Modern Banking

Origins

European banking originated in the 'merchant bank' of Lombardy, where grain merchants gradually displaced Jews, who were not allowed to hold land in Italy. Payment was advanced against the future delivery of grain shipped to distant ports, and then developed into services for third parties: settling trades for others, holding deposits, and issuing bills of exchange. To avoid carrying large sums of cash with them, merchants carried documents issued by moneychangers that were redeemable at fairs distant in time and space, and these documents could be discounted at rates that reflected the date and likelihood of redemption. Henry II of England levied a tax in 1162 to support the Crusades, and it was the Knights Templar that introduced more sophisticated banking practices from the Muslim east, until, grown dangerously rich and powerful, they were suppressed by Philip IV of France in 1307. The first Venetian bank with guarantees from the state was established in 1157, and by the mid 13th century banks throughout Italy had found ways of evading the medieval ban on usury. The Acciaiuoli, Mozzi, Bardi, Peruzzi and Medici banking families were prominent in Florence, and Lombard moneychangers travelled the busy pilgrim routes throughout Europe. Bankers came to dominate large areas of trade, and were correspondingly restricted or expelled, from Aragon (1401), England (1403), Flanders (1409) and Paris (1410). Nonetheless, two great banking families emerged in Germany of the fifteen century, the Fuggers and the Welsers, who controlled much of the European economy and dominate international high finance in the following century, which also saw important banking dynasties rise in Genoa. {1}

Banking innovation then moved to Holland which, after the 1585-1620 Dutch Revolt, offered a wide range of modern investment products — public bonds on a national, provincial, and municipal level, marine and commercial insurance, shares in publicly-traded companies like the Dutch East India Company (VOC), and their derivatives. Institutions like the Amsterdam stock exchange, the Bank of Amsterdam, and the merchant bankers set strict standards which, with the Dutch propensity to save, helped produce a large capital stock and so set the scene for Dutch finance systems under the new Dutch king of England, William III. {2}

The Dutch also employed bonds to finance the maintenance of canals, bonds that were continually renewed (as they were in Venice). Earlier to start even were life annuities, which go back to the thirteenth century in France. By 1535, 60% of Amsterdam's annual budget went on debt and annuity payments, and in 1671, de Witt's Value of Life Annuities in Proportion to Redeemable Annuities recognized the importance of life expectancy — which led to the proper study of probability by mathematicians throughout Europe (in which they were somewhat preceded by Sung China). {2}

England

Innumerable projects, large and small, foreshadowed banking in England, from the opening of the Royal Exchange in 1566, the draining of the Fens, the various joint-stock companies created for overseas exploration and trade, city loans by goldsmith-bankers, insurance in the Dutch manner, and the small loans farmers habitually needed to tide them over till harvest time. Most banks — and there were 119 country banks in 1784, and 552 in 1822 — were small, local affairs, limited to a few hundred pounds capital, though often with links to larger London banks that gave them security and greater opportunity. Most loans were for working rather than fixed capital, and the large merchant banks of London were much more interested in overseas opportunities than investment in British industry — one reason why the country did not maintain its early lead in the industrial revolution. {3}

But the Bank of England was a new departure, and by issuing banknotes against a national debt introduced the modern conception of capital creation. A limited liability corporation was formed in 1694 to provide a £1.2 million loan to the government of William III that was needed for war with France. Funds came from forty private individuals. The loan did not have to be repaid but an interest of 8% would be levied annually by taxes. The bank was the only limited-liability corporation in the country allowed to issue bank notes, which were thus a promise by the government to accept tax payments in paper money. From this modest proposal developed a national bank, one that proved immensely useful in an England strengthened by its union with Scotland in 1707, and went on to play a large role in the successful outcome of the Napoleonic wars a century later. The Bank of England also tied financial institutions to the Whig party and the Hanoverian monarchy, incidentally: a Jacobite party — popular with landowners — might have returned England to a Stuart policy of raising funds by taxation, greatly restricting trade and investment. The Bank Charter Act of 1844 rationalized matters, and the Bank of England gradually became the sole note-issuing authority. The bank acted as lender of last resort in the financial panic of 1866, but only a small part of its reserves (no more than 4%) were held in gold. In fact, Britain came off the gold standard in 1931, when the Bank was already transforming itself into a national entity under the governorship of Montagu Norman, was nationalized in 1946, but was given considerable independence in monetary policy under the Labour government of 1977. {4}

