coggan 2

Money and Interest Rates


MONEY


Primitive societies did not have money, since they did not trade. When trade began it was under a barter system. Goats might be exchanged for corn, or sheep for axes. As society became more complex, barter grew inadequate as a trading system. Goats might be acceptable as payment to one man but not to another, who might prefer sheep or cattle. Even then it was easy to dispute the question of how many sheep were worth a sack of corn.
Gradually precious metals and, most notably, gold and silver were used as payment and became the first money. Precious metals had several advantages. Money had to be scarce. It was no good basing a monetary system on the leaf. Everyone would soon grab all the leaves around and the smallest payment would require a wheelbarrowful. Money also had to be easy to carry and in divisible units – making the goat a poor monetary unit. Gold and silver were sufficiently scarce and sufficiently portable to meet society’s requirements.
Of course, it soon became inconvenient to carry gold and silver ingots. Coins were created by the kings of Lydia in the eighth century BC. From the days of Alexander the Great the custom began of depicting the head of the sovereign on coins.
There are a variety of functions which money serves. It is a measure of value. Sheep can be compared with goats and chalk with cheese by referring to the amount of money one would pay for each product. Money is also a store of value. It can be saved until it is needed, unlike the goods it buys, which are often perishable. Creditors will accept money as a future payment, confident that its value will remain stable in the meantime.
Of course, today’s money is made from neither gold nor silver. Coins are made from copper or nickel, and the most valuable monetary units are made of paper. There are two main reasons for this. The first is that supplies of gold and silver were outstripped by the demands of society. If money is scarce, it is difficult for the economy to expand and for us to get richer. The second reason is the so-called Gresham’s Law that ‘bad money drives out good’. When money was in the form of gold coins, it was tempting for those with a large number of coins to shave off a tiny fraction of each coin. The resulting shavings could be melted down to make new coins. Gradually some coins contained less gold than others. Anyone who had a coin with the maximum amount of gold would have been foolish to spend it lest he received a coin with less gold in return. So the best coins were hoarded and the worst coins circulated. Bad money drove out good.
The earliest issues of money that was not backed by gold were known as fiduciary issues. Money is now totally divorced from its precious metal origins and seems unlikely to regress.
Banknotes and Cheques


The next stages of the development of money – banknotes and cheques – are dealt with in Chapter 3, on the banks. It is sufficient to point out here that banknotes were, in origin, claims on gold and silver. Now money depends on the confidence of its users in the strength of the economy. When economies break down (as they occasionally do in wartime) money disappears and is replaced by some other commodity such as cigarettes.
As money has grown more sophisticated, so it has grown farther away from its origins. Banknotes replaced coins. Cheques replaced banknotes. Now debit and credit cards have taken the place of cheques, and many people use debit cards rather than cash for shopping.
The system depends on the confidence of all those concerned. Shopkeepers accept credit cards because banks will honour them; utility companies accept cheques as payment for gas and electricity bills. Bank accounts are therefore money in the same sense as notes and coins are, since they can be used instantly to purchase goods.
Banks can thus create money. This is because only a small proportion of the deposits they hold is needed to meet the claims of those who want to withdraw cash. Much of the need is met by those who deposit cash. A simple way for a bank to lend money is to create a deposit (or account) in someone’s favour.
Suppose that a country has only one bank, which finds that it needs to keep 20 per cent of its deposits in the form of cash. It receives an extra £200 worth of cash deposits. The bank then buys £160 of BT shares, leaving £40 cash free to meet any claims from depositors. The person from whom it bought the shares now has £160 in cash, which is deposited with the bank. So the bank has £360 in deposits (the original £200 plus the new deposit of £160), of which it needs to keep only £72 (20 per cent) in the form of cash. The bank is therefore able to increase its total investments to £288 (£360 – £72) and can buy a further £128 of BT shares. Once again the person from whom it buys the shares will receive cash, depositing this with the bank. This process will continue until the bank has deposits of £1,000, of which £200 is held in the form of cash. The bank’s balance sheet will then look like this:

ASSETS
LIABILITIES
Cash
£200
Customer deposits
£1,000
BT shares
£800
TOTAL
£1,000
£1,000

(Note that customer deposits are a liability, since they might at any time have to be repaid.)
To find out the total amounts of deposits that can be created from the original cash base, divide 100 by the percentage which the bank needs to hold as cash (known as the cash ratio). Then multiply the result by the amount of the original deposit. Thus, in this example, dividing 100 by the cash ratio of 20 per cent gives 5, and multiplying that by the original deposit equals £1,000.
The cash ratio is therefore very important. If, in the example, the ratio had been only 10 per cent, the amount of deposits created from the original deposit would have been £2,000 and not £1,000. In practice, banks find that they need to keep around 8 per cent of their deposits in the form of liquid assets.
This relation between the money which banks need to hold in liquid form and the amount which they can lend has, in the past, been used by the Bank of England to control the level of credit in the economy (see Chapter 5).
Defining the Money Supply


As money has become increasingly sophisticated, so it has become more and more difficult to define exactly what it is. This issue assumed particular importance with the prominence of the monetarist school of economics, which believed that the level of inflation is closely related to the rate of increase of the money supply. In the late 1970s and early 1980s many Western governments, including the UK’s, were strong adherents of the monetarist school and attempted to base economic policies on its theories. Accordingly, they needed to define the money supply before they could control it.
This proved to be difficult; Professor Charles Goodhart of the London School of Economics remarked that any measure of money supply would misbehave as soon as it became used as a policy guideline. The financial sector is constantly finding new instruments and ways of lending money. As a result, the Bank of England has published several definitions of money over the years. But with the money supply data less crucial to the formation of economic policy, it now focuses on just two – narrow money, broadly defined as notes and coins in circulation with the public and broad money, known as M4. The latter largely consists of lending by UK banks and building societies to the private sector.
INTEREST RATES


Money on its own is a very useful but, in the long run, unprofitable possession. That £200 stashed under the mattress will in five years’ time still be only £200. In the meantime inflation will have eroded its purchasing power, so that it may be able to purchase only half as many goods as it could five years before. Had the money been deposited with a building society, however, interest would have been added periodically. At 10 per cent a year the original cash deposit would have increased to £322.10 at the end of the five-year period. This interest rate is essentially the price of money. The price is paid by the borrower in return for the use of the lender’s money. The lender is compensated for not having the use of his money.
There are two alternative methods of calculating interest: simple and compound.
Simple interest can be easily explained. If a deposit of £100 is placed in a building society and simple interest of 10 per cent per annum is paid, then after one year the deposit will be £110, after two years £120 and so on. Nearly all interest is paid, however, on a compound basis.
Compound interest involves the payment of interest on previous interest. In the above example the depositor would still receive £10 interest in the first year. In the second year, however, interest would be calculated on £110, rather than on £100. The depositor would thus earn £11 interest in the second year, bringing his deposit to £121. In the third year he would earn £12.10 interest and so on. The cumulative effect is impressive. The same £100 deposit would become £350 after twenty-five years of simple interest but £1,083.50 with compound interest. Most savings accounts operate on the principle of compound interest, but most securities pay only simple interest. A bond may pay 5 per cent a year but only on the principal amount borrowed. That amount does not increase over the bond’s lifetime.
When dealing with a bond or with a share, it is more important to talk of the yield than merely of the interest rate or dividend.
Yield


