the book The End of Banking: Money, Credit, and the Digital Revolution McMillan explores our current financial system, taking a close look at how the digital revolution is changing it. In an effort to make the book as accessible to the lay reader as possible, he starts with an overview of banking, defining what it is and what it is not. He then does a deep dive into the mechanics of banking for those in finance and economics.

Shareable connected with McMillan, as his banker and economist selves, about the inspiration for the book, the financial problems we currently face, and what a world without banking might look like.

Shareable: What inspired the creation of The End of Banking and why are you two the best people to write it? What unique perspectives, or collaborative perspective, do you have?

Banker (B): At the beginning, there was this nagging feeling that something is wrong. Both of us were unhappy about how economists and financial professionals dealt with the Financial Crisis of 2007-08.

Economist (E): I was particularly disappointed about how science responded to the crisis. Academics tend to move in very small steps. This way, they may marginally improve existing models. However, they seem to have completely forgotten the big picture. In macroeconomics, for instance, you find not a single theory which incorporates money and credit in a meaningful way. The impact of the digital revolution on existing institutions was also barely an issue. In my view, mainstream macroeconomics is in a desolate state today. This has been rather frustrating.

B: I could not say that bankers are in a desolate state. Actually, those of us who kept their jobs are still doing very well. The thing is that financial professionals – bankers and regulators, are not interested in real solutions. They rather keep the deeply dysfunctional system we have today and enjoy the perks as long as possible.

Many outsiders – Occupy Wall Street or the Tea Party – want radical change, but they resort [to] ideological responses and lack a genuine interest in the workings of a financial system. This is not helpful either.

E: Although for me, Occupy Wall Street has had some impact. Shortly before we started with the book, a friend of mine participated in some Occupy protests. I was puzzled because the protesters did not have any agenda; they do not provide any alternative. That is true, she said, but the people who should know about the system and develop an alternative need to feel our outrage. This is why she protested, to tell the economists to provide some actual alternatives not just silly mathematical models. It was an eye-opening moment.

B: We both felt that things did not go into the right direction. Something needed to change. And who, if not us, were up for this challenge? Together, we combine hands-on experience in finance with a fundamental understanding of economic concepts. By now, we have acquired more than twenty years of experience in finance and economics. Still, when we started, we both had not even turned thirty; we neither had conflicts of interest nor much to lose. Perfect conditions to write a book called the The End of Banking.

E: Since you ask about "the best person": I am not too happy with this expression because it sounds static to me. It is not like you sit down and write a book. You grow with the task and have to develop your ideas and skills. It was an intense journey that took us about four years. There was a lot of research and rewriting involved. During this process, our collaborative perspectives gradually evolved.

Our unique view, which we developed over the years, is that the digital revolution is a real game changer in finance – far bigger than even the Fintech guys imagine today. Information technology challenges every aspect of our financial system. Most current problems – from central banks inability to regain control over the price level up to negative interest rates spreading over the world – can be explained once you adopt our perspective.

Early in the book, you clarify that banking is not confined to the institution that we call the bank, and that not all the activities banks are engaged in are banking. When you call for the end of banking, which aspects of our financial system are your referring to?

B. Our definition of banking is razor sharp: banking is the creation of money out of credit. Understanding how banking creates money out of credit, and how this activity impacts the economy is critical to understanding our modern financial system. Many people, even bankers, are unaware that most money is created by banking institutions.

E. This is a bit better in my area. Most economists do understand that banks create money. Hence, some of them support organizations like Positive Money that want banks to prohibit money creation. Positive Money is big in the UK. The problem with their proposals is that they ignore the digital revolution. They only focus on money creation within the institutions that actually call themselves banks. But information technology opened up so many new avenues to create money out of credit.

B. This is an area where my experience from working in an investment bank was really helpful. In today’s world, a big chunk of the money is created not in the old-fashioned way via bank deposits, but via fancy financial innovations. The new financial products to create money were only made possible by the digital revolution. In this context, one often speaks of shadow banking.

E. When money was only created by banks, things could be kept in check. Banking panics were prevented by insuring deposits. Side-effects of these public guarantees could be managed by closely regulating banks. But the digital revolution allowed so many new ways to create money out of credit, regulators had no chance to keep up.

On a fundamental level, the Financial Crisis of 2007-08 happened because shadow banking went completely out of control. Unchecked by regulators, all the money created via mortgage-backed securities, collateralized debt obligations and the like fueled a gigantic real estate bubble. When this bubble finally burst, people lost trust and a shadow banking panic followed suit.

B. So with the end of banking, we are basically referring to all the areas of the financial system that are part of money creation. This field is only limited by the imagination of creative bankers. It can cover financial insurance contracts, securitization vehicles or many more.

What might a post-banking world look like and why do you consider it necessary?

B. Well, first of all, it is important to see that, in the digital age, a world without banking will be a beautiful world – and this comes from a banker. [laughs]

Now on a more serious note, I think that one thing becomes increasingly obvious: Since the financial crisis, the economy is not really picking up pace again. We are stagnating and inequality has reached record levels. Both are consequences of a deeply dysfunctional financial system. And the financial system is broken because banking is out of control.

E. But if we free our financial system from banking, we can let it once again do the job that it is supposed to do: Channeling resources to where they can be put to best use, and distributing the rewards in an appropriate manner. Once modern information technology is used in a constructive manner for finance, we will see rewards we not even dare to dream of today.