Like all state banks, the Bank of England controls the money supply by a. setting the minimum reserve requirements for the individual commercial banks, b. the buying and selling, interest-bearing bonds, and c. adjusting the interest rate at which it lends funds to banks, (which in turn controls the rates at which they lend to customers and to each other). {5}

America

From a banker's point of view, the history of coinage, currency and banking in the United States is one of increasing order, from ad-hoc local currencies in colonial times, through a burgeoning of poorly-licensed banks in the nineteenth century, to a well-regulated banking system overseen by the Federal Reserve Bank. {6}

The early colonists adopted local currencies of fur and wampum (strings of shells) for trade with native peoples, and a wide range of materials for internal transactions — country money (tobacco, rice, wheat, etc.) foreign coinage (especially Spanish and Portuguese silver), British coinage (golden guinea, silver crown and shilling and copper penny, halfpence and farthing: the official coinage but scarce) and their own coin and bank notes. All were inter-convertible at rates that varied across the country, and North Carolina in 1775 had no fewer than seventeen types of money declared legal tender. Bank notes were often over-issued, of course, which led to inflation and bank failures. As is well known, the British Government passed measures to prohibit paper money which, with ill-thought-out taxation, led to social unrest, war and the Declaration of Independence.

Under its Coinage Act of 1792, the new republic adopted the dollar, which was defined as 371.25 grains of silver or 24.75 grains of gold — i.e. both the newly minted gold and silver coins issued by the Philadelphia mint in 1794 were to be legal tender. Unfortunately, because the minted silver was slightly overvalued (at 15:1 gold) more silver was brought in for minting than gold, which became rather scarce. Other silver to gold ratios prevailed abroad, and it was not until 1834 that America came into line with the British ratio of 16:1. {7}

To raise funds for the 1861-65 Civil War, the Union first levied taxes, raised tariff duties and issued 20 year government bonds offering 5% interest. Similar measures were adopted by the Southern States. Much more successful was the $450 million issue of 'Greenbacks', which were in effect a fiat currency, not convertible to specie, but authorized as legal tender for all payments except customs duties and the interest on government securities. A 2% tax was imposed on State bank note issues in 1862, which was raised to 10% in 1866, but State banks survived. They declined in number from the pre-war peak of 1,601 in 1861 to 247 in 1868, but then grew more popular again. State banks were indeed overshadowed by private banks, and the number of all banks in the USA reached the staggering total of nearly 30,000 in 1921. {7}

The National Banking Acts of 1863 and 1864 attempted to bring order to this confusing scene by creating a system of national banks, a uniform national currency, and an active secondary market for Treasury securities to help finance the Unions funding of the Civil War. A Treasury Department, the office of Comptroller of the Currency, was instituted to insure compliance with the regulations, to hold Treasury securities deposited there by national banks, and, via the Bureau of Engraving, to design and print all national banknotes.

The Fed, a consortium of private banks that controls American monetary policy, was set up in great secrecy in 1913, first to address financial panics but then with the stated public aims of maintaining maximum employment, stable prices, and moderate long-term interest rates. It was preceded by a study of foreign banking systems running to 24 volumes, the most thorough of its kind, and the Pujo committee in 1913, which reported that it had 'no hesitation in asserting that an established and well-defined identity of interest. . . held together by stock-holdings, inter-locking directoriates and other forms of dominion over banks, trusts, railroads' etc. . . ' has resulted in a vast and growing concentration and control of money and credit in the hands of a comparatively few men'. The Fed was to correct those dangers. It would act in a supervisory central bank, as a clearing house, and the lender of last resort. By buying Government Treasury bills from selected commercial banks, and automatically creating the money to do so, the Fed would expand the money supply. To contract the money supply it would sell those Treasury bills again. {7}

Those critical of banking see matters very differently. The preceding panics and bank runs were engineered so that financiers like Morgan and Rockefeller could acquire companies cheaply and consolidate their hold on key industries. Creating the Fed only furthered that ambition, and the institution is still a private cartel, operating without democratic oversight but in close association with Wall Street. Far from making banking socially accountable, the Fed imposes yet another layer of secrecy on actions that have favoured cartel members more than US citizens, especially during the Depression years and the financial crash of 2008. Indeed the whole process under which silver was gradually outlawed as legal tender and a gold standard imposed brought the American machinery of government under private and possibly foreign control. Two well-known quotes are:

'Some people think the Federal Reserve Banks are US government institutions They are not . . . they are private credit monopolies which prey upon the people of the US. for the benefit of themselves and their foreign and domestic swindlers, and rich and predatory money lenders. The sack of the United States by the Fed is the greatest crime in history. Every effort has been made by the Fed to conceal its powers, but the truth is the Fed has usurped the government. It controls everything here and it controls all our foreign relations. It makes and breaks governments at will'.