A deposit account in a building society carries an annual interest rate. The money deposited will be returned in full with the accumulated interest, but the lump sum (capital) will not grow. Other investments, like shares, bonds and houses, are not as safe as a building society account but offer the potential for capital growth. Shares, bonds and property can all increase in price as well as provide income in the form of dividends, interest or rent. Since the price of these securities can alter, the interest rate or dividend will be more or less significant as the price falls or rises. The interest rate or dividend, expressed as a percentage of the price of the asset, is the yield. A security with a price of £80 that pays interest of £8 a year has a yield of 10 per cent. If the value of the security rises to £100, the yield will fall to 8 per cent. In assessing the profitability of various assets, calculating their yield is very important; articles in the financial press will talk about equity yields and bond yields as much as about dividends and interest rates.
Until the 1950s, the yield on shares was higher than that on most bonds, since shares were perceived as a riskier form of investment. Since then, shares have offered lower yields than bonds or savings accounts because the prospects of capital growth are much greater. That changed in the case of the credit crunch as share prices plummeted. It is too early to tell whether it is the start of a new era.
Probably the best way of showing the importance of yields is to cite the bond market. Suppose that in a year of low interest rates the Jupiter Corporation issues a bond with a face value of £100 and an interest rate (normally called the coupon) of 5 per cent. In the following year interest rates rise and bond investors demand a return of 10 per cent from newly issued bonds. Those investors who bought Jupiter bonds are now stuck with bonds which give them only half the market rate. Many of them will therefore sell their Jupiter bonds and buy newly issued bonds.
Who will they sell the bonds to? Potential buyers of Jupiter bonds will be no more willing to accept a yield of only 5 per cent than the sellers. Bond sellers will therefore have to accept a reduced price for the Jupiter bonds. The price will have to fall until the returns from Jupiter and other bonds are roughly equal. If the bond price fell from £100 to £50, then each year bondholders would still receive £5 on a bond which cost them £50 – a return, or yield, of 10 per cent. The Jupiter bond would be as attractive as a bond priced at £100 with a 10 per cent coupon, which would also yield 10 per cent.
Calculating the yield on a bond is not quite that easy, however. The bond will be repaid at some future point. Say, for example, it has a nominal value of £100, sells for £96, pays £5 interest a year and has one year to go before it is repaid. Over the next year the bondholder will receive £5 interest and £4 capital – the difference between the £96 it sells for and the £100 which will be repaid. So the bond yields £9 on a price of £96, just under 10 per cent. A yield which is calculated to allow for capital repayment is called the gross yield to redemption. Going back to the Jupiter issue, the bonds would not have to fall in price as low as £50 to keep their yields in line. If they had a five-year maturity, they would have to fall only to around £83 to have a gross yield to redemption of about 10 per cent. Bond trading depends on quick and sophisticated calculation of yields and exploitation of anomalies in the market.
This process of adjusting prices to bring yields in line gives bond investors the prospect of capital gain (or loss) on their holdings. An investor who buys Jupiter bonds at £100 would lose £25 if the price fell to £75 because of the yield adjustment. That would more than wipe out any interest earned on the bond. However, if the interest rate offered on other bonds fell back to 5 per cent again, then Jupiter’s bonds would climb back to their face value of £100. An investor who bought at the low of £75 would have made a capital gain of 33 per cent and still earned interest in the process.
Because of the yield factor, bond prices have an inverse relationship with interest rates: bond markets are generally euphoric when interest rates are falling, depressed when they are rising.
INTEREST-RATE DETERMINANTS


Having understood the difference between simple and compound interest and the importance of yields, we can now look at the factors that determine an interest rate. In fact, it is more correct to talk of interest rates. At any one time a host of different rates are charged throughout the economy. So it is important to distinguish the determinants of specific interest rates as well as those which affect the general level of rates in the economy.
First, let us look at the determinants of specific rates. One of the principal elements is risk. There is always the chance, whomever money is lent to, that it will not be repaid. That risk will be reflected in a higher interest rate. This is one of the general principles of finance. The riskier the investment, the higher the return demanded by the investor. It is a principle which sometimes is ignored, mainly because investors do not always assess risk adequately. Nevertheless, it is a useful principle to bear in mind, especially when it is stood on its head. Those investors who seek extremely high returns would be wise to remember that such investments normally involve extremely high risk.
Governments are usually presumed to be the least risky debtors of all, at least by lenders in their own country. (Other countries’ governments are a different matter, as many banks who lent to Brazil and Argentina in the 1970s discovered.) But the government of a lender’s country can always print more money to repay the debt if necessary. In any case, if the government does not repay debt, it is reasonable for investors to presume that no one else in the country will.
Banks were traditionally rated next on the credit ladder. Nowadays, however, many large corporations are considered better credit risks than even the biggest banks. For the benefit of potential investors, some agencies have devised elaborate rating systems to assess the credit-worthiness of banks and corporations (see Chapter 11).
At the bottom of the ratings come individuals like you and me. Individuals have a sad tendency to lose jobs, get sick, overcommit themselves and default on their loans. Unless they are exceptionally wealthy, individuals thus pay the highest interest rates of all.
One of the other main elements involved is liquidity. The house buyer with a mortgage has to pay a higher rate than is received by the building society depositor because the society needs to be compensated for the loss of liquidity involved in tying up its money for twenty-five years. The society faces the risk that it will at some point need the funds that it has lent to the house buyer but will be unable to gain access to them. As I mentioned in the Introduction, this is another of the basic principles of finance. The more liquid the asset, the lower the return. The most liquid asset of all, cash, bears no interest at all.
Logical though the above arguments are, it often happens that long-term interest rates are below short-term rates. To understand why, we must look at the yield curve.
The Yield Curve


We have already proposed a general principle of finance – that lesser liquidity demands greater reward. That being the case, longer-term instruments should always bear a higher interest rate than short-term ones. This is not always true. Long-term rates can be the same as, or lower than, those of short-term instruments.
A curve can be drawn which links the different levels of rates with the different maturities of debt. If long-term rates are above short-term ones, this is described as a positive or upward-sloping yield curve. If short-term rates are higher, the curve is described as negative or inverted.
What determines the shape of the yield curve? The three main theories used to explain its structure are the liquidity theory, the expectations theory and the market-segmentation theory.
The liquidity theory, which has already been outlined, states simply that investors will demand an extra reward (in the form of a higher interest rate) for investing their money for a long period. They may do so because they fear that they will need the funds suddenly but will be unable to obtain them, or they may be worried about the possibility of default. Borrowers (in particular, businesses) will be prepared to pay higher interest rates in order to secure long-term funds for investment. Thus, other things being equal, the yield curve will be upward-sloping.
The expectations theory holds that the yield curve represents investors’ views on the likely future movement of short-term interest rates. If one-year interest rates are 10 per cent and an investor expects them to rise to 12 per cent in a year’s time, he will be unwilling to accept 10 per cent on a two-year loan. It would be more profitable for him to lend for one year and then re-lend his money at the higher rate. A two-year loan will therefore have to offer at least 11 per cent a year before the investor will be attracted. Thus if interest rates are expected to rise, the yield curve will be upward-sloping. If investors expect short-term interest rates to fall, however, they will seek to lend long-term. That will increase the supply of long-term funds and bring down their price (i.e. long-term interest rates). Thus the yield curve will be downward-sloping.
What determines investors’ expectations of future interest-rate movements? Much may depend on future inflation rates. If inflation is set to rise, then price rises will absorb much of an investor’s interest income. So investors will demand higher rates when they think inflation is set to increase.
The economist John Maynard Keynes constructed a more elaborate theory which depended on the yield of securities. If people expect interest rates to rise, Keynes argued, they will hold on to their money in the form of cash, in order to avoid capital loss. But if they expect rates to fall, they will invest their money to profit from capital gains. Of course, this principle applies to bonds rather than to interest-bearing accounts. As we have seen, if interest rates rise, the price of previously issued bonds falls until investors earn a similar yield from equivalent bonds. Thus a bond investor who expected rates to rise will sell his bonds before the rise in rates and the resultant fall in the bond price occurs. The investor will hold the funds in the most liquid form available so that he can reinvest them as soon as rates rise. If the same investor expects interest rates to fall, he will hold on to the bonds because their price will rise as rates fall.
The third theory of the yield curve is the market-segmentation theory. This assumes that the markets for the different maturities of debt instruments are entirely separate. Within each segment interest rates are set by supply and demand. The shape of the yield curve will be determined by the different results of supply/demand trade-offs. If a lot of borrowers have long-term financing needs and few investors want to lend for such periods, the curve will be upward-sloping. If borrowers demand short-term funds and investors prefer to lend for longer periods, the curve will be downward-sloping.
Economic Theories on the General Level of Interest Rates


