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The Lessons

What then are the lessons to be learnt? To start with, it is clear that when private players make financial decisions, limited interventions such as accounting standards, disclosure norms, behavioural guidelines and capital adequacy requirements, are inadequate restraints on the extent of risk accumulation in the system. If there are no structural and behavioural constraints, such as the restrictions on cross-sector activity put in place by Glass-Steagall, financial firms find ways of increasing profits by circumventing regulation. One form that took was the transition in banking from a buy-and-hold to originate-and-sell strategy, which allowed a geographically extensive banking system to create credit assets far in excess of what would have been the case in a more regulated system. This had a number of implications. First, the role of banks as mere agents for generating the credit assets that could be packaged into products meant that risk was discounted at the point of origination, since banks felt that they were not holding the risks even while they were earning commissions and fees. Their capital adequacy requirements did not constrain the overhang of risk in the system they created, making Basel a poor instrument to control systemic risk exposure. Second, a risk-weighted CAR based on either ratings by private firms or internal models really meant that this regulation could be diluted by ‘obtaining’ a high rating on assets that were risky. That this did happen is reflected in the fact that highly rated assets were rendered worthless in a short period when the crisis began. Third, the transition in banking meant that though banks were important from the point of view of depositors and real economy borrowers looking for short term capital, other segments of the financial system became as or more important within the overall financial structure. The Wall Street investment banks, which epitomised financial innovation, were not banks in the conventional sense and were therefore lightly regulated and not subject to the kind of capital adequacy requirements applicable to banks. They, along with the hedge funds, private equity firms and insurance companies, came to occupy crucial intermediary positions within the financial system. Moreover, the circumvention of regulation resulted in banks, which were in search of higher returns, exposing themselves to these institutions involved in more risky and highly leveraged operations. This damaged the belief implicit in the Basel framework that regulation of banks is regulation of the core of the financial system and that guidelines which treated banks differently so as not to expose ordinary depositors to high risk were effective in cordoning off the banking sector. Fourth, the thirst for profit meant that the earnings of top managers were linked to the (accounting) profits their firms made, through bonuses that exceeded salaries. As a result, the appetite for risk among private decision-makers increases tremendously. What was introduced as an incentive for performance became an incentive to speculate. Fifth, so long as fully private players adopted these aggressive strategies, even government sponsored entities and public banks had to follow this route if they were not to lose their business to private players. Public or quasi-public ownership became meaningless from the point of view of regulating behaviour. Nothing illustrated this more than the fate of Fannie Mae and Freddie Mac. Sixth, the freedom to innovate resulted in maturity mismatches in the system, as was true for example of auction rate securities which used liquid short term funding for long term purposes. When liquidity froze, those who were convinced that they were holding liquid securities found them to be illiquid, worsening the crisis. That is innovation increased the areas of vulnerability. Finally, capital adequacy proved meaningless when the crisis came because losses stemming from this structure of asset holding were adequate to wipe out the capital base that had been provided for by many banks, necessitating equity infusion and nationalisation.

The Way Ahead

These lessons from the ongoing financial crisis make clear that the accumulation of risk and the manufacture of crisis are inevitable in a private-led, deregulated financial system that makes short term profits the prime objective. Limited intervention cannot fundamentally alter financial behaviour to avoid such an outcome. When financial markets are left unfettered, the system goes through a sequence of events that inevitably generate a financial and real economy boom that soon goes bust. Strong regulation is called for. One form that such regulation can take is that put in place since the passing of the Glass-Steagall Act.  This in itself may not be a full solution today, and there could be contexts where a degree of financial integration could play a role. In particular, countries which want to use the financial structure as an instrument to further broad-based growth may need to opt for universal banks that follow unconventional lending strategies, when compared with the typical commercial bank. Many years ago Gerschenkron had pointed to the role which certain institutional adjustments in the financial sector played in the success of late-industrialisers like France and Germany. Basing his arguments on the roles played by Crédit Mobilier of the brothers Pereire in France and the ‘universal banks’ in Germany, Gerschenkron (1962) argued that the creation of “financial organisations designed to build thousands of miles of railroads, drill mines, erect factories, pierce canals, construct ports and modernise cities” was hugely transformative. Financial firms based on the old wealth were typically in the nature of rentier capitalists and limited themselves to floatations of government loans and foreign exchange transactions. The new firms, were “devoted to railroadisation and industrialisation of the country” and in the process influenced the behaviour of old wealth as well.