— Congressman Louis T. McFadden, Chairman, House Banking and Currency Committee, June 10, 1932 {8}

'This is a staggering thought. We are completely dependent on the commercial Banks. Someone has to borrow every dollar we have in circulation, cash or credit. If the Banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless position is almost incredible, but there it is. It is the most important subject intelligent persons can investigate and reflect upon. It is so important that our present civilization may collapse unless it becomes widely understood and the defects remedied very soon.'

— Robert Hemphill, Credit manager of Federal Reserve Bank in Atlanta. 1935. {9}

Collapse of the Banking System

 

US Crisis 2007-2012

The financial crisis of 2007-2012 — which brought about the near-collapse of large financial institutions, the bailout of banks by national governments, stock market downturns, housing evictions, business failures, the European sovereign-debt crisis and unemployment across the world — wiped out several trillion dollars in consumer wealth. The story is well known through films, articles and books, though the remedial actions are still controversial.

Banking was once a safe occupation earning modest profits, around half that of the non-financial sector in America through the 1960s and 70s. Following deregulation in the 1980s, however, profits rose to 4-12%, considerably more than the 2-5% of non-financial firms. Many companies turned themselves into finance houses, and the ratio of financial to non-financial assets in US corporations rose from around 0.4 in the 1970s to nearly 1 in the early 2000s. {10}

Banking also became more enterprising in the 1970s, addressing the housing needs of disadvantaged Americans through 'subprime' loans at competitive rates. To aggressive selling was added easy credit, deregulation, financial status fraud and financial complexity. Loans were often sold as a second mortgage, and often again to those who didn't read the fine print on the higher repayments being charged after year two. Defaults weren't the problem of the originating mortgage company because the loans were securitised, i.e. branded as assets (secure streams of income) and sold on as complex financial products, often through a chain of intermediaries. Many observers were aware of the risks but said little, being unwilling to spook the markets or interrupt its moneymaking powers. The regulators assumed that Wall Street knew what it was doing, and Wall Street assumed the market was self-regulating: indeed their (faulty) models assured them they were fully covered. But when mortgage holders began to default in droves, those revenue streams became problematic. Good and bad loans had been complexly diced together, often several times over, which made all such assets suspect ('toxic'), and so untradable. The rating agencies had recklessly branded the financial instruments as safe investments, and guarantees had been issued by large insurance houses (often through CDSs, credit default swaps), though these guarantees became worthless when the houses could not meet the increasing extent of their commitments. The insurance houses were indeed linked to other investment companies, which in turn were interlinked further, creating a complex web of commitments whose ramifications often eluded the understanding of their own managements. {11}

The mortgage market reached saturation around 2005, and when the higher payments began to kick in, and the Fed several times upped interest rates, the bubble burst. Real estate values fell as properties were repossessed, devaluing the assets which had been sold to banks round the world. Banks had little collateral in many cases, sometimes only a few percent of loans, so that asset devaluation effectively bankrupted them. Potential losses were not confined to investment banks because repeal of the US Glass-Steagall Act in 1999 placed even high street customers deposits at risk. Banks refused to deal with each other. Nor would they lend without a proper assessment of their financial standing, which was impossible in many cases: no one could value the assets, or indeed wanted to. Banks were nonetheless complexly indebted to each other and to countries across the world. All were damaged. Businesses suffered. Companies cut staff or folded altogether. Stock markets crashed.

