Haldane on the evolution of banking

by Russ Roberts on October 25, 2011

in Gambling with Other's $

Andrew Haldane of the Bank of England (HT: Diane Coyle) in a recent speech looks at the increased leverage and the socialization of losses in the banking industry:

This century-long evolution in banking occurred for understandable reasons; it was no-one’s ‘fault’. But it has also unearthed a governance fault-line. Ownership and control rights are exercised by shareholders. But for banks, equity is a vanishingly small fraction of their balance sheet. Worse still, equity-holders often have risk-taking incentives out of line with the interests of other bank stakeholders, much less society. This fault-line lies at the heart of the imbalance between privatised returns and socialised risks. Only in banking do control rights and incentive wrongs combine so uncomfortably.

Confirms all my prejudices. They might actually be right.

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Greg Webb October 25, 2011 at 5:47 pm

Russ, the quote from Andrew Haldane’s speech is exactly right based upon my more than casual observation of the last two banking crises.

Jim October 25, 2011 at 6:32 pm

Give control of money to a private industry. Allow government to borrow based on politicians whose election hopes will rise in relation to how many favors they give to their constituents and donors. Add confusing economic malarkey where increased spending based on the Ponzi scheme of taxes can actually destroy the negative effects of mis-aligned capital, even if it is perpetrated by erroneous banking monetary policy.

The ending is inevitable. The banks will subsume the lion’s share of the economy’s profits under towering government debt.

kyle8 October 25, 2011 at 6:55 pm

The Fed is a political animal, The treasury is of course also political. The Giant mega banks that were allowed to swallow up all their regional competitors until they became too big to fail have also become politicized.

So everything is bent to the party line, we must have these deficits, we must monetize this debt!

In this the OWS is correct, we have allowed both parties to push crony capitalism to the brink.

W.E. Heasley October 25, 2011 at 7:27 pm

“This fault-line lies at the heart of the imbalance between privatised returns and socialised risks.” – Andrew Haldane

In the main, hasn’t the last eighty years of public policy [politico-policy through the mechanism of government] fostered the socialized risk from the bottom up? James and Jane Goodfellow can not lose a dime up to the FDIC insurance limit. Small and medium banks that fail are taken over by other banks. When large banks fail they are bailed out and/or nationalized-rehabilitated. Hence no one fails from the bottom up.

“Risk” would imply gain or loss. The risk to fail has been removed yet somehow risk remains and hence requires a return [privatized returns]. Hence a rational participant in this scheme would maximize risk to maximize return as maximum risk is the rational avenue if implied loss is merely socialized risk meaning no ultimate loser.

Martin Brock October 26, 2011 at 8:12 am

Haldane hits the nail on the head. A bank need not hold title to the collateral for its loans. The bank’s creditors (depositors, note holders) may hold these titles and bear most of the risk of depreciation as well as receiving the lion’s share of the rewards of extending credit. Since the accounting functions of a bank can now be automated, this arrangement is very practical.

A bank operating this way does not create opportunities for bank owners (and their administrative surrogates) to reap large rewards by gambling on leverage (and bailouts), and that’s the problem. Bankers are accustomed to reaping these rewards, so they aren’t interested in automating themselves out of the business.

A modern bank with modern technology can decentralize the credit policing business for which bankers are nominally responsible but which they routinely pass on to statesmen when they perform it poorly in the pursuit of highly uncertain profits. Decentralization is the only solution to this problem, because decentralized creditors are the only people with sufficient knowledge to take more rational risks.

Unfortunately, creditors are so accustomed to bailouts that they hardly understand the risks of extending credit anymore. This problem exists at every scale, from too-big-to-fail megabanks to depositors in state insured bank accounts.

Even nominal “experts” expect formulaic risk-hedging techniques to solve all of their problems, but these techniques often model risk simplistically and unrealistically, by assuming a thin-tailed distribution of risk for example. In other words, these “experts” and “generalists” are clueless central planners substituting simple machinations for knowledge they do not and cannot possess.