We have already looked at the factors which affect the level of interest rates for different maturities, instruments and borrowers. It is also worth considering theories which concern the general level of rates in the economy.
As already mentioned, the rate of inflation is generally accepted to be a substantial ingredient of interest rates. Lenders normally expect interest rates at least to compensate them for the effect of rising prices. They therefore watch closely the real interest rate – that is, the interest received after inflation has been taken into account. Historically, real interest rates have averaged around 2–3 per cent; that is, if inflation were 7 per cent, interest rates would be 9–10 per cent. However, this relationship is far from permanent: real interest rates have been, at times, negative (below the rate of inflation), and at times in the 1980s they were as high as 8 per cent, making that a very good time to lend.
The most important inflation rate is the rate which a lender expects to occur during the lifetime of his or her investment. The inflation rate which is published by the government, the consumer price index, gives only the previous year’s price rises, but it is next year’s price rises which will affect the value of the lender’s investment. So lenders must undertake a difficult piece of economic forecasting.
It is very important to remember that financial markets are now international. Rates in Britain cannot be separated from those in other countries. UK investors can invest abroad if there is the chance for higher rates overseas, and foreign investors can invest here if UK rates are above their own. Both decisions are linked with the level of exchange rates. An investment in the US might yield a high dollar rate of return, but if the dollar fell against sterling, investors would find themselves worse off.
Governments concerned about the level of interest rates will often intervene to try to influence their movement. They may be concerned about the exchange rate and may push interest rates up to defend the pound. Alternatively, they may be concerned about the amount of credit in the economy. People may be borrowing because interest rates are low, with the result that excessive demand is leading to inflationary pressures.
The classical explanation of the level of interest rates is associated with the theory of supply and demand. Thus the interest rate is the balancing point between the flow of funds from savers and the need for investment funds from business. If more funds become available from savers, or if industry has less need to borrow, interest rates will fall. If the funds available from savers are reduced, or if industry has a greater need to borrow, interest rates will rise. The demand for funds is likely to be affected by business people’s expectations of future profits. If they believe that they will achieve a high rate of return on investment, they will be willing to borrow.
The supply of funds for borrowers depends largely on the willingness of the personal sector to save. Why do people save? One of the main reasons is to provide for old age or for children and spouses in the event of early death. This form of saving normally takes the form of investment in pension funds and life assurance and is helped by tax advantages. There has been a substantial growth in this form of saving since the 1960s. Another reason is to guard against rainy days caused by illness or unemployment: by its nature, such saving needs to be very liquid and is normally placed in building societies or interest-bearing bank accounts. A third reason for saving is to allow for major purchases or for holidays: again, such savings need a liquid home like a building society account.
Just as important as the reasons why people save are the reasons why the proportion of their income that they save changes over time. A certain amount of wealth is necessary before people can save – if all of someone’s income is needed just to pay for food and rent, there will be no money left to save. However, it is not correct to assume the reverse: that the larger a person’s income, the more he or she saves. The highest income-earners are often among the biggest borrowers, since banks will extend credit only to those who they think will be able to repay. The greater a person’s income, therefore, the greater the possibility for incurring debt. Debt is negative saving. In fact, the cautious middle classes have traditionally been the biggest savers.
However, academic explanations of movements in the savings ratio (the proportion of income which is saved) have focused on income levels. If income rises, according to theory, there will be a larger increase in the level of savings; if income falls, savings will drop disproportionately as people run down their incomes to pay for their expenditure.
During the inflationary 1970s the savings ratio increased sharply, much to most economists’ surprise. Since inflation erodes the purchasing power of savings, it was assumed that consumers would run down their cash balances and deposits, which bear a negative real interest rate, and would prefer to hold physical assets such as property, the value of which tends to increase in line with inflation.
What seems to have happened instead is that savers, perhaps for the rainy-day reasons outlined above, were concerned to maintain the purchasing power of their savings. Because of the rate of inflation, they needed to save a greater proportion of their income merely to keep the value of their savings constant. The rise in the savings ratio in the 1970s was followed by an equally sharp decline in the 1980s as inflation fell and it became easier to maintain the value of savings.
Saving seems to have a clear correlation to the state of the economy. In times of boom, people tend to save less. They are more confident about their job prospects and are happy to borrow money to make expensive purchases, such as cars and durable goods. In times of economic slowdown, they cut back their expenditure because they are less confident about their job prospects.
In analysing savings patterns an important distinction to recognize is that between committed and discretionary savings. Committed savings are made up of contributions to life assurance and pensions schemes and, as such, are relatively inflexible to changes in income. Discretionary savings represent payments into building society accounts or perhaps unit trusts. Such savings adjust much more quickly to income movements. Repayment of a mortgage represents committed savings in that it is an investment in the value of a real asset (i.e. a house).
Indeed, many believe that the housing market has distorted UK savings patterns. Years of inflation, and the favourable tax treatment of home ownership, has taught British investors that property is the safest store of wealth.
What does seem clear is that the greater sophistication of the modern financial system causes interest rates to move more frequently than ever before.
The Retail Banks and Building Societies


Banks are at the heart of the financial system. They are the one type of financial institution with which all of us are bound to come into contact at some point in our lives. When they falter, as they did in 2007 and 2008, governments feel obliged to come to their rescue since, without them, the economy could not function.
Like banks, building societies take deposits from individuals and lend them to others. Over the last twenty years or so, many societies have either turned into, or been acquired by, banks. So whereas in previous editions they merited a separate chapter, they now need to be treated as part of the banking industry.
THE FIRST BANKERS


Gold and silver have traditionally been the two predominant monetary metals for the reasons outlined in Chapter 2. As a result, goldsmiths and silversmiths became the earliest bankers. Nervous citizens, who were well aware of the dangers of keeping their gold under the mattress, began to use the smiths, who had safes to store their wares, as a place to keep their wealth. In return, the smiths would give the depositor a handwritten receipt. It soon became easier for the depositors to pay their creditors with the smiths’ receipts, rather than go through the time-consuming process of recovering the gold or silver and giving it to the creditor, who might only re-deposit it with the smith. Creditors were willing to accept the receipts as payment, provided that they were sure that they could always redeem the receipts for gold or silver when necessary.
The receipts were the first banknotes. The legacy of those early receipts is visible today in the form of the confident statement on banknotes: ‘I promise to pay the bearer on demand the sum of …’
Despite having the image of the Queen to back it up, that statement is of no value today and anyone attempting to redeem a five pound note for gold at his local bank will be disappointed.
Smart goldsmiths were able to take the development of banking one stage further. They noticed that, of the gold stored in their safes, only a small quantity was ever required for withdrawal and that amount was roughly matched by fresh deposits. There was therefore a substantial quantity of money sitting idle. The money could be lent (and interest earned) in the knowledge that the day-to-day requirements of depositors could still easily be covered (see Chapter 2).
The Italian Influence