Lehman Brothers went bankrupt, as did many mortgage companies. Meryll Lynch was taken over by Bank America. AIG, Fannie Mae and Freddie Mac, and others had to be bailed out by the government — plus a host of non-finance companies, including General Motors — with TARP (Troubled Assets Relief Program) for $700 billion, with another $13 trillion earmarked for relief, of which $6.8 tn had been spent by June 2009. {12}

Protection from undue government regulation had been purchased through political campaign donations and lobbying. Countries seeking safe homes for trade surpluses (China, Japan, the Gulf oil states) invested in US treasury bills, or (less safe) financial products offered by the Wall Street banks. These were zero sum plays: the sums lost by some investors would equal profits made by others. Wall Street was preferred as the dollar is the world's currency. America enforced dominance by 'agreements' with trading nations (e.g. 1985 'Plaza agreement') and by exploiting weaknesses ( Mexico peso crisis of 1994, the Asia crisis of 1997). {13}

World Financial Crisis

Other countries suffered their own defaults. A share in Northern Rock, Barclays and RBS had to be acquired by the UK government. There were serious bank failures in France, Iceland, Spain, Greece and Italy. Contagion proved hard to contain, but countries faring best were those with conservative banking regulations and a variety of measures to improve foreign currency financing. {14}

A Little Terminology

OTC

Over the Counter is stock (commonly debt securities and other financial instruments such as derivatives) traded through a dealer network rather than over a centralized exchange. ETDs (exchange-traded derivatives) are traded via specialized exchanges

Derivatives

Derivatives are simply contracts between two parties that specify the conditions (date, quantity, price) under which payments are to be made. Derivatives often have special legal exemptions, making them an attractive way to extend credit, but their complex and opaque nature can underprice credit risk, which indeed contributed to the financial crisis. All have useful aspects, however, and business would be scarcely possible without them. Common groupings: {15}

Forwards: contracts to buy at a specific time in the future at today's predetermined price.
2. Futures: contracts to buy or sell before a future date at a price specified today.
3. Options: contracts that give the right, but not the obligation, to buy (call option) or sell (put option) at a specified (strike) price. How long the right exists is specified by the maturity date.
4. Binary options: contracts that provide the owner with an all-or-nothing profit profile.
5. Warrants: long-dated options (maturity date generally over a year): generally OTC.
6. Swaps: contracts to exchange cash (flows) on or before a specified future date, based on the underlying value of currency exchange rates, bonds/interest rates, commodities, stocks or other assets prices.
7. Swaption: option on a forward Swap.

Hedge Funds

Hedge funds are large investment vehicles used by wealthy individuals, pension funds and insurance companies, which probably account for half the daily turnover on the London and New York stock markets. Hedge funds invest internationally in anything that makes a profit, and are naturally secretive about their activities. Many charge high fees and do better for their managers than investors.

By using complex strategies, hedge funds aim to produce a positive return whatever way the market goes. Four main types are often recognized:
1. Market neutral or relative value, which try to exploit market inefficiencies or mispricings.
2. Event driven, which invest on anticipated mergers, bankruptcy or corporate reorganizations.
3. Long/short, which allow fund managers to buy some assets but sell others they do not yet own.
4. Tactical trading, perhaps the most volatile of all, which speculate on the future direction of markets.

Hedge funds are regulated by the appropriate authority (SEC in America, FSA in the UK), and tend therefore to be based offshore where tax and other liabilities are less onerous.

Hedge funds are not merely passive beneficiaries of market changes, but have the financial clout to make the changes, often through 'shorting'. Shares, bonds or currencies are 'borrowed' through a compliant broker, often without money actually changing hands. The market is influenced with rumours and/or a short selling spree, and the shares are 'sold back' at a lower price. The difference (less broker commissions) is profit. Naked shorting (borrowing without paying for the stock, i.e. not actually owning it) is illegal in many countries, but not in tax havens where many hedge funds are located. {16}

Credit Default Swaps

A credit default swap (CDS) is a form of insurance, a financial agreement in which the seller of the CDS will compensate the buyer in the event of a loan default or other credit failure. To receive this protection, the purchaser of the CDS makes a series of payments (the CDS 'fee' or 'spread') to the seller. Credit default swaps began in the early 1990s, and increased in use after 2003, rising to a total of $62.2 trillion at the end of 2007. CDS are unregulated but extremely useful, providing a measure of how the market views the credit risk of sovereign states, corporations and financial institutions. Since they can be purchased by anyone, even those without an insurable interest in the loan ('naked' CDSs), they may be used by large hedge funds to profit when their influence has been sufficient to trigger payment. In December 2011, the European Parliament banned naked CDSs in sovereign nation debt transactions. {17}