When these simple techniques generate profits, the planners declare themselves brilliant and award themselves a bonus. When the techniques fail, they declare an “emergency” and call their Congressman for a bailout. This problem will persist as long as the bailouts persist.

Per Kurowski October 26, 2011 at 8:22 am

Astonishingly, or perhaps not, Haldane makes no mention of the role that the pillar of the Basel bank regulations, namely the capital requirements that discriminated based on ex-ante perceived risk, played in the increase of bank leverage… as if the regulators, playing risk-managers for the world by means of arbitrarily assigning their risk-weights, and which for instance allowed the banks to build up their exposure to Greece leveraging their capital over 60 to 1, had nothing to do with it.

Martin Brock October 26, 2011 at 9:37 am

If regulators allowed banks to take risks, as opposed to compelling them to take risks, I don’t have a problem with it. Regulators should allow banks to take any risk they like in my way of thinking.

If banks “allowed” to take risks somehow merit a bailout when the risks that they’re “allowed” to take generate losses, that’s the problem.

Methinks1776 October 26, 2011 at 8:33 pm


Hobson October 26, 2011 at 9:37 am

Actually Haldane’s comments make very little sense.

Whatever the share of a bank’s balance sheet equity represents, it represents 100% of the money invested by the bank’s shareholders. None of them want to lose any of their money no matter no matter how small a fraction it represents of the bank’s balance sheet. In theory they would exercise all the control they have to avoid losing their investment.

The quantum of control of shareholders is not affected by the fraction that equity represents on the balance sheet.

Moreover, shareholders “control” publicly traded banks (or any other kind of publicly traded corporation) more in theory than in practice, because: (1) Most shareholders are so diversified with their investments that they can afford to pay little attention to any one holding, (2) They typically assume that they know less about banking than the bankers, (3) They are informed about what the bank is doing as little as the bank thinks it can get away with, (4) The shareholders are no more likely to appreciate the hazards of bank’s actions than are the bank’s board or officers, and (5) The means of coordinating the exercise of shareholder action so that it is large enough to have any effect are few and cumbersome. This is true (now and even more so 100 years ago) no matter the share of the balance sheet equity happens to represent.

Haldane appear to be ad hoc storytelling at its finest because it sounds erudite and it is new to most listeners. The storytelling is so good it can suck in some really smart people. It’s a great illustration of Russ’s confirmation bias concern.

Martin Brock October 26, 2011 at 9:56 am

The quantum of control of shareholders is not affected by the fraction that equity represents on the balance sheet.

The fraction that equity represents affects the risk that shareholders will bear, because the upside of a highly leveraged balance sheet is theoretically unlimited, while the downside is limited to the shareholder’s investment. The large upside rewards involve black swans and fat-tailed risk distributions. Some people reap huge rewards by taking these risks, but diversification does not lower the risk.

Moreover, shareholders “control” publicly traded banks (or any other kind of publicly traded corporation) more in theory than in practice …

That’s also true. The shareholders’ administrative surrogates.actually make the risky decisions on a daily basis, and these surrogates are even more insulated from the downside. Often, they’re salaried employees with golden parachutes of one form or another.

jim October 26, 2011 at 10:06 am

Have banks been financing the compounding increases in unrepayable gov’t debt? 2nd Question – who will be paying the Piper?

Appo Agbamu October 26, 2011 at 5:22 pm

GenAppo is a blog that gives insight to our generation on economic issues that will impact us. These decision are being made whether or not we get involved. Lets Reclaim Our Future.

Canada Goose on Sale October 26, 2011 at 10:57 pm

In my opinion, the bank always has an exorbitant profit from the common people, they are the winner for ever.

Ken October 26, 2011 at 11:32 pm


The wonderful thing about free trade is that it is win-win. When someone wins, like the banks in your example, the “common people”, as you call them, win as well. They have a safe place to store their money and they have access to credit with which to buy things, like houses and cars.

Richard Epstein clearly explains this.


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