Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Do we need banks?

More than a decade ago, in the days before the Global Financial Crisis, I asked a provocative question on this blog: “Had we invented CDOs first, would we have ever found it necessary to invent banks?” (I followed up in the early days of the crisis with a detailed comparison of banks with CDOs).

I am revisiting all this because I just finished reading a fascinating paper by Juliane Begenau and Erik Stafford demonstrating that, banks simply do not have a competitive edge in anything that they do. Specifically, the return on assets of the US banking system over the period 1960-2016 was less than that of a matched maturity portfolio of US Treasury bonds. This is a truly damning finding because banks are supposed to earn a return from two sources: maturity transformation (higher yielding long term assets funded by cheaper short term financing) and credit risk premium (investing in higher return risky debt). What Begenau and Stafford found is that their actual return does not match what you can get from maturity transformation without taking any credit risk at all.

That raises the question as to why banks have survived for so long. Another finding of Begenau and Stafford can be used to provide an answer: maturity transformation (even without any credit risk) with typical banking sector leverage is not viable in a mark-to-market regime. The banking regulators have acquiesced in the idea that the loan book of the banks need not be subject to mark to market. Making illiquid loans and taking credit risk is the price that banks have to pay to become eligible for hold-to-maturity accounting of their loan book. Banks are able to undertake maturity transformation with high levels of leverage without wiping out their equity because the loan book is not marked to market.

Hold-to-maturity accounting allows banks (and only banks and similar institutions) to carry out leveraged maturity transformation. This competitive advantage means that banks are able to make money on maturity transformation. However, they are so bad in their credit activities that they lose money on this side of their business. This offsets some of the returns from maturity transformation, and so they underperform a matched maturity portfolio of risk free bonds.

It is important to keep in mind that credit risk earns a reliable risk premium in the bond markets. Therefore, if banks manage to earn a negative reward for bearing credit risk, it is clear that either their credit risk assessment must be very poor or their intermediation costs must be very high. Interestingly, Begenau and Stafford do find that maturity transformation using risk free bonds has no exposure to systematic risk (CAPM beta), banks have CAPM betas close to one. The credit activity of the banks creates risks and loses money; in short, banks are really bad at this business.

I have always been of the view that banks are an obsolete financial technology. They made sense decades ago when financial markets were not developed enough to perform credit intermediation. That is no longer the case today.

This is particularly relevant in India where we have spent half a century creating an over-banked economy and stifled financial markets in a futile attempt to make banking viable. The crisis of bad loans in the banking system today is a reminder that this strategy has reached a dead end. As I wrote nearly a year ago:

India needs to move away from a bank dominated financial system, and some degree of downsizing of the banking system is acceptable if it is accompanied by an offsetting growth of the bond markets and non bank finance.

After the recent multi-billion dollar fraud at a leading Indian public sector bank, there has been a chorus of calls in India for privatizing state owned banks. We would do better to shut some of them down. Time and money are better spent on developing a bond market unshackled from the imperatives of supporting a weak banking system.

7 responses to “Do we need banks?

  1. oldschoolfinance March 19, 2018 at 11:16 am

    Absolutely agree with you sir, on the need for debt markets to determine the cost of funding to various projects/ endeavours/initiatives. Many FMs have repeatedly defended the role of state-owned banks to provide banking for all. If they really believe so, and such banks are not part of their quid pro quo system, they should limit the mandates of state-owned banks to retail and probably MSME banking.

    Let the market forces decide the funding rates of viable and unviable projects. But we know the hidden agendas behind controlling the capital of a country for personal gain.

    I agree with you that privatization is not the answer but so is shutting them down. It is highly unpractical given the number of employees, vote bank politics and the optics behind such a move would suggest favouring a few businesses.

    However, changing the mandate to retail banking will theoretically free such banks from the influence of politicians and big loan exposures.

    Your thoughts on this are welcome.

  2. Keshav Vats March 22, 2018 at 12:48 am

    first two links broken for me

    • Jayanth Varma March 22, 2018 at 11:10 am

      The links are working when I try it. Also, they worked when I used a cellular connection to check whether it is broken when accessed from outside the IIMA network.
      Are others having a problem?

  3. Pingback: Read, Learn, Improve – 24-Mar-18 – Random Thoughts of Analyst

  4. Pingback: Why do we even need banks?

  5. City Training UK August 1, 2018 at 3:00 pm

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  6. Ritwik Priya August 28, 2018 at 9:17 pm

    Sir – I agree that the current shape of the financial system and banking is held together more by legacy than efficiency. Banks have been hyper successful at convincing regulators and policy-makers that the incumbent is the system, to the system’s detriment.

    However the particular critique has pitfalls.

    For a particular bank, poor credit performance is indicative of poor credit assessment. For the system as a whole, ex-post poor returns simply reflect the economic performance of the underlying credits being inter-mediated. If for example, banks are providing (unwittingly?) a public service by systemically under-pricing credit risk ex-ante, thereby enabling greater innovation than otherwise, we might see much the same result. It’s not clear whether the higher credit risk premium for corporate bonds you mention is sex-ante or ex-post.

    Similarly, if bilateral bank loans that sit higher in the capital structure were somehow subsidising the growth of a corporate bond market by allowing bondholders to generate a significant premium by 1. outsourcing the task of actual credit assessment (vs liqudity/ downgrade assessment) and 2. letting go of collateralisation, we could see a similar result.

    If loans are a relationship product (as corporate IG loans often are) that allow universal banks to generate higher margin fee-based revenues (e.g. M&A), one would expect to see a systematic underpricing of loan risk premium. This would be particularly true in an underbanked market.

    Lastly, for a very long time now, banks have been largely duration matched on the rates curve (some often engage in negative maturity transformation), so a non-trivial portion of the the Treasury portfolio returns have been paid away in swap spreads.

    In general, the profit/return performance of an intermediary is an unreliable – perhaps even contradictory – indicator of the efficiency of the system being intermediated.

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