Asset-Backed Security

An ABS is a security (revenue stream) whose value and income payments are derived from (backed or 'collateralised') from a pool of underlying assets. The pool typically consists of small and illiquid assets (credit card, mortgages, auto loans, leases, royalty payments, student loans and movie revenues) that are bundled together ('securitisation') to make a financial instrument attractive to investors. In this way, the credit risk of the underlying assets is transferred to another institution, the originating bank can remove the value of the underlying assets from its balance sheet, receive cash, improve its credit rating and reduce the amount of capital that it needs to hold. The disadvantage is moral hazard: the mortgage originator has little interest in the borrower once the loan is sold on. (Nor could the householder negotiate with the mortgage company, incidentally, which no longer existed: a current legal tangle.) ABSs are usually awarded a rating by a credit rating agency: another conflict of interest if the agency puts profit above principle. {18}

Collateralized Debt Obligation

CDOs are a form of ABS with multiple 'tranches'. Each tranche offers a different of risk and return, from pension fund holders (low return and low risk) to high growth assets (high risk but also high returns). The 'senior' tranches are the safest securities, and the junior the most risky. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for the higher risk of default.

Synthetic CDOs are a step further, there being no collateral behind the ABS, only 'exposure' to events. The financial product is thus a form of gambling on the performance of investments, though a relatively safe one unless there is massive default. Some synthetic CDOs were also traded as normal bonds.

Finally (in this very brief summary: financial products are complex) came derivatives in which CDSs (credit default swaps) were bundled with CDOs or synthetic CDOs and sold by banks to their more trusting clients. A top rating by one of the rating agencies was essential as the products were difficult to assess. Because the banks owned the CDSs, and the clients the CDOs, the banks were able to unload their riskiest assets onto clients and still profit when the CDSs failed (as most did). Many of these products were deemed unethical in the investigations that followed the financial crash, but not illegal. {19}

 

Current Situation

Little has been done to make another financial collapse impossible or even improbable. The new act (Dodd-Frank Wall Street Reform and Consumer Protection Act of July 2010 ) gives the Fed more investigative powers. Regulators can ferret out systemic risk. A new consumer agency will see fair play and help borrowers withdraw from loans they cannot pay. Otherwise, the changes are largely cosmetic, although banks must now submit contingency plans. Shadow banking continues, bank scandals multiply, and the bonus culture is alive and well. Through Wall Street banks, the Fed is thought to be supporting the US stock markets, a policy driving away the smaller investor, and further increasing debt levels. The US Attorney General has admitted that some banks' operations are too big and complex to police. Banks are indeed using their 'excess' deposits — the excess of deposits over loans — as collateral for borrowing in the repo market, increasing the risk of default by entering into businesses that greatly extend their purported role: acquiring airports, toll roads, and ports, power plants and the like. Some view their growth as not merely parasitic but a dangerous cancer on the capitalist system, which must ultimately destroy even itself. {20}

Left-wing economists go further in their criticism of financial institutions. By making money out of money and not through socially-responsible investments in industries, infrastructure and public services, Wall Street has effectively bankrupted the country, transferring funds from middle- and working-class families to a small percentage of the already very wealthy. Some profits have certainly been ploughed into tangible capital investment, but more has gone into military spending, overseas investments, into loans for real estate, and purchases of stock and bonds. Far from enjoying the leisure economy predicted from the 1980s, American families are harder-pressed than ever. Productivity has gone up, but the gains are not reflected in higher wages: quite the contrary. On current labour participation rates, women will have to work 18 hour days by 2020 if economic trends are not to falter. Savings have been run down, and consumers, real estate and industry left in debt. Corporate raiders have hollowed out viable companies, raiding pension funds, cutting the work forces and achieving a paper profit to pay back loans granted entirely for that purpose. Corporations may also evade their obligations to the state that provides them with a healthy, disciplined and educated workforce: internal book-keeping fictions allow them to provide different statements to their shareholders and to the relevant tax authorities, at home and abroad. Finance unnecessarily inflates land prices: some 80% of bank credit in the USA goes to buy real estate, whose value depends largely on what the banks will lend. Financial institutions have successfully lobbied to keep interest tax-deductible, again inflating stocks, bonds and land prices. Anyone marrying today has commonly to pay off their student debt, take out a 30 year mortgage and an auto loan. Education has been privatised, and Social Security is under threat. America is not the democracy of free enterprise but closer to an oligarchy of the rich. Job insecurity has indeed kept pay increases muted, as workers live from wage to wage packet in paying off their debts. {21}