Among the earliest bankers were goldsmiths and silversmiths from the Lombardy region of Italy who were granted land in London by King Edward I. One of the sites they received – Lombard Street – is at the heart of the modern City of London. Back in Italy, the money lenders had conducted their business from wooden benches in market places. The Italian word for bench, banco, was corrupted by the English into ‘bank’. The Italians were also responsible for introducing the symbols that were synonymous with British money until 1971 – £, s. and d., or lire, solidi and denarii. It is a nice irony that those who wear the £ symbol as a signal of opposition to Europe are in fact displaying an Italian figure.
Many of the early bankers misjudged their ability to absorb ‘runs’– times of financial panic when investors rushed to claim back their gold. In such cases, bankers had insufficient funds to meet the claims of depositors upon them and thus became ‘bankrupt’ (literally ‘broken bench’). Such runs could easily become self-fulfilling. As soon as depositors feared that a bank might become bankrupt, they would flock to the banks in order to demand their money back, thus accelerating the bank’s deterioration into ruin. Because of the nature of banking, no bank could stand a determined run. Some tried ingenious methods to do so. One bank arranged for a few wealthy depositors to arrive by carriage at the front of the bank and withdraw their gold ostentatiously. The queuing small depositors were impressed. Meanwhile, the wealthy depositors sent their footmen round the back to re-deposit the gold, so it could be used to meet the claims of the other depositors.
Bankruptcies did not reduce the total number of banks. The seeming ease with which it was possible to make money from banking soon attracted others to take the places of the institutions that had failed. Gradually, depositors regained confidence in the trustworthiness of the banks. Thus began a regular banking cycle of boom and bust. Professor Galbraith explained that the length of these cycles ‘came to accord roughly with the time it took people to forget the last disaster – for the financial geniuses of one generation to die in disrepute and be replaced by new craftsmen who the gullible and the gulled could believe had, this time but truly, the Midas touch’.
In the UK Charles I, that unlikely saint, gave banking an unwitting boost in 1640 by seizing £130,000, which merchants had unwisely committed to his safe-keeping by placing it in the Royal Mint. Merchants decided that in future it would be rather safer to deposit their funds with the bankers in the City. It was not until 1694 that the government’s financial reputation could be restored and the Bank of England established: by that time, the crown was on the head of the sober and respectable Dutchman, William of Orange.
MODERN BANKING


The history of the Bank of England is considered in Chapter 5. This section considers the modern banks which have grown out of the early activities of the goldsmiths.
There are many varieties of banks, but the two types that are best known in Britain are the retail and the investment banks. Investment banks are considered in the next chapter and are best known for arranging complex financial deals and for financing trade. Retail banks take deposits from customers and lend them out to companies and insolvent individuals.
The banks which most people know, and are indeed at the heart of the UK financial system, are the clearing banks, so called because individual transactions between them are cleared through the London Clearing House system. This saves the banks, and therefore their customers, a lot of time. Rather than have Lloyds pay over £20 to Barclays for Mr Brown’s gas bill and Barclays pay £15 to HSBC for Mrs Smith’s shopping, the clearing house tots up all the individual transactions and arrives with a net position for each bank at the end of the day. Lloyds might owe Royal Bank of Scotland £20,000 and HSBC owe Barclays £15,000 – the important fact is that on a daily basis, each bank is involved in only one clearing house transaction with any other.
Chaps


In 1984, the clearing process was much improved by the introduction of the Clearing House Automated Payment System (CHAPS), which replaced the old manual system for processing cheques and bankers’ payments. Rather than laboriously adding up the total of each bank’s payments and receipts by hand, a CHAPS payment results in an adjustment to a running total held on the system. At the end of the day, each bank has logged up a deficit or surplus vis-à-vis the other banks in the system. Payments are cleared in a few minutes rather than the hour and a half of the old system.
The work that the clearing banks handle is huge. In 2004, CHAPS was handling an average of 130,000 payments worth £300 billion each day, up from just 7,000 transactions worth £5 billion when it first started. And CHAPS is part of the Target system designed to settle deals across the European Union.
Twenty years ago, there were four big banks – Barclays, Lloyds, Midland and National Westminster. That pattern has changed significantly thanks to takeovers and the conversion of building societies into banks. Some banks are still recognizable. For example, Lloyds acquired the Trustee Savings Bank and became Lloyds TSB; it then bought the building society Cheltenham & Gloucester and the life insurance firm Scottish Widows. In 2008, in the midst of the financial crisis, it bought HBOS, the bank that combined the old Halifax building society with the Bank of Scotland. The deal was disastrous for shareholders and the government ended up owning a majority stake. But after all these changes, Lloyds still uses the black horse logo and is largely a retail bank.
Barclays Bank has had a mixed record in investment banking, building up a group known as BZW and then slimming it down to Barclays Capital before taking advantage of the financial crisis to buy the US operations of Lehman Brothers. The bank has been extremely successful in fund management where, as Barclays Global Investors, it is one of the biggest investors in the world, with a particular expertise in tracking stock market indices.
Midland Bank has long since lost its independence, agreeing to a takeover by the Hong Kong and Shanghai Banking Corporation (HSBC) in 1992. The Midland brand name was duly phased out.
NatWest was acquired by the Royal Bank of Scotland in 2000, after a fierce bidding battle, but still trades under its original name on the high street. RBS went on to buy ABN Amro of the Netherlands, a terrible deal that ended up forcing the government to rescue the bank.
Another big British banking presence is the Spanish Grupo Santander which acquired the former building societies Abbey National in 2004 and Alliance & Leicester (along with the savings accounts of Bradford & Bingley) in 2008.
Relative to the big American banks, such as Citigroup, or continental European banks like Deutsche or Union Bank of Switzerland, the British banks are not as big players in investment banking (although both HSBC and Barclays have respectable operations). That is a pity to those who would like to see a national champion in every industry.
But the problem with the all-singing, all-dancing bank is that every few years they tend to hit a flat note or trip over their own feet. The solid commercial bankers start to resent the flashy, highly-paid investment bankers who tend to lurch from one disaster to another. The concept is thus highly expensive and very risky. Mind you, the commercial banks have managed to have plenty of disasters in the theoretically safer area of domestic personal and corporate banking.
The Importance of Retail Deposits


