Where is the liquidity?

Have you ever wondered why it’s become so difficult to open, or even just simply operate, a bank account these days? Why your bank treats you in a way that makes you wonder if they want your business at all? If so, I think I have the explanation for you and, for once, I think banks are not to blame.

Regulators are price setters. They may not like it, or like to admit it, but whether it’s in electricity, gas, water, data-lines, telephony, or public transport, the cost of ‘production’ or the cost of distribution, or both, are set by regulators directly or indirectly.

Take water: OFWAT in the UK, for example, controls not only the environmental impact of ‘production’ methods, but also the wholesale and retail price of water. It controls both costs and unit-revenues of the sector.

Banking is moving in the same direction: We want ‘cleaner’ banking (which should cost more), and we want to control the costs and where the profits go in the banking system. And we don’t want this to impact the service level. In short, we want to have our cake and eat it too.

Regulation is generally most prevalent in the sectors which materially influence the wider business environment: Infrastructure, transport and banking are part of this. And, quite rightly, we see the business of providing a good ‘business environment’ as an issue of public concern. This is why conflicts of both ideology and political practice typically focus on exactly those sectors when searching for the right balance between state-run monopolies (whose costs and inefficiencies tend to ratchet up and up over time) and a free market (which is good in generating profits and efficiencies, but will at times produce unforeseen, uncontrollable, and unintended consequences).

The international political consensus over the last years was that by simply being tougher on banks the ‘excesses’ of the free market would be contained and we get back to a healthier system. It has been a tempting story to sell to a public which is angry at the damages caused by, and the excesses discovered in, the banking system. But it is a non sequitur, even a miscalculation, with real consequences: Just by putting pressure on and lowering the margins, you don’t get a ‘cleaner’ industry.

Let’s see how this would work in the water sector: If you reduce the unit-margins on water, companies may be tempted cut corners: You may get less clean water, or less compliance with environmental rules. So you have to tighten your controls on both the quality of the water and the environmental controls at the same time as you put the squeeze on margins. The consequence is that while you drive up the cost of production you’ll get less output, as some previously profitable pockets becomes loss-making. The overall supply of water goes down.

It would work the same way in the transport sector, in wholesale data, in power generations, etc: you can tighten control on margins, but you’ll have to tighten controls on ethics and quality at the same time, and you’ll end up with less supply.

So does anyone still wonder why credit is in short supply? It’s a natural fact that you cannot control (a) the cost of production and distribution, (b) the ethical standards and the social impact, and (c) the quantity of supply all at the same time. Banking (ironically, much like failed communist regimes), failed in dimension (b) in the past. With that starting point, if you fix (b) and in the process make the whole thing more expensive at the same time (point a), you have to get a squeeze on supply (point c). It’s that simple.

It’s just what happens if you are a price (or cost) setter: you will shift the supply balance. Now remember that the regulated sectors are regulated precisely because they are the most critical to a functioning society: A shortage of potable, affordable water will make people go and drink unsafe stuff bought at the street-corner. Nobody wants that. A shortage of ‘clean’ and affordable banking services will push up peer-to-peer lending (at best), pay-day lending and loan-sharking at worst, and drive up the incentive to participate in the cash-based, grey economy. etc. etc.

Today, it is often difficult to open, or even just operate a bank account. Banks will not give you a reference, will send your statements to the wrong address, make you pick up important documents in person, refuse to deal with you over the phone or over the internet, and lose some of the documentation you have already provided, all before you have even opened the account. Their service levels are appalling compared to what they used to be just a few years ago, and that’s deliberate: There is simply no point for banks in growing their customer business at present. We have reached the point where the customers are so ‘protected’ (and therefore expensive) that nobody wants them any more, at least not at the price point we have come to expect before the global financial crisis. It’s like French labor laws which try to ‘protect’ the labor force so much that no-body wants to create jobs any more. This is not a great state to be in as a society!

To see what’s going on in banking at the 50,000ft level, you have to just try and deal with the everyday. Banks respond to a margin-squeezed environment by trying to shrink themselves to health. And because they can’t just fire their customers, the next best thing is to treat them poorly: change interest rates, withdraw credit lines, mislay documents, invent new hurdles, etc. They may be quietly glad if you feel that they don’t like you, and praying that you voluntarily take your business elsewhere (and if you stay you will certainly pay more in fees). Alas, where do you go when the next bank has the same issue? Again, this is not good for the economy, or for anyone!

Meanwhile, politicians blame banks for withholding credit from the real economy, while what’s really wrong is that the planners have forgotten or ignored that you cannot regulate both margins and supply independently of each other, in a regulated free market. 

Regulators must accept that they are price setters. In a regulated free market, this power is akin to that of a central planner. With that comes a grave responsibility not to fall prey to populist rhetoric.

It is not all bad, though. Perhaps we understand that a ‘clean’ banking system will cost us growth compared to the turbo-charged sub-prime mortgage years, and maybe that’s a price we have become ready to pay as a society after the global financial crisis. It’s just that everything in the last few years tells me that the US is doing a much better job than Europe in recognizing that a balance has to be struck nonetheless, between improving protection and ensuring supply.