Much has been written since the JP Morgan trading fiasco and the big Congressional hearing last week – some of it enlightening, but most of it confusing some of the basic elements about banking and money in general. I was reading this piece yesterday on Bloomberg about the responsibilities and the “job” of banks. It got me thinking about how badly people confuse the role of banks in our system. So I thought I’d chime in.
Banks are, at their core, profit seeking establishments that serve as the lifeblood of a complex payments system in the monetary system. Banks make a profit by having liabilities that are less expensive than their assets (well, it’s more complex than that, but let’s keep things simple here). They compete for deposits and business by offering various products and services. In the USA banks are almost exclusively owned by private shareholders (as in, not the government or public sector). Like most other private profit seeking entities the goal of a bank is not just to service the smooth facilitation of this payments system, but to to make money for its owners. Most of the time, these two functions do not conflict, but at times the risks banks take can indeed jeopardize the functioning of the system. Despite all the bad press that banks receive the progress surrounding their various services have actually had a positive impact on the world (for the most part). Bank accounts, credit cards, debit cards, investment services, business hedging services , etc are all elements that make the institution of money more useful and more convenient. Seeing as money is a tool and a social construct it makes sense that banks have evolved products and services to help facilitate the ease of its usage (all in the name of competition and profit generation, of course).
But we have to ask ourselves the question again. What is Wall Street’s job? Wall Street’s job is simple. It is to increase earnings for their shareholders. It is not to provide jobs for the private sector. It is not to make sure the US economy is running smoothly. It is not to make sure you feel good about your day to day life. It is to generate a profit for its owners. This is the essence of private banking. To generate a profit. But banks play a unique role in our capitalist system. I’ve explained before that banks are not the engine of capitalism. They are simply the oil in the machine. As the oil in our machine, banks must be functioning smoothly in order for the machine as a whole to be functioning smoothly. So when big banks do bad things that threaten their well-being parts of the system begin to malfunction. And sometimes when these mistakes are big enough the contagion leads to the entire machine malfunctioning and requiring a major repair (hello 2008!).
But make no mistake, your local bank is not your best friend or a public purpose serving charity. For instance, when a bank extends a mortgage (a word literally meaning “death security pledge” from the latin root “mortuus” for death and germanic “security pledge”) they are not doing you some charitable service to help you buy your home. They are rating your credit risk and evaluating you as a potential profit engine for their shareholders. That might not be the most pleasant way to think about it, but it is what it is. A bank is not a charity. It does not really care if your mortgage results in jobs or happiness for you. Of course, it would be great if this did because that might result in more future business, but the bank does not need these things from you in order to generate a profit. It really just wants to manage its risks in a way that helps to generate a profit for their shareholders without excessive risk. Obviously, the debtor finds the mortgage advantageous, but don’t confuse this service for charity work. It’s just good old fashioned profit seeking and offering a service where one is needed (in this case, the debtor being able to obtain money they could not otherwise currently obtain).
The business of private banking is largely about risk management. A good bank manages risk by understanding how the various business components threaten the stability of the overall bank and align with this goal of generating a profit. And as we ripped down the regulations structuring the amount of risk these institutions can and cannot take (in addition to making the risk taking business more complex) we realized that banks just weren’t very good risk managers. This is not surprising to anyone who has been around markets for a while. Investors and people in general are irrational, inefficient and poorly suited to manage the risks associated with complex dynamical systems. So, for some reason, we all seem shocked when these profit seeking entities take excessive risks and prove to be poor risk managers. And since we would never blame ourselves (the home buyers for instance) we blame the banking institutions. And we write silly things about how they’re not doing their “job” or how they’re all out to screw the whole world. It’s just not that black and white.
From a social perspective, this is all an extraordinarily interesting discussion. Money is a social construct and a simple tool that helps us achieve certain ends within our society. But money is something that is to be earned within our society (or utilized by the government in a democratic manner that is in-line with our goals as a society). So there’s an interesting reality at work within the banking system. Banks, as loan originators, act as a way to obtain access to money for someone who has not yet earned money. And in return, they are charged a fee for “borrowing” this money that is technically not yet theirs. If there was no interest fee attached to loans the demand for this money would obviously be through the roof and it would render it worthless. Likewise, if banks make credit standards too lax, fail to properly asses risks and make credit plentiful they can create an imbalance within the system (by lending to people who can’t service their debt) that threatens the viability of the monetary system through the risk of excessive debt, defaults and inevitable de-leveraging (as we’re seeing now). In this world of “what have you done for me lately” and “get rich quick” (or more often, appear rich quick!) you have a messy concoction of borrowers who want their McMansion YESTERDAY and lenders who are willing to give you the money to obtain that McMansion TODAY so they can generate a bigger profit TOMORROW.
To me, none of this is a conflict though and does not mean the system, at its core is corrupted or failing. Banks are private profit seeking entities who play an important role in our society, but are not public servants and should not be public servants (a government managed loan system would almost certainly be a disaster waiting to happen). Obtaining money is a privilege, not a right. And a private profit seeking banking system serves to regulate the ability to obtain money before one has necessarily earned it (though there are certainly instances, such as some forms of government spending, where money is rightly distributed by political choice). But because banks deal in distributing the social construct that binds our society together we have a responsibility to oversee that money so as to bring the interests of these profit seekers in-line with the interests of society as a whole. So to me, it is not the capitalist profit motive that is evil here. Nor is it the greedy consumption driven actions of the borrowers that is evil. These are crucial elements of a healthy functioning monetary system.
I think we need to recognize that money is a social construct that is to be protected by the society that creates it. But we must also understand that, while private profit seeking banks are a superior alternative to a government managed loan system, these banks will inevitably be poor risk managers at points during the business cycle. There is plenty of blame to go around for the current debacle that is the US economy. Home owners were greedy in the run-up and the profit seeking banks were quick to turn that extra demand into higher earnings per share. This production/consumption component is a healthy functioning part of the capitalist machine. But when it involves the very oil that greases the engine we must understand that this is a component of the economy that requires great oversight and better regulation. I fear we still do not have this despite the recent changes. And the result is that this boom/bust cycle is likely to continue causing people to believe the very essence of capitalism is corrupted when in fact, it is the users and their misunderstandings who have abused the system. In failing to properly oversee the institution of money we have allowed it to fail us.
In sum, it is the misunderstanding of the essence of money that is evil here, not the system itself. We have misunderstood the essence of money as a tool and a social construct and how it relates to modern banking. And in doing so, we have allowed both borrowers and lenders to abuse that social construct. And with 8% unemployment and a floundering economy it is not just the banking system that appears bankrupt, but our society as a whole. Better oversight of the institution of money might not be able to fix our current problems, but it can certainly ensure that future generations don’t have to suffer through these same events.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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