The retail banks long had a built-in advantage – the current accounts of ordinary depositors like you and me. Such accounts traditionally paid no interest whereas the banks could charge as much as 20 per cent on overdrafts – a fairly hefty profit margin. Banks without retail deposits have to borrow at market rates in the money market in order to obtain funds. It can be said in justification of the retail banks that the costs of such a large network of branches, in terms of buildings, staff and paperwork, take a substantial slice of that margin.
This so-called endowment effect started to disappear in the 1980s when competition from building societies forced the banks to offer interest-bearing accounts. In the late 1990s, retail deposits started to look as much of a burden as a boon. The problem was that servicing those depositors required the maintenance of a vast and expensive branch network.
Rivals emerged with the ability to ‘cherry pick’ the best retail customers. One group was the supermarkets, which offered interest-bearing accounts to their customers. Another was internet banks, such as Egg, which were able to offer interest-bearing accounts without the need for branch networks. The big banks reacted by cutting costs, laying off staff and closing banks in rural areas and small towns. They also encouraged investors to switch to banking over the telephone or the internet, and focused on other higher-margin products such as life insurance and fund management.
But internet banking has created a new class of ‘rate tarts’, investors who will take the highest rate on offer but will switch as soon as another more attactive deal comes along. This has allowed overseas banks, such as ING of the Netherlands and Landesbanki of Iceland, to win market share (when the latter went bust in 2008, 300,000 British savers were affected). As a result, deposits are less ‘sticky’ than they used to be – in other words, banks cannot be sure of hanging on to them. This has caused some banks to depend more on the wholesale, or money, markets for funding, with important consequences.
Banks and the Subprime Crisis


Over the last decade or so, there has been a global move away from depending on retail deposits and to what is known as an ‘originate and distribute’ model. Banks raise money from other institutions in the wholesale markets. They still make loans – to individuals, companies and so on – but they do not hang on to them. They bundle them up into pools of assets and sell them to outside investors.
Why does this occur? From a bank’s point of view, the approach is attractive because of regulations. Under the Basel international accords, they were required to set aside reserves for certain loans on their balance sheets. These reserves must be held in the form of low-yielding assets such as government bonds. The more reserves a bank has, the lower its profits are likely to be. Thus there is an incentive for the bank to get those loans off its balance sheet by selling them, provided it can still earn some sort of fee income from making the loan in the first place.
Why would anyone want to buy such loans? Low inflation in the 1990s and 2000s drove the yields on government bonds down to very low levels. This made investors desperate for assets offering higher returns. Asset-backed securities, as they became known, offered such returns. They might be pools of mortgages, car loans or credit cards. In theory, because the pools were diversified, the losses would be predictable. This process of securitization has been going on for thirty years or so but it took off amazingly quickly in the early part of this century.
Credit booms tend to be self-reinforcing. Say the average house price is £100,000 and banks are willing to lend 80 per cent of the home value. The average homeowner puts down a deposit of £20,000, borrows £80,000 and buys the house. Prices rise by 20 per cent, so the average home is now worth £120,000. Homeowners are better off and banks are now feeling better about lending to them; after all, the value of their collateral has gone up. So they now figure they can lend against 90 per cent of a house’s value. Now potential homeowners only need £12,000 for a deposit. So there will be more potential buyers, which will push house prices up further, making banks more confident about lending and so on.
This is what happened in the early years of this century in America and to a lesser extent in Britain. As house prices rose, lending standards were relaxed. Securitization speeded this process. After all, if you were going to sell the loan within a few months, why worry about whether the borrower would be able to repay in a few years’ time? And why would borrowers worry about repaying if they expected to sell the house for a quick profit?
In the US, the extreme part of the process was so-called ‘liar loans’ which were made to borrowers who had to provide no proof of their income. Of course, such loans carried higher rates of interest, but they were not high enough. Some of these borrowers were ‘Ninjas’, a term indicating they had no job, no income and no assets.
All was well while house prices were going up. But as soon as they started to falter, it became clear that many borrowers could not afford to keep up the interest payments. Indeed, once it became clear that house prices were falling, some walked away without making any payments at all. The bonds backed by these mortgages, known as subprime in the jargon because of the low credit ratings of the borrowers, started to default.
But what made the crisis worse was that the mortgage-backed bonds themselves had been bundled up and repackaged. Securities known as collateralized debt obligations or CDOs had been created. These were made up of bundles of asset-backed bonds.
The CDOs were sliced and diced into different elements, known as tranches. The riskiest slice, known as equity, paid the highest yield. But in return, they suffered the first loss when any of the underlying assets defaulted. The higher tiers in the pyramid carried less risk but paid a lower yield. The top tier of all, often known as supersenior, was in theory extremely safe.
There were lots of problems, however, with this structure. One was the tiering of risk. Portfolios were assembled that comprised the riskiest parts of mortgage-backed securities. As a result, when they were pooled together in CDOs, risks were concentrated, not diversified; if one part of the portfolio was likely to default, so was the rest. This meant the more senior parts of the portfolio were more risky than the owners had thought.
This problem was compounded by the use of borrowed money, or leverage. As already explained, supersenior tranches offered fairly low yields. This made them unexciting investments. But if you could borrow money for less than the yield on the supersenior, this made them potentially a lot more enticing. And the regulations that governed the level of bank capital did indeed make this an attractive option, on the assumption that the bonds would never default.
Alas, when the scale of the subprime crisis became apparent, the prices of these securities fell and banks were forced to reveal their losses. The problem was made worse by the existence of specialist vehicles such as conduits and structured investment vehicles (SIVs). These, like the banks, had used borrowed money to invest in mortgage-backed securities and CDOs. In fact, they had borrowed the money from the banks. In some cases, they were unable to repay their loans; in others, the vehicles were clearly creatures of individual banks, and the banks were forced to rescue them.
Britain was not immune from this problem, even though it originated in the US. In part, this was because some of the banks had invested in the complex CDOs that proved so difficult to value when the housing market turned down. But it was also because British banks had moved to the originate and distribute model. When the credit crunch hit, some of those banks were particularly vulnerable.
The Northern Rock Collapse


Building up a base of retail deposits takes time and resources. Either you need a big base of branches (with lots of costly property and staff), a call centre to handle consumer enquiries or you need to offer a high return to attract the rate tarts who surf the internet.
The originate and distribute model seemed to offer a quicker and easier route to gain market share. Instead of waiting for deposits to build up, a bank could go out and make the mortgage loans it desired and then sell those loans in the financial markets. Provided it received a higher rate from homeowners than it paid in the market, such a strategy would be profitable.
Northern Rock, a Newcastle building society turned bank, was the British institution that proved most aggressive in pursuing this strategy. By 2007, it was Britain’s fifth biggest mortgage provider even though it had just 76 branches. When it ran into trouble, only a quarter of its funds came from retail customers.
The strategy had enabled Northern Rock to expand very quickly; in the first half of 2007, its lending was 31 per cent higher than the year before. This approach looked highly profitable. Ironically enough, the last annual results that it produced before its collapse showed record pre-tax profits of £627 million, 27 per cent higher than the previous year. Indeed, anyone who looked at the raw data might have been surprised by Northern Rock’s collapse; the repayment arrears on its mortgages were less than half the industry average.
But these headline numbers belied some fundamental weaknesses. It takes time for mortgages to go wrong and when it got into trouble, a third of Northern Rock’s loans were less than two years old. As it expanded, it was increasing the proportion of loans to homebuyers with a small deposit (and to those who wanted to borrow more than the value of the house itself). It was also heavily involved in the buy-to-let market. Investors were well aware that it might be vulnerable if house prices fell; its share price was declining steadily from the spring of 2007.
The bank had also made one fatal assumption; that the money markets would always be open to it. But in August 2007, alarmed by losses on subprime loans, investors suddenly wanted nothing to do with mortgage-backed securities. Northern Rock had raised money from the markets in January and May, and was scheduled to do so in September. In August, it was thus low in cash. It had not thought to put emergency funding plans in place.
So the bank had to turn to others for help. An attempt was made to sell the bank to Lloyds TSB but Lloyds wanted a £30 billion loan from the Bank of England before it would sign the deal. The central bank was unwilling to agree; ironically, its eventual exposure to Northern Rock proved much larger. The only option left was direct help from the Bank of England, and when news of that deal leaked, retail customers started to demand their money back. What emerged was a classic ‘run on the bank’ such has been seen many times in history.
Even without the run, Northern Rock was probably finished as an independent entity. But the run ruined Northern Rock’s brand name, making it more difficult to sell the bank to a private company. Eventually, it had to be nationalized. And the run on the bank caused the authorities to worry that other banks might be threatened; Alistair Darling, the chancellor, was forced into making the extraordinary pledge of guaranteeing, not just Northern Rock’s deposits, but those of any other bank that got into trouble.
Order was eventually restored with the help of a change to the deposit insurance scheme, that guaranteed the first £35,000 of all deposits (in 2008, this had to be increased to £50,000). But the whole affair dented confidence in Britain’s financial system. When the credit crunch bit again in 2008, worries about the dependence of HBOS on the wholesale markets forced it into the arms of Lloyds TSB, and Bradford & Bingley was closed by the government.
These measures only seemed to exacerbate the crisis, by decreasing investor confidence in the banking system. It became either impossible or very expensive for banks to get finance from the wholesale markets. In turn, that made them more cautious about lending to companies and consumers. The crisis reached such a peak that, in October 2008, the government was forced to unveil a massive £400 billion rescue scheme that involved buying bank shares, guaranteeing their loans and lending them money to tide them over until the markets resumed normal trading.
The effective nationalization of parts of the banking industry raised some difficult questions. Should the government control the pay of individual bankers? And should it direct where banks make their loans?
Assets and Liabilities


