November 28, 2007
Why banking is an accident waiting to happen
By Martin Wolf
Why does banking generate such turmoil, with the crisis over securitised lending the latest example? Why is the industry so profitable? Why are the people it employs so well paid? The answer to these three questions is the same: banking takes high risks. But the public sector subsidises this risk-taking. It does so because banks provide a utility. What the banks give in return, however, is gung-ho speculation.
Perhaps the most striking characteristic of the banking sector is its profitability. Between 1997 and 2006, for example, the median nominal return on equity of UK banks was 20 per cent. While high by international standards, this seems not to be exceptional. In 2006, returns on equity were about 20 per cent in Ireland, Spain and the Nordic countries. In the US they were a little over 12 per cent. Returns in Germany, France and Italy seem to have been close to US levels.
As Andrew Smithers of London-based Smithers & Co and Geoffrey Wood of the Cass Business School at the City University London note in a splendid report, from which I have taken these data, long-run real returns on equity in the US have been a little below 7 per cent.* Another study estimated the global real return on equity in the 20th century at close to 6 per cent.**
The remainder of this column can be read here. Debate from our guest economists appears in the comments below.
Andrew Hodge (Guest): The 2007-2008 banking crisis in a nutshell: History will view this crisis as brought on by the rise of hard-to-know derivatives, mixed with buyer ignorance and really bad accounting. With the exception of Goldman, Morgan and a few others, no one really knows even themselves what they are holding and worth, much less who they want to lend to.
I estimate more than one-third of the gains in bank and security house profit share - the major source of developed country profits gains the last 20 years - have been at the expense of their customers, or overvaluation of their own assets. They were packaged from basic parts, assembled and presented in a misleading way, and inflated in price, then carried on the customer’s balance sheet at that inflated price.
Mortgage paper is the $11 trillion biggest piece of this problem. Not just the sliced diced and derivitivized pools. Even the basic paper has an embedded borrower put, bad collateral, small eroding losses at the margin, and virtually no info on the latest borrower credit. Abetted by Fannie and Freddie, the accountants, and the rating agencies, it was all sold at inflated “retail” prices
I favor homeowner help. But this is a $350+ billion writedown problem, and a half trillion plus problem if US house prices fall 15 per cent or more. Effective homeowner help could reduce losses, but by by no more than say $40 $50 billlion. It will also cost some lender givebacks. The SIV rescue talk is misguided, trying to prop up paper prices four months now after they are seen to be unsellable at the fake prices. Its only “virtue” is delaying the CP holders from declaring default.
So these steps are offering “no” help to clear the financial markets, meaning get to tradeable prices. But the Fed is doing an exceptionally good job so far in crisis managing uncleared markets with little trust. What awaits us? Perhaps $300 billion more writedowns and large parts of financial profit flows going away. A lot more government aid will be required to clean up the behavior you and I describe
Andrew Hodge, formerly head of US forecasting at Global Insight, is an economist at the Commerce Department. He writes in a purely personal capacity
Posted by: A Hodge | December 3rd, 2007 at 6:45 pm | Report this commentMartin Wolf :I have been surprised at the absence of comment on what I expected to be rather a controversial piece. I don’t know whether this is because members of the forum think I am obviously correct or utterly wrong. Anyway, I thank Mr Hodge and agree with everything he says. But there is a big lesson here: a financial system that generates such a mess when the world economy has been growing healthily is surely fundamentally unsound, for the reasons I presented. We cannot surely continue with a system that generates quite so much private profit at the expense of so much public risk.
Posted by: Martin Wolf | December 4th, 2007 at 11:38 am | Report this comment