Other countries have fared worse: Iceland, Ireland, Latvia. One third of the latter's population has emigrated abroad or is planning to, inevitably when public sector wages have been cut by 30%, and when from wages taxed at 59% have to be paid large mortgages and fees to privatised services. The European Central Bank has ensured that creditors and bondholders of reckless loans made by Irish banks are paid back through higher taxes and lower social spending in the country as a whole. To pay its debts — which increase on each 'bailout' — Greece has had to surrender real estate, public buildings and services, port facilities, electric utilities and oil and gas rights in the Aegean. In short, the long-term goals necessary to public services and industry are being sacrificed to the destructive short-term interests of banks. The solutions are obvious, but unlikely to be implemented when finance and big business own governments and the media — reform the Supreme Court, reinstate the Glass-Steagall Act, send crooked bankers to prison, tax speculators, close down tax avoidance in offshore accounts, cancel bad debts that are never going to be paid, and invest in infrastructure and public services, keeping them unprivatised. Quantitative easing  has enabled banks to reflate their assets and avoid government takeover. {22}

 

The Transnational State

Some commentators view the traditional economic model of finance as superannuated. With well-developed stock markets, futures markets, real estate markets, commodities markets, derivatives markets, and similar markets for speculation, a large part of company profits is no longer reinvested into capacity building but diverted into making money out of money. Prior to 1980s, corporate and financial investment moved in tandem — both about 9% of GDP — but have since diverged. Corporate or real investment has declined to about 4% of GDP, while corporate profits have increased to about 12% of GDP. Approximately 80% of bank loans in the English-speaking world are real estate mortgages, and much of the balance is lent against stocks and bonds already issued. The so called FIRE sector ( finance, insurance and real estate) has grown astronomically. Over the 1980 and 2005 interval, profits in the financial sector increased by 800%, more than three times the growth in non-financial sectors. In the early 1990s there existed only a couple of hedge funds; by 2007 their number had grown to 10,000. The number of mortgage brokers, replacing old-style Savings & Loans and regional banks, has likewise mushroomed in recent years/decades: 50,000 thousand of them, employing nearly 400,000 brokers, more than the whole U.S. textile industry 'The money that's made from manufacturing stuff is a pittance in comparison to the amount of money made from shuffling money around. Forty-four percent of all corporate profits in the U.S. come from the financial sector compared with only 10 percent from the manufacturing sector.' The damage is to American jobs, but finance is now truly transnational, and often more powerful than the democratic will of even the largest countries. {23}

Some critics of banking go further. Ellen Meiksins Wood distinguishes between the Roman 'empire of property', a land-based system that stimulated unending territorial conquest; the Arab, Venetian and Dutch 'empires of commerce', dedicated to the protection of trade routes and market dominance; and the British 'empire of capital', marked by the imposition of market imperatives on conquered territories. Globalisation is the 'new imperialism' , the USA acting as the great enforcer — hence the overweening size of the U.S. military and that military’s need to leap into foreign entanglements that have no clear connection to U.S. interests. The likely end is constant war, currently termed an unending war on terrorism. {24}

Regulation of Banks

Banks generally resist regulation, arguing that such checks and restrictions interfere with free market forces. Yet money is not simply a commodity but also a measure of the trust inherent in making the loans that create and support business opportunities — essentially a trust that the loan will be repaid under the terms agreed. Money and credit is therefore a social relationship of trust — between banks and their customers, buyers and sellers, governments and their citizens. Long experience has obliged societies to create institutions to strengthen and safeguard that trust: the law of contract, standardized accounting procedures, the criminal justice system, codes of conduct for banks, and often a central bank to regulate and become the lender of last resort. All are essential, and need to work in a fair and transparent manner. Countries or periods of country's history lacking these guarantees see credit drying up and economic activity declining. Because they diminish the supply of credit, and the opportunities to apply that credit, European austerity measures have been generally counter-productive, as they indeed have throughout history. {25}