The demise of Northern Rock illustrated one of the perennial weaknesses of banks; they borrow short and lend long. In other words, if people lose confidence in the banks, they can get in trouble very quickly.
Understanding bank finances requires a good grip on the terminology and this can be a little counter-intuitive. The monies we hold in our current accounts are not the assets of the banks; they are their liabilities since we can ask for them back at any moment.
Banks’ assets are the loans and investments which they make with the deposits provided and which earn them interest. Those assets are held in a variety of forms. A substantial proportion is lent out short-term – either at call (effectively overnight) or in the form of short-term deposits in the money markets (see Chapter 6). The bulk of banks’ assets is held in the form of loans – to individuals and to businesses.
The banks also lend longer-term, both domestically and internationally. In the UK, the loans are vital to the development of industry. Most companies start with the help of a bank loan, usually secured on the assets of a company. That means that if the firm folds, the bank has a claim on the firm’s fixed capital such as machinery or buildings.
The proportion of the banks’ assets which they need to hold in the form of cash is known as the cash ratio. The ratio has from time to time been set by the Bank of England to ensure that banks remain sound. It determines to some extent the total amount banks can lend. However, there are other factors involved.
One of the most important is the supply of creditworthy customers. Banks are normally cautious about the people to whom they grant loans. If we assume that the number of people who are good credit risks (i.e. they have a steady job, good references, a good financial record) remains fairly constant, that puts a limit on banks’ expansion.
The general state of the economy will also affect the growth of bank lending. If the economy is healthy, more businesses will be seeking to borrow funds to finance their investment plans. If the economy is in recession, however, few industries will be prepared to invest and therefore to borrow. Banks might seek to attract more borrowers by lowering their interest rates, but there is an obvious limit to such a process. The banks cannot afford the return from their lending to fall below the cost of their borrowing. The return from lending must always be significantly higher, because of the substantial costs involved in running a branch network.
Banks tend to follow a feast-and-famine process. Lots of loans will be made in times of economic boom, and when asset prices are rising. But when the economy starts to contract, and asset prices fall, some of those loans will fail to be repaid. That will prompt banks to suffer losses in the form of write-downs of their loan portfolios. If the bad debts are substantial, as occurred in Japan during the 1990s and across the world in 2007 and 2008, the future of individual banks may be threatened.
BUILDING SOCIETIES


Building societies face a threat to their long-term survival. In retrospect, the decision of a number of the biggest societies to turn into banks looks like a mistake. All those societies that did so have either gone bust, or been taken over by high street banks. Those who received ‘windfall shares’ at the time of flotation may feel it wasn’t much of a windfall at all.
For a long time, however, societies were perceived as one of the most consumer-friendly elements of the financial system. They were the repositories of the small savings of millions of people and the providers of finance for the vast majority of home purchases. Few folded because of financial mismanagement.
Over the years, societies have grown closer and closer to banks in any case. In the old days, they talked of surpluses, now they talk of profits. They compete with banks in terms of offering current accounts, cheque books, cashpoint cards, personal loans, foreign exchange, unit trusts and life assurance.
Only in structure are they different. Societies are mutual societies, owned by their members (savers), rather than public companies with shareholders.
Origins


The original building societies were literally that – groups of individuals who subscribed to a common fund so that they could buy or build themselves a house. Once the house or group of houses were built, the societies were folded up.
After a rather shaky period in the late nineteenth century, when a spate of society collapses sapped public confidence in the movement, the building societies established an important place in the financial community.
The scramble for personal savings increased in the 1980s when the Building Societies Association’s control over the mortgage and savings rates charged by members gradually weakened. The result was that building societies began to compete more aggressively among themselves for funds, with extra interest accounts offering instant withdrawal without penalty for the saver. Rates will vary depending on the amount of money invested, the notice needed before withdrawals and the frequency of interest payments.
A Shrinking Industry


Even before the wave of mergers in the mid-1990s, the industry had experienced a long period of consolidation. The total number of societies fell from 2,286 in 1900 to 273 in 1980 and 59 by early 2008. The largest society, Nationwide, had £137 billion of assets in 2007, almost four times more than the next biggest, Britannia, with £35 billion. The smallest society, Century, had just £20 million.
In some ways, the building society industry was like many others. Economies of scale helped societies reduce costs and that enabled them to offer better rates, pull in more depositors and achieve greater economies of scale.
But greater size brought its own dangers. At the start of the 1980s, building societies were still very small compared with the big banks, but their success encouraged banks to enter the mortgage market. Competition between the banks and the societies became intense and has remained so now that many former societies have converted.
Increased competition in the mortgage market meant that societies had to look elsewhere for profits. In the 1980s, there was a big drive to sell endowment mortgages, loans linked to an insurance policy which would grow sufficiently (in theory) to repay the capital. Endowments earned high commissions for the societies. In the 1990s, endowments became less popular and attention switched to building and contents insurance.
In the savings market, competition has forced societies to abandon some of their long-held customs. In November 1984, the Building Societies Association Council decided to stop recommending specific interest rates to its members, bringing an end to the interest-rate cartel which the societies had practised for so long. The resulting competition has led societies to increase the number of so-called ‘premium’ accounts which grant savers extra interest if they fulfil certain conditions. They also attacked the banks head on by offering withdrawals from automated teller machines, chequing facilities and home banking; no longer is it the case that banks are for current accounts and building societies for savings accounts.
Conversion into banks created an initial bonanza for building society members and put pressure on other societies to convert. The Nationwide, the largest remaining society, narrowly fought off a call for conversion in the summer of 1998. It subsequently made clear that new investors would not be rewarded in the case of conversion – an attempt to discourage ‘carpet-baggers’, savers who deposit small sums in a number of institutions in the hope of benefiting from a spate of windfalls. Other societies imposed minimum investment levels to prevent carpet-baggers cashing in.
Enthusiasts for the sector still hope that it can survive. Traditional building societies are mutual organizations, that is they are owned by their savers and borrowers rather than shareholders. That has some advantages to the savers and borrowers. Instead of paying out profits to shareholders, the profits can be used to increase (or for borrowers, reduce) the societies’ interest rates.
There are some hopeful signs for building society fans; the Northern Rock debacle may make the building society structure look more attractive. If societies can pay rigorous attention to the interests of their members by keeping down their costs, offering competitive rates to savers and borrowers, and by refusing to sell unsuitable add-on policies just because it earns them commission, then there should be a place for them in the twenty-first-century financial system.
The Mortgage Business