Well, you might think now that everyone can say so. But we are not proposing some weird revolutionary concept. The only thing we want is to bring a well-known and proven idea back into finance: markets and competition. If we fix a simple little flaw in corporate law – as we propose in The End of Banking –, we will end up with a decentralized financial system. This has many benefits.

B. Yes, decentralizing the system will not only bring back competition. It will ultimately create a financial system in which risk, rewards, and responsibility will go hand in hand with every financial decision we take. This will have direct consequences on how companies behave. All of us will get much more power in our investment decisions. As a consequence, we can impose our values on companies and governments. Yes, we can indeed build a much better world without banking.

You argue that the current problems with banking are deeply entrenched within the financial system and that fundamental changes are needed. Where do you propose these changes begin?

B. We need to start with changing the mindset of people. Chances are that you despise banking and the culture surrounding it. However, you probably have never even considered a world without banking. The belief that banking is an indispensable part of our world is deeply entrenched in your head.

E. I agree. This is what needs to change first. We are still stuck with banking because most of us cannot imagine a world without it. If you really think hard about why we have banking, you only find reasons that no longer apply in the digital age. And once you acknowledge that banking is no longer needed, you quickly realize that we are much better off without it.

B. Banking has no longer any purpose. If I had to summarize The End of Banking in one sentence, it would be the following: We no longer need banking, we no longer want banking, and we can end banking and free finance if we only want it. Everything else will follow.

E. Yes, we should not jump the gun. The end of banking is no hype, but a vital, long-term project to adapt our financial system to the digital age. Changing the mindset is where the changes have to begin.

Your vision for a financial system without banking is different from a banking system in two fundamental ways: it separates the functions of money and credit, and it sets clear boundaries between the public and private spheres. Can you please explain the importance of these aspects?

E. This is an all-important aspect of a financial system without banking. It is the direct consequence of our proposal. I mean, if we implement the ideas put forward in The End of Banking, money will be separated from credit, and a clear boundary between the public and the private spheres is imposed. It is a situation we should very much strive for as it has many benefits. Quite interestingly, many economic models implicitly assume such a separation in the world.

B. You cannot imagine how far apart economic theory is today from practice in finance.

Let us take credit as the first example. In theory, it should be a private affair. What does this mean? If you do a good job in selecting and monitoring borrowers, you get your money back with interest. If not, well, it was your decision to lend money, so you are supposed to carry the losses. It should be just as business everywhere else is.

In practice, if you are a banking institution – that is, you create money out of credit – you will be saved by the government even when you lent money to someone with no job, no income, and no assets (the infamous “Ninja loans”). So, if borrowers repay, you get your money with interest. If they do not repay, the government will make good for it.

As such, the public sphere interferes in credit and creates a distorted “tails I win, heads you lose” situation. It goes without further saying that this is a huge problem.

E. This interference has implications for money, too. In theory, money is supposed to be a public affair: the central bank conducts monetary policy to pursue price stability and economic prosperity in the best interest for society.

In practice, however, central banks have no control over the broad money supply anymore. This is exactly because the interference in private credit markets backfires. Banking, motivated by the “tails I win head you lose” situation, creates vast amounts of money. Unconstrained banking fueled bubbles such as the one of subprime mortgages in 2007.

B. Eventually, every bubble bursts. Central banks are then expected to save the day. In the last crisis, the mess was huge. The Fed found itself forced to buy billions of mortgage loans, the same loans that fueled the bubble in the first place. Again, the public interferes into the private sphere of credit and distorts incentives even more.

E. The solution we envision thus cuts through this mess. It assigns clear roles and responsibilities. Money should become a public affair, credit a private one. In turn, prices and allocations will no longer be distorted.

As you point out, banking was a sensible way to organize the financial system in the industrial age, but with information technologies, it has gotten out of control. How can these technological tools be leveraged to create a new financial system?

B. The technological tools we intend to leverage are already used today. Loan officers do no longer extend loans based on personal judgment – IT-based scoring models do this job. Peer-to-peer lenders source money directly from individual investors and pool it into large loans for mortgages or businesses. They do so resorting to online platforms. Finally, electronic marketplaces satisfy liquidity needs across a wide range of assets.

The problem is that as long as the technological tools are used for banking, they contribute to the instability of the financial system. But if we end banking, these tools will enhance the matching of borrowers and lenders.

E. In a world without banking, competition for the best financial service will spur innovation. More and better technological tools will continuously be developed. In a way, market forces will leverage technology to create the best possible financial system.

You’ve said that the main purpose of the book is to show how to restore a functional financial system—and that how this system would be organized is of an “importance that cannot be exaggerated.” What do you hope comes out of the book? What would you like to see?

B. It may sound silly, but we hope to change the world for the better.

E. True, this foolish ambition has always been the main driver behind The End of Banking. Seeing how broken the whole system is motivated us to write a book in the first place. Changing the world might be a naïve objective, it is a moonshot project. Still, you have to start somewhere.

B. I really hope we can reach some people outside the world of finance. Financial professionals know that things are fucked up. They even agree with many of the points we make, but they benefit too much from the status quo. So, people from the real world are critical. Finance will not change itself, we have to force finance to change. So, read our book, and connect with us here to end banking and free finance.