Why do we need banks? 1: Credit
March 14, 2016
It’s quite plain to see that something is wrong with the current banking system. From crisis to ongoing scandal and outrageous bankers’ bonuses, the banks have rarely been out of the headlines, and for all the wrong reasons.
In fact, the banking system is actually causing or exacerbating some of the biggest problems of our time – whether that’s financing the fossil fuel industry, proliferating nuclear weapons, or pumping up another debt-filled bubble in our unproductive economy.
So why do we persist with it? Why do we need banks in the first place?
In the first of a new series of blog posts, Move Your Money asks whether we need banks at all – what is the social function of banks? Why are the big banks not providing this? And what are the alternatives?
One of the main reasons banks exist is to create and distribute credit.
If you’re short on cash or want to buy a large purchase (like a house, car or holiday), you can borrow money by using an overdraft or a loan. The same goes for businesses – if you’re looking to invest in something, or need extra funds to cover operating expenses, you can borrow the money from a bank.
Most of us have borrowed money from a bank at some point or other, and it can be a useful social function of banks because it can allow you to improve your life circumstances, expand your business, and create greater prosperity and opportunity within your local area. When used in the right way, borrowing money can have a beneficial effect for society.
Banks create money by advancing credit (loans and overdrafts) to businesses and individuals.
This is a crucial point to understand. Instead of lending out money that they have already received from other depositors (customers), banks create new money when they credit your account with funds.
Other than Governments, banks are the only entities that are able to create money from nothing. This gives them incredible power – not only because banks create money out of nothing and then profit from this by charging an interest rate on that money, but also because they advance this credit to anywhere in the economy that they want it to go.
Where banks choose to lend this money, then, has a broad impact on the economy, and as a result on peoples’ lives.
Given that banks are private, profit-maximising companies, banks are keen to allocate credit to wherever they will make the most money. In turn, this may not be the best place for the money to go from a societal point of view.
As shown in the chart above, banks have increasingly created money for mortgage lending and for other financial institutions over the last few decades.
This is because they can charge higher rates of interest on their newly created money in these sectors, compared to slower, smaller loans – for example to small and medium sized businesses, which account for the majority of private sector employment in this country.
This type of self-serving, profit maximising credit allocation has a number of serious consequences. It means house prices have skyrocketed, while small businesses face chronic underfunding year after year. It means financial crises become more likely, and are also longer lasting when credit creation spirals out of control.
Why do big banks do this? The simple answer is that they are structurally and fundamentally set up to do one thing: to make profit for themselves and their owners, the shareholders.
In fact, through something called “Fiduciary Duty” they have a legal obligation to make as much money as possible for their shareholders. As a result, RBS has estimated that for a big bank to be profitable enough to satisfy its shareholders, the bank has to make around 12% profit as a whole institution.
That’s quite a big margin, and so leaves the bank seeking out the highest profits in the shortest amounts of time. And as you can probably guess, investments with the highest rewards often carry the greatest risks too.
On the other side of that same coin, smaller, slower loans are less attractive – even if they are still profitable – because big banks need to make a lot of money very quickly. This leaves small businesses unable to secure funding when they need it – which in the long term has seen the British economy become less productive and more import-dependent.
Such a situation is beneficial for the biggest banks, because they can make profits in this environment. But it’s not necessarily beneficial for society, because businesses that are providing jobs and employment cant get the credit that they need, whilst the housing bubble has made homes unaffordable for many in the UK. This is more than just theoretical – it’s peoples’ jobs, their homes and their lives.
As a result, a more balanced and safer economy would include banks that did not have profit-maximisation as their core purpose, but instead a type of bank that was hard-wired to serve the needs of businesses, society and the economy. Banks that could lend patiently and without the need to satisfy shareholders with such huge profit margins.
Indeed, these sorts of banks exist all over the world, and Britain is almost alone amongst developed nations for not having them. Without stakeholder banks to counterbalance them, Britain’s biggest shareholder-owned banks are likely to continue to pour credit into all the wrong places – making another financial crisis a question of when, not if.
Next week, we’ll be looking at the second major function of banks: taking deposits