Nor have the banks behaved properly. Irregularities, fraud and sometimes criminal actions of banks continue to make headlines,  and many see government action, or rather inaction, as another example of complicity with financial shenanigans. No banker goes to prison, and the large fines imposed become simply 'the cost of doing business' . Given the symbiotic relationship between government and big banks, and the ability of government to now access and manipulate individual bank accounts, the current drive towards a cashless society may make the banks even less accountable, though digital state banks are one way of curbing the power of financial interests. {26} 

Banking regulation in America during the last century not only greatly reduced bank defaults, but — coupled with trade union power — led to greater social equality. The 'golden period' of the 1950s and 1960's was not created by unshackled capital and entrepreneurial enterprise but by shared responsibility. Social commentators therefore argue for fairer taxation of capital gains, the closure of corporate tax loopholes, and a financial transactions tax — all of which would steer investment away from 'rent seeking' into manufacturing and social improvements. But few now in the public arena want to take on the banks. As the European Commission president, Jean-Claude Juncker, memorably said in 2013: European politicians know very well what needs to be done to save the economy. They just don't know how to get elected after doing it. Clearly, western democracies will continue to be menaced by financial institutions until honest but unseated politicians can be found worthwhile employment elsewhere in the system, when they can safely turn from career needs to public service again. {27}

Predatory Capital

Modern capital is mobile and predatory. In 1997 the ‘tiger nations’ of south-east Asia suddenly caught a chill. There was nothing fundamentally wrong with their industries, and not all were heavily indebted to overseas banks and financial institutions, but once some investors began to pull their funds initial doubts turned to fear. Some $600 bn. fled the region in a year. The IMF, though set up to help in such situations, did nothing for several long months as currencies in Thailand, South Korea, Indonesia and Malaysia plummeted, credit dried up and thousands were laid off. When IMF loans did come they were accompanied by austerity conditions: employment had to be cut, social safety nets removed and investment deregulated. All but Malaysia accepted the terms, but their economies did not bounce back. Spooked by the crisis, investment did not return. In the resulting chaos, industries and local businesses were ruined and anti-Chinese riots in Indonesia left hundreds dead. Foreign banks and financial institutions made a rich killing, however, acquiring key industries at fire-sale prices. Over this period some 24 million lost their jobs. Of the 63.7% South Koreans who counted themselves ‘middle class’ in 1996, only 38.4% saw themselves so in 1999. The Asian threat to US manufactures was clearly checked, and continued so: economies have not recovered to pre-crisis levels. {28}

Future of Banking

Should something so vital to the public good remain in private hands? Many argue for state banks that offer loans only to prudent and successful local businesses. The Bank of North Dakota is often quoted: it flourished quietly through the 2008 financial crash. Others have suggested a 100% reserve solution, i.e. banks can only loan what is actually deposited with them, rather similar to 1911-67 US Postal Savings System. Sweden and Denmark offer interest-free and loan facilities, making a charge to cover costs. Governments are not always less efficient, as the unsuccessful privatisation as California's electricity and Britain's railways show. Indeed there are many banking possibilities that eliminate the casino mentality of private banking. {29}

Do we need banks at all now? Commercial banks face such competition from less well-regulated institutions — pension funds, mutual funds, investment banks and the like — that they have been obliged to shift away from the core business of issuing loans to more lucrative practices, thus adding to the great recession following the 2008 financial crash. Today the business of the big banks lies in four areas: funding their own portfolio with cheap money, corporate finance, selling their own securities and market trading. Many enterprising individuals, towns and areas have set up their own equivalents, which were remarkably successful until closed down by the authorities. Examples include Guadiagrele in Italy, German cities during Weimar hyperinflation, the Global Exchange Network after Argentina's bankruptcy in 1995, a system that eventually had 7 million members throughout Latin America, 30 local currencies in north America, and various electronic currencies. All offer the most basic of banking services, cash deposits and withdrawals, and do not speculate with loans and commissions applying. {30}

Radical Proposals

Some of the most radical proposals come from academics and economists associated with CADTM (Committee for the Abolition of Illegal Debt). Far from following through on promises to make the banking system more responsible, to separate commercial banks from investment banks, to end exorbitant salaries and bonuses, and to actually finance the real economy, they note that the banks have continued their risky and sometimes illegal practices. Even since 2008, over fifteen have been convicted of toxic loans, fraudulent mortgage credits, manipulation of currency exchange markets, of interest rates (notably, the LIBOR) and of energy markets, massive tax evasion, money-laundering for organised crime, and banks have been bailed out with public funds in France, Italy, Belgium, Portugal, Cyprus, Slovenia, Holland and Austria. There is an immediate need to:

1. Restructure the banking sector by breaking up the bigger banks and separating their commercial from investment activities.

