Misunderstanding the Banking Industry

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Please cite the paper as:
&lquo;Richard Whelan, (2012), Misunderstanding the Banking Industry, World Economics Association (WEA) Conferences, No. 3 2012, Rethinking Financial Markets, 1st November to 31st December, 2012&rquo;

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Abstract

This essay makes the case for a fundamental reconsideration of the role of the banking industry in the West in a situation where economic growth and development is much more dependent on that industry than many of us envisaged. It looks at the growing intermingling of important public social, political, economic, and financial activities between the banking industry and Western governments and the consequences of those unplanned developments.

The approach is diagnostic, not prescriptive. I hope that readers will understand that I eschew the standard reflex reactions of the political Right and the Left as they – like the system they criticize – fail to deal with the problems they purport to confront, and crucially do not understand the nature of the banking industry today.

In analysing the banking industry as it actually operates in the West, my agenda is to begin a discussion on the real nature of that industry-if we do not understand it properly, our proposals on its restructuring, reform, and regulation will be at best misplaced.

I begin by drawing attention to the fact that the banking industry no longer belongs in the public or private sectors, but is a uniquely powerful hybrid of both, and its multi-faceted activities reach directly into core activities of government. As in all human endeavours, villains occur from time to time, but my purpose is get beyond the sterility of the “blame game” to initiate a meaningful discussion on the first steps to a New Banking Order which is robust, responsible and accountable. My belief is that this first step is a dispassionate factual examination of where that industry is today. I hope this essay will be understood as an attempt to move in that direction.


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6 responses

  • Dear Prof. Whelan,

    I fully support your concluding remark „ It may be impossible to regulate the Western banking industry in any meaningful fashion until significant restructuring of its relationship with Western governments has been completed. That will not happen any time soon, I fear.“.

    Another final remark I think needs some (mathematical) refinement:„…Western banking industry should not be thought of as part of the private sector, but a unique sector all on its own, utterly separate from the public and private sectors.“.Well, from a social point of view, I also will support this remark too.

    But, from a just econometric viewpoint, their is a diametral contrary point to reflect on: First of all your are right, in classical growth theory of macroeconomics the financial sector of the economy is not mentioned enough, and even not mentioned in a suitable way, but mostly not even anyway. And this is of course the main fact why classical theories of economic growth did not work, as they never include a financial crisis as an intrinsic possibility.

    If one takes every asset, every financial product, into the account (the whole of debt owned to the market), the outcome is quite perfect. It will show perfectly the evolution of the economy as the upcoming of crisis after time also.

    To say it in short, the reason why the economy gets into crisis is, that the whole of interests for the whole of all assets traded in an economy after two generations gets larger than any remaining possible growth of the economy. From this point on interests and especially the compound interests „eat up“ the entire growth plus more.

    As a rough approximation of this fact, we shall have a look at the well known quantity equation [pmath]<MV=HP[/pmath], saying that the flow of money MV equals the flow of trade HP. In classiocal growth theory, this assumption is used just for the rael economy. But we have to expand it to all traded goods, including the socalled financial products. Thus we split it to the two parts of it:

    [pmath]KV=M_R V_R + M_I V_I=H_R P_R + H_I P_I=Y_0[/pmath]

    where index R is denoting the „real“ economy and index I the „Banks own Business“ (I for Investmentbanking) with financial products, which are by them selfs a kind of money (derivatives). The index 0 just identifies the maximal possible GDP Y(t). We can thus rearrange it easily to:

    [pmath](M_R V_R + M_I V_I) – H_I P_I = H_R P_R [/pmath]
    which can be rewritten by definition to

    [pmath] KV – H_I P_I = H_R P_R = Y_R < Y_0 [/pmath]

    The effect we see is, that the BanksOwnBusiness shortens the money available for the real economy. But as all of the functions M,V,H,P are (mostly growing) functions of time, the effect increases dramatically only after some time, when the I-part of the economy has about doubled the real economy. This will take about 60 years in average. A reset of the dramatic increased situation can only be done by destroying the M_I part, and thus is a political „incorrect“ way, which leads allmost offen to the large wars, which work as the main gadget to reset economies. Especially it is politcally a very problematic task, as the mixing of Banks Business between the I and the R part of financial business is as such strong, that destroying M_I also effects deeply M_R.

    How it works in detail you may find some literature which evolved since 2009 at the link http://genreith.de/index.php?id=economics-of-growth-and-crisis .You'll find there also a free readable mathematical Webbook to the whole Theory.

    With best regards, Heribert Genreith.

    • Dear Sir,

      Thank you for your comments. I apologise for the delay in responding.