As noted in the Introduction, building societies perform a piece of financial magic by turning customers’ deposits, which can be withdrawn at any time, into home loans, extending up to thirty-five years. To guard against sudden shortfalls in deposits, they also have limited investments in safe short-term instruments like short-dated gilts. For much of the twentieth century, the business of building societies was extremely sound because of the credit record of its borrowers. Most people made every effort they could to keep up the payments on their mortgage; and since inflation tended to erode the value of the debt, it was relatively easy for them to do so.
But the 1980s and the early 2000s saw house price bubbles. The profits made by some people from their properties drew more and more people into the housing market. Competition from other lenders caused building societies to lower their credit requirements; some people were allowed to buy homes on 100 per cent loans, that is without putting up a deposit, and were lent large sums in proportion to their incomes. (Incredibly, a few were allowed to borrow more than the value of their house.)
All this activity was built on the assumption that house prices would rise forever. But one bubble eventually burst in the early 1990s, and the same process seemed to repeat in early 2008. Eventually, prices rise so far (or interest rates go up) that first-time buyers are shut out of the market. As the prospect of easy profits vanishes, speculators also lose heart. And the banks and building societies also become more cautious about lending. As house prices fell, many mortgages became worth more than the homes they are secured on – a state known as ‘negative equity’ (see Chapter 15).
Negative equity faces lenders with a tricky dilemma. Once borrowers default on their interest payments, societies have the right to reclaim the asset, i.e. the house. But selling the house would not provide enough cash to pay off the loan. Furthermore, the more homes the societies repossessed, the more empty homes there were on the property market, depressing house prices and giving an extra twist to the downward spiral.
The Mortgage Rate


The mortgage rate goes up or down with the general level of rates in the economy. The building societies cannot stay separate from the other financial institutions, since they must compete with them for depositors and they must sometimes borrow from them. As the cost of raising their funds rises and falls, so must the mortgage rate. In general, however, the mortgage rate is slower both to rise and to fall than bank rates.
As interest rates rise and fall, societies switch their concern between savers and borrowers. In 1990, when base rates were 15 per cent, the typical mortgage rate was just a fraction above that level, at 15.4 per cent. Societies were holding down the rate to prevent any more pain being inflicted on homeowners. In late 2001, when the Bank of England cut rates to 4 per cent, many building societies were charging 5.5 per cent, a margin of 1.5 percentage points. The societies had switched their concern from borrowers to savers.
A big change in the 1990s came with the development of fixed rate mortgages. These promise borrowers a set rate for several years at a time, allowing them to plan their budgets and avoid the danger of a sudden jump in rates. The catch is that borrowers do not benefit if rates fall and, if they try to repay the loan ahead of time, they face heavy redemption penalties.
Building societies fund fixed rate deals by borrowing in the wholesale markets. The problem that emerged in 2008 was that wholesale markets were either closed to new borrowing, or extremely expensive to access. The result was that homebuyers seeking fixed rate mortgages found that loans were either withdrawn from the market or became a lot more expensive. That did not help a housing market that was already struggling.