As Gershcenkron argued: “The difference between banks of the credit-mobilier type and commercial banks of the time (England) was absolute. Between the English bank essentially designed to serve as a source of short-term capital and a bank designed to finance the long-run investment needs of the economy there was a complete gulf. The German banks, which may be taken as a paragon of the type of the universal bank, successfully combined the basic idea of the credit mobilier with the short-term activities of commercial banks.” (Gerschenkron 1962: 13).

The banks according to Gerschenkron substituted for the absence of a number of elements crucial to industrialisation: “In Germany, the various incompetencies of the individual entrepreneurs were offset by the device of splitting the entrepreneurial function: the German investment banks-a powerful invention, comparable in economic effect to that of the steam engine-were in their capital-supplying functions a substitute for the insufficiency of the previously created wealth willingly placed at the disposal of entrepreneurs. But they were also a substitute for entrepreneurial deficiencies. From their central vantage points of control, the banks participated actively in shaping the major-and sometimes even not so major-decisions of the individual enterprises. It was they who often mapped out a firm’s paths of growth, conceived far-sighted plans, decided on major technological and locational innovations, and arranged for mergers and capital increases.” (Gerschenkron 1968: 137).

An Opportunity in the Current Bail-out

Thus, setting up Chinese Walls separating various segments of the financial sector may not be the best option. Nor could investment banks and hedge funds be abolished. What could however be done is to monitor investment banks and hedge funds and subject them to regulation, while seeking an institutional solution that would protect the core of the financial structure: the banking system. Fortunately, the current bail-out has provided the basis for such a transformation by opting for state ownership and influence over decision making.

Can this be an important step in shaping an alternative regulatory structure in developing countries, in particular? Public ownership of banks could serve a number of overarching objectives:

• It ensures the information flow and access needed to pre-empt fragility by substantially reducing any incompatibility in incentives driving bank managers, on the one hand, and bank supervisors and regulators, on the other. This is a much better insurance against bank failure than efforts to circumscribe its areas of operation, which can be circumvented.
• By subordinating the profit motive to social objectives, it allows the system to exploit the potential for cross subsidization and to direct credit, despite higher costs, to targeted sectors and disadvantaged sections of society at different interest rates. This permits the fashioning of a system of inclusive finance that can substantially reduce financial exclusion.
• By giving the state influence over the process of financial intermediation, it allows the government to use the banking industry as a lever to advance the development effort. In particular, it allows for the mobilization of technical and scientific talent to deliver both credit and technical support to agriculture and the small-scale industrial sector.

This multifaceted role for state-controlled banking allows policies aimed at preventing fragility and avoiding failure to be combined with policies aimed at achieving broad-based and inclusive development. Directed credit at differential interest rates can lead economic activity in chosen sectors, regions and segments of the population. It amounts to building a financial structure in anticipation of real sector activities, particularly in underdeveloped and under-banked regions of a country.

The importance of public ownership to ensure financial inclusion cannot be overstressed. Central to a framework of inclusive finance are policies aimed at pre-empting bank credit for selected sectors like agriculture and small-scale industry. Pre-emption can take the form of specifying that a certain proportion of lending should be directed at these sectors. In addition, through mechanisms such as the provision of refinance facilities, banks can be offered incentives to realise their targets. Directed credit programmes should also be accompanied by a regime of differential interest rates that ensure demand for credit from targeted sectors by cheapening the cost of credit. Such policies have been and are still used in developed countries as well.

Credit pre-emption, aimed at directing debt-financed expenditures to specific sectors, can also be directly exploited by the state. In many instances, besides a cash reserve ratio, the central bank requires a part of the deposits of the banking system to be held in specified securities, including government securities. This ensures that banks are forced to make a definite volume of investment in debt issued by government agencies. Such debt can be used to finance expenditures warranted by the overall development strategy of the government, including its poverty alleviation component. Beyond a point, however, these roles have to be dissociated from traditional commercial banks and located in specialized institutions.

Inclusive finance of this kind inevitably involves the spread of formal financial systems to areas where client densities are low and transaction costs are high. Further, to ensure sustainable credit up-take by disadvantaged groups, interest rates charged may have to diverge from market rates. This regime of differential or discriminatory interest rates may require policies of cross-subsidization and even government support to ensure the viability of chosen financial intermediaries. Intervention of this kind presumes a substantial degree of “social control” over commercial banks and development banking institutions.