2. Eradicate speculation by outlawing the practice outright, prohibiting derivatives, requiring financial products to be first inspected and authorised, and prohibiting shadow banking, high-speed trading and naked shorting.

3. End banking secrecy by prohibiting OTC trades, tax haven dealings and the present unaccountability of banks to their customers.

4. Regulate the banking sector by increasing the equity/ assets ration to 20%, taxing profits fairly, protecting deposits by customers, prosecute transgressing directors, increasing the liability of major shareholders to bank failure and instituting sound procedures for the orderly wind up of failing banks.

5. Find alternate ways of financing public expenditures, probably requiring banks to hold some quota of public securities and offer loans to public authorities at zero interest rates.

6. Bring banks back into the public sector, strengthening those that still exist and nationalising those that have been privatised.

Few of these proposals are novel, but CADTM has a socialising mission, urging major changes to banking law and oversight that would enable:

1. Citizens and public authorities to escape the influence of the financial markets,

2. Public authorities to finance projects more cheaply and securely, and

3. Banking to dedicate itself to the common good, effecting a transition from a capitalist, production intensive economy to one more concerned with social and environmental matters.

Many of these will be fiercely resisted, especially nationalisation, i.e. the expropriation of banks with compensation only to smaller shareholders, creation of alternative public services for simple saving, credit and investment needs, proper transparency to customers and a banking system answerable to public needs. {31}

Blockchains

The most radical of recent proposals would do away with traditional banks altogether through 'blockchains'. Physical cash and commercial banks would slowly become unnecessary as citizens held digital accounts, making transfers through central banks with 'digital blocks' that are verified through databases held by thousands of computers across the world. Each transfer would be a unique record with a unique history, making fraud well nigh impossible. The technology exists to process 80,000 transactions a second, and to date- and location-stamp each of them. It is indeed already in use by some American states, companies, pension funds and some millions of individuals.

Sceptics wonder if the drive towards a cashless society is yet not another erosion of citizen rights, and whether the human ingenuity required to set up such a system could not be undone by a similar ingenuity working in reverse. Bitcoin units have also been very volatile in value, and have attracted transaction charges as high as 7%. Nonetheless, if extended to eliminate settlement time between trades, and augmented with automatic credit-worthy assessment, the system would change every money transaction system we know, eventually dispensing with banks, clearing houses and brokers. Banks are reportedly developing similar technologies themselves, but have been leery of linking to existing schemes like Bitcoins because of associations with elicit activities. Countries at present vary in their acceptance and regulation of such schemes. {32}

Bonds

Not all capital is raised through share issues or bank loans Companies also employ bonds, which run for a set period of time at a stated interest rate. Upon maturity the loan (bond principal) is returned. Interest is usually paid every six months. Bonds are also issued by municipalities, states and (most importantly) by sovereign governments. {33}

Bonds are traded. If a $1 bond yielding 1.5% interest is sold at 80 cents, reflecting doubts on its future value, the interest is effectively $1.5/0.8 or 1.875%, the acquirer being rewarded with an increased yield for accepting a higher risk. Many factors enter into risk assessment (interest rates, maturity of the obligation, credit risk, liquidity, embedded options; and tax treatment of the obligation). Spreads are the differences between two stated prices or other variables, and provide a measure of market concerns. In money markets, for example, the TED spread, a difference between T-bill and Eurodollar rates, compares the difference between a 'risk free' Treasury rate and a comparable commercial rate. Spreads between LIBOR (rate at which banks lend money to each other) for different currencies also indicate their relative strengths, and may determine forward exchange rates. {33}

Conclusions

In short, banking, and the financial world generally, is a multi-faceted and intricately interlinked machine running on trust and perceived levels of risk. Changes in any input, from individual investors to state enterprises, can have unexpected and sometimes serious consequences — far more than economic models will predict.

References and Further Reading

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