      I appreciate the effort you have made in supplying the econometric information in your commentary. I am not expert enough in that area to comment specifically on that information. I would however point out that I am not convinced that information fully contradicts contradicts the core contention in my paper that the banking industry, particularly from the point of view of economic and financial understanding and regulation, should not be seen as a normal part of the private sector, but instead should be considered a unique hybrid of the public and private sectors.

      Kind regards,

      Richard Whelan.

  • The maths in my last comment got misshaped. The pmath shape should be:

    [pmath] MV=HP[/pmath]

    [pmath] KV=M_R V_R + M_I V_I=H_R P_R + H_I P_I=Y_0[/pmath]

    [pmath] (M_R V_R + M_I V_I) – H_I P_I = H_R P_R < Y_0[/pmath]

    [pmath] KV – H_I P_I = H_R P_R = Y_R < Y_0[/pmath]

  • misshaped again, should I better use the syntax?

    MV=HP

    KV=M_R V_R + M_I V_I=H_R P_R + H_I P_I=Y_0

    (M_R V_R + M_I V_I) – H_I P_I = H_R P_R < Y_0

    KV – H_I P_I = H_R P_R = Y_R < Y_0

  • Aaron Pitluck says:

    Mr. Whelan, I found your paper a rewarding read—with clear and succinct prose you make non-trivial arguments that have direct implications for how to rethink financial markets.

    I agree with you that there are many aspects of the banking industry that are unique to other industries, and therefore I agree with your argument that the banking industry has unique regulatory problems. However I think you do a disservice to your argument by exaggerating the sector’s uniqueness, and therefore separate yourself from lessons that we could learn from regulating other sectors of economic life.

    The evidentiary weight for your uniqueness thesis (i.e., “three sectors now need to be separately distinguished, regulated, and recognized—the public sector, the private sector, and totally different from both—the banking sector”, p.2) is in pages 2-3. This section takes an argument that we are all familiar with—“too big to fail”—and expands it to include the entire banking sector rather than merely the largest transnational banking corporations. I think many readers would consider this an extreme position. Your position may indeed be correct, but to be persuasive, extreme arguments need particularly strong supportive evidence. You argue that “the impact of the collapse of a bank (unless it is absolutely tiny) on any individual country is such that there is worth almost anything to the party in power and the public sector to prevent such a collapse. This gives undue power to the banking industry, vis-à-vis both the public sector and the political party in power.” (2)

    In the United States, we can see potential counter-evidence in the long historic period before deposit insurance when bank failures were shockingly common. Government intervention to prevent bank failures in the period was apparently minimal. In our current era of federally insured deposits, the populist political pressure to politically prevent every bank failure seems even weaker since depositors are only minimally affected. Following the sub-prime crisis, a historically large number of banking firms have gone belly up every year, with the government providing the public good service not of preventing the bank’s failure, but rather of easing the transition and finding a buyer.

    A fine journalistic account of on how bank failures in the US routinely occur (and are managed) was told in a nice piece of radio journalism by Chana Joffe-Walt: http://www.thisamericanlife.org/radio-archives/episode/377/scenes-from-a-recession?act=2

    Here’s a list of 492 banks that the Federal Deposit Insurance Corporation has taken into temporary receivership and sold since 2000: http://www.fdic.gov/bank/individual/failed/banklist.html

    For readers interested in the relationship between politics and financial markets, I heartily recommend a historic perspective: Bruce Carruthers, 1996, City of Capital: Politics and Markets in the English Financial Revolution, Princeton University Press.

    Aaron

  • Dear Sir,

    Thank you for your kind and detailed comments. I apologise for the delay in responding.

    Whilst no expert in US banking, I note the helpful information you have provided with respect to the willingness of US authorities to let banks fail, not just historically but also in the current era. I fully accept that the comments in point 1 of my paper are therefore not applicable to the US, and therefore the argument in that point does not have application to the West overall. Having reconsidered the contents of that particular point, following your comments, it is clear that that point (1) is the main applicable to the Eurozone only.

    That raises an important question. As a resident of the Eurozone have I mistakenly applied the issues and structures in its banking industry to the West overall?

    I have reconsidered the arguments made in the other six points in my paper in this regard and believe them to be certainly applicable to the US, and potentially the West overall in the main, whilst acknowledging that my knowledge of the underlying detail in the US with respect to point 4 is limited.

    My initial conclusion is therefore that, while accepting the argument you have made with respect to point 1 in my paper, the overall position set out by me of the uniqueness of the banking industry in the broader sense still has considerable merit. That overall conclusion does require further detailed consideration, research, and debate. As part of that exercise, the precise definition of banking in this regard, a matter you correctly draw attention to, should be carefully considered.

    Kind regards,

    Richard Whelan.