It implies that “social banking” involves a departure from conventional indicators of financial performance such as costs and profitability and requires the creation of regulatory systems that ensure that the “special status” of these institutions is not misused. In sum, “inclusive finance” as a regime is defined as much by the financial structure in place as by policies such as directed credit and differential interest rates. To ensure compliance with financial inclusion guidelines, governments can use and have used public ownership of a significant section of the banking/financial system to ensure the realization of developmental and distributional objectives. This was recognized by governments in many countries in Europe, where banking development in the early post-World War II period took account of the vital differences between banking and other industries. Recognizing the role the banking industry could play, many countries with predominantly capitalist economic structures thought it fit either to nationalize their banks or to subject them to rigorous surveillance and social control. France, Italy and Sweden are typical examples in this respect. Overall, even as late as the 1970s, the state owned as much as 40 per cent of the assets of the largest commercial and development banks in the industrialized countries (United Nations, 2005). An example of a more recent successful transition to inclusive finance through nationalization of a significant part of the banking system is India post-1969.

Public Ownership and Inclusive Finance in India

India’s achievements with regard to financial sector development after bank nationalisation have been remarkable. There was a substantial increase in the geographical spread and functional reach of banking, with nearly 62,000 bank branches in the country as of March 1991, of which over 35,000 (or over 58 per cent) were in rural areas. Along with this expansion of the bank branch network, steady increases were recorded in the share of rural areas in aggregate deposits and credit. From 6.3 per cent in December 1969, the share of rural deposits in the total rose to touch 15.5 per cent by March 1991 and the rural share of credit rose from 3.3 per cent to 15.0 per cent. More significantly, with the target credit-deposit (C-D) ratio set at 60 per cent, the C-D ratios of rural branches touched 64-65 per cent on the basis of sanctions. Sectorally, a major achievement of the banking industry in the 1970s and 1980s was a decisive shift in credit deployment in favour of the agricultural sector. From an extremely low level at the time of bank nationalization, the credit share of the sector grew to nearly 11 per cent in the mid-1970s and to a peak of about 18 per cent (the official target) at the end of the 1980s.

Conclusion

This example illustrates the positive effects that public ownership can have in varying contexts. But this is not to say that this one advance can resolve the crisis and guard against future instances. Unfortunately, efforts are already on to prevent such a direction in policy. In November 2008, Nout Wellink, Chairman of the Basel Committee, announced plans to formulate “a comprehensive strategy to address the fundamental weaknesses revealed by the financial market crisis related to the regulation, supervision and risk management of internationally-active banks.” “Ultimately, our goal is to help ensure that the banking sector serves its traditional role as a shock absorber to the financial system, rather than an amplifier of risk between the financial sector and the real economy,” Wellink reportedly said. However, many feel that if we drop the hyperbole this amounts to nothing more than choosing to apply grease paint on a spent actor. By way of curtain raiser all that the Committee can offer are likely decisions “to strengthen capital buffers and help contain leverage in the banking system arising from both on- and off-balance sheet activities.” According to the Committee’s press release, the key building blocks of the strategy would include:

• strengthening the risk capture of the Basel II framework (in particular for trading book and off-balance sheet exposures);
• enhancing the quality of Tier 1 capital;
• strengthening counterparty credit risk capital, risk management and disclosure at banks; and
• promoting globally coordinated supervisory follow-up exercises to ensure implementation of supervisory and industry sound principles.

In short, more of the same, perhaps with a new title such as Basel III. Coming after a crisis that showed that the Basel framework is no insurance against a crisis and in fact contributes to precipitating it by permitting banks to operate with inadequate reserves, this is an unconvincing response at best. In fact, many see it as a manoeuvre to avoid much-needed reregulation. Others see it as an exercise to salvage the Basel framework, which some policymakers have demanded should be scrapped.

References

Business Cycle Dating Committee, National Bureau of Economic Research (2008), Determination of the December 2007 Peak in Economic Activity, December 11, available at http://www.nber.org/cycles/dec2008.html, accessed December 15, 2008.

Gerschenkron, Alexander (1962), Economic Backwardness in Historical Perspective: A Book of Essays, Cambridge, Mass.: The Belknap Press of Harvard University Press.

Gerschenkron, Alexander (1968), Continuity in History and Other Essays, Cambridge, Mass.: The Belknap Press of Harvard University Press.

Kareken, John H. (1992), “Regulation of commercial banking in the United States”, in Peter Newman, Murray Millgat and John Eatwell (1992), The New Palgrave Dictionary of Money and Finance, Vol. 3, London: The Macmillan Press Limited, pp.315-319.

Organization for Economic Cooperation and Development (2000), The Service Economy, Paris: OECD.

Organization for Economic Cooperation and Development (2008), OECD Economic Ourlook: Preliminary Edition, No. 84, November 2008, Paris: OECD.

Shiller, Robert J. (2008), The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do About It, Princeton: Princeton University Press.

World Bank (2008), Global Economic Prospects 2009: Commodities at the Crossroads, Washington D.C.: The World Bank.

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