Investment Banks


Most people have a pretty clear idea of what retail banks do: take deposits and make loans. But the public understanding of investment banking is far less developed. Perhaps the first time they really hit the headlines was in the crisis of 2008, when in effect, independent investment banks disappeared. Three of the leading five banks in the US lost their independence (or went bust) within six months; the other two (Morgan Stanley and Goldman Sachs) applied for commercial banking status.
But while the banks may have vanished or mutated, the business of investment banking goes on. In Britain, the sector used to be known as merchant banking; investment banking was the American term. Investment banking is only part of the activities of the likes of Merrill Lynch and Goldman Sachs, which are also known as broker-dealers, and larger banking groups such as Citigroup or Union Bank of Switzerland have their own investment banking arms.
The key change of the last twenty to thirty years has been that investment banks no longer depend on fee income for the bulk of their profits. Now they put their capital at risk through trading and underwriting. This has hugely increased their importance and, as we saw with Bear Stearns and Lehman Brothers in 2008, the risk they pose both to their own financial health and to the system.
Broadly speaking, the investment banks earn their money from four areas: advising clients on everything from takeovers to how to handle currency risk; broking (connecting buyers and sellers in return for a fee); trading in the markets; and asset management (looking after other people’s money).
The roots of the industry grew out of trade. Before the development of a worldwide banking system, much international trade depended on trust – trust that goods would be delivered and that they would be paid for. It was much easier for overseas clients to trust merchants with whom they had traded before or those with whom their friends had traded. Thus, the larger and well-established merchants found it easier to trade than their smaller and less familiar competitors.
The smaller firms needed some way both of assuring their clients that they were trustworthy, and of raising money to cover the interval between the time goods were delivered and the time they were paid for. The normal method for raising finance in this period was for the exporter to draw up a bill of exchange, whose value was a large proportion of the value of the goods being sold. The exporter could then sell the bill to a local banker at a discount and receive a substantial proportion of the money in advance. The extent of the bank’s discount would represent two elements, a charge equivalent to interest on what was effectively a loan and a charge reflecting the risk of non-payment.
Small exporters found the banks would often charge a very large discount to advance money on their bills, if they agreed to do so at all. So the smaller merchants began to ask their larger brethren to guarantee (or accept) their bills. In the event that the small merchant failed to pay up, the large merchant would be liable. In return for the service, the large merchants charged an acceptance commission, based on a percentage of the size of the bill.
Eventually, some of these large merchants found that they could earn more money from their finance activities than from their trading and became full-time merchant banks or accepting houses. For a long time, their business was centred around the financing of trade but gradually, as they developed a reputation for financial acumen, they increased the corporate finance side of their activities.
Many merchant banks were begun by immigrants, refugees or Jews, shut out of the rather stuffy world of the clearing banks. The wheeling and dealing involved appealed to the more adventurous spirits. However, the business was so lucrative that the merchant banks became absorbed into the mainstream establishment.
From the 1950s onwards, merchant or investment banks used their financial expertise to help their corporate clients, advising on share issues, bond issues and takeovers. For this, they were rewarded with fee income, a very good business in boom times. Unlike their commercial banking rivals, they had no need to maintain a vast branch network. Their fixed costs were low; their profits-per-employee high.
But, as we saw in Chapter 1, the international financial markets changed in the 1980s. Large companies no longer needed advice alone; they needed banking advisers who could commit capital to deals. The clients wanted the assurance that, if things went wrong, the investment bank could ensure that the money was still raised.
That spelled the end for the old British-style merchant bank, which was often a private business, run by a small group of partners. It also meant that, having raised large amounts of capital, investment banks started to move into new areas. They used their expertise to deal on their own behalf, through proprietary trading desks. They sold their expertise to clients as asset managers. They dreamed up exotic new products, particularly in the derivatives markets, and sold them round the world. They lent money to favoured clients such as hedge funds and private equity groups (see Chapter 9).
This has earned investment bankers a lot of money. But it has also brought them to the heart of the global financial system. It was significant in March 2008 that the US Federal Reserve felt obliged to help with the rescue of Bear Stearns, an investment bank. The bank had no retail depositors. There would have been no queues of worried consumers, as there were at the British bank Northern Rock. Neverthless, Bear Stearns was deemed too big to fail (TBTF in the jargon), or even TCTF (too complex to fail).
Bear Stearns was a participant in a multitude of complex deals, in which investors and companies took positions on everything from exchange-rate movements through commodity prices to the possibility of corporate failure. Had it defaulted, it could have taken ages to sort out the mess because markets are so interconnected. Some banks might, for example, have taken a position betting on a rising dollar with Bear Stearns and then hedged that by betting on a falling dollar with someone else. The failure of Bear Stearns would thus have given such banks a currency exposure they did not desire. While everyone involved tried to work out their exposure, the markets could have been frozen.
When the US authorities changed tack in September 2008 and allowed Lehman Brothers to fail over a weekend, the consequences were immediate. Merrill Lynch decided not to take the risk of depending on market support and opted for a takeover by Bank of America. A lack of investor confidence caused AIG, a huge insurance company, to have trouble raising capital, sending it into the arms of the US government. The cost of borrowing money in the banking sector soared, and share prices of the remaining investment banks came under attack. The US Treasury was forced to dream up a $700 billion bailout plan to buy the mortgage-related assets that were undermining bank balance sheets. For a few weeks the financial markets seemed to freeze completely.
In short, the huge change in the international financial markets, which has allowed capital to flow freely across borders, made investment banks just as important as commercial banks. Indeed, investment bankers often make the system tick by acting as market makers; they offer to buy or sell shares and bonds at a given price in the market.
In theory, market markers can make money through the spread – by buying shares or bonds at a lower price than they sell them. But in an electronic market with thousands of players, it can be quite difficult to make a lot of money this way. So they end up betting on trends in the markets – trends that can go wrong.
The risks were increased by the high level of leverage (use of borrowed money) employed by the banks. They used gearing ratios of 25 or 33 to 1, meaning their assets were many times their core capital. In such circumstances, a fall of 3 or 4 per cent in asset prices could wipe them out. Of course, the investment banks employed highly sophisticated models (devised by PhDs in maths and physics) to monitor those risks. But either these models were flawed or the risk managers were simply overwhelmed by the power of the traders, who could point to the short-term profits they were generating.
Top traders can take home earnings (including their bonuses) that easily stretch into six figures and often top a million. If not properly monitored, however, their activities can endanger the health of the bank, as Barings found with Nick Leeson and the French bank Société Générale found with Jérôme Kerviel. Derivative instruments, such as futures and options, can be difficult to understand and can behave in unpredictable ways. It can be easier to disguise losses for long periods.
Even when traders are not careless or fraudulent, they can just be wrong. When markets fall sharply, banks often face losses from their proprietary trading activities. Even the more standard activities of arranging new issues and takeovers can be highly volatile; when markets are in the doldrums, few companies use the stock market to raise capital and few bids are announced. Market downturns in the early 1990s or in 2000–2002 caused a number of banks to announce write-offs to profits.
But in the good years, the best investment banks earned very high returns on capital. It is rather like the film business. A lot of films lose money and it costs a fortune to hire a Hollywood star; but get the right picture (such as Titanic) and the profits are huge.
In particular, the returns on capital can be very high. That explains why investment bankers can earn enormous amounts, in return of course for working very long hours. The annual bonus round is the most important time in an investment banker’s year. A big payment may mean a new house, or financial independence. But this is a relative, as well as an absolute, contest. Bonuses are supposed to be private but the best rewarded can rarely avoid boasting about their gains. And nothing spoils the pleasure of a £250,000 bonus more than knowing your colleague got £500,000.
It is a tricky decision for an employer. Make the bonus too small and the employee will leave in disgust. Make it too large and he may leave anyway, because he has already lined up another job on the quiet. In addition, it may well be that the employee’s success is down to luck not skill, particularly if he is a trader. When traders lose money, they may get fired but don’t have to pay past bonuses back. That creates skewed incentives.
The demise of Bear Stearns and Lehman Brothers illustrated the problems. It was not that the bankers didn’t suffer; a lot of them had their wealth tied up in company shares, which were virtually wiped out. But the bonus culture may have encouraged them to dream up complicated instruments like derivatives that earned high fees in the short term but were very dangerous to the health of the banks in the medium term.
Their key weakness proved, like Northern Rock (see Chapter 3), to be their dependence on the wholesale markets for capital. The markets proved to be ruthless in withdrawing their money from faltering institutions. That forced them into the arms of the big commercial banks, that had more stable sources of funds from retail depositors.
The irony is that, after the crash of 1929, regulators decided it was too risky to let investment and commercial banks be part of the same group. The Glass–Steagall Act of 1933 separated the two, so that the funds of ordinary Americans would not be put at risk. The response to the 2007–2008 crisis has been to push the two together again.
One further point is worth exploring. The biggest investment banks are all-singing, all-dancing institutions which play almost every role in the financial system. For example, many have fund management arms, which manage money on behalf of small pension funds or charities, or the savings of private investors, via unit and investment trusts.
The banks also have their own teams of investment analysts who pore through the accounts of companies listed on the market and make recommendations about which shares are attractive or overvalued.
This raises a number of conflicts of interest. Suppose a corporate finance team is arranging a takeover for a client, which involves that company using its own shares. What if the analyst covering the company thinks the shares are overvalued? That would send out a bad message to the market. But if the analyst changes his view and starts singing the praises of the shares, his clients are entitled to be cynical. And what if the bank’s fund management arm buys shares? Is it doing so because of a dispassionate analysis of the company’s merits or because the purchase will help the deal go through?
This issue came to the fore during the dotcom boom of the late 1990s when analysts touted the attractions of companies which had never made a profit and had little even in the way of revenues.
It became clear that analysts were far from unbiased and were motivated by the need to ‘do deals’– to persuade companies to hire the analyst’s bank as managers for the company’s flotation. The more optimistic the analysts were prepared to be, the more likely it became that his or her bank would get the deal.
Analysts face a further problem. Companies do not like to hear that their shares are overvalued, any more than actors or writers like to receive a bad review. Analysts who tell their investment clients that they should sell a company’s shares may find that the company’s management refuses to speak to them. That can be a real problem for an analyst seeking to prepare an in-depth report on a company’s finances.
The net result of all these pressures is that analysts make very few sell recommendations – according to one survey, buy recommendations exceed sells by 9–1. Many of the big institutional investors now employ their own analysts to get round this problem of biased advice.
The future of investment banking is open to question after the events of 2008. A few boutiques will remain, offering the kind of advice that used to mark out merchant banks. Goldman Sachs received a vote of confidence from the world’s most famous investor, Warren Buffett and Morgan Stanley received an injection of capital from the Japanese bank Mitsubishi UFJ. The decision to take commercial banking status should help by allowing them to borrow directly from the US central bank (and to take on more stable retail deposits.) Nevertheless, it will be interesting to see what would happen if either bank incurred further trading losses. They may only have to be unlucky once.
What we learned from the crisis of 2007 and 2008 is that investment banks are just as important as commercial banks to the health of the financial system. They are at the heart of the markets, involved with deals with big companies, governments, pension funds and charities. When they fail, confidence in the system fails. And that is disastrous for the economy.