Why new law puts banks between an anvil and a hammer

One of the key and widely popular planks of Bernie Sanders campaign platform was a proposal to break up big banks.

This was not just another campaign promise. Sanders has been pushing legislation to do just that.

His unambiguously titled “Too big to fail, too big to exist Act” proposed to compel the US banking authorities to break up big banks.

Sanders was targeting the eight biggest banks but if the official big bank threshold of $50 billion in assets were used, it would ensnare as many as 40.

US banks received $700 billion in public bailout funds and $14 trillion interest free loans following the 2007/2008 financial crisis.

While the rest of the economy was still reeling from the crisis, banks made a record $152 billion profit in 2014.

According to Sanders, by last year, three of the four biggest banks were 80 per cent bigger than they were when they were bailed out.

The UK Auditor General put the total cost of the bailout there at £850 billion, a good 20 times our annual GDP.

Also among Sanders’ raft of banking reforms is, wait for it, capping credit card interest rates at 15 per cent, which are currently in the 13-21 per cent range depending on type of card and holder’s creditworthiness.

I have not heard of any society on earth that was ever happy with its moneylenders.

You can also be sure that there will always be politicians who have a populist, flawed solution.

From the 1933 to 1986, US interest rates on deposits were capped by law, and banks were prohibited from paying interest on checking (current) accounts until 2011. Why?

Bank failures during the Great Depression was attributed in part to intensive competition for deposits which in turn narrowed spreads undermining profitability of banks, and also encouraging excessive risk taking.

Close to 5,000 banks failed during the Great Depression. The interest rate law known as Regulation Q was part of a broader regulatory response the failures, of which the Glass-Steagal Act, which enforced separation of investment and commercial banking, is the best known.

The interest rate regulation sowed the next seeds of the next crisis, namely, the S&L crisis that saw over 1,000 savings and loan associations, the US equivalent of building societies), a third of the total, fail in the early 80s.

The S&Ls crisis was precipitated by the post 1973 macro-economic turbulence, referred to as “stagflation”, as it was characterised by inflation, stagnation and rising interest rates.

STATE REGULATION

The interest rate caps prevented the S&Ls from adjusting their deposit rates to compensate for rising inflation, causing deposit flight as people sought inflation hedges.

The government as usual prevaricated. By the time it deregulated in 1981, it was too little to late.

The financial deregulation culminated in the repeal of the Glass-Steagal Act in 1999, which is often cited as a cause of the 2007/2008 financial crisis.

So government responds to banking crisis by regulation. Regulation precipitates the next financial crisis.

Government responds by deregulation. Deregulation is blamed for the next crisis, precipitating a clamour for re-regulation. Damned if you do, damned if you don’t.

I came across an animated exchange on social media about the interest rate capping, in which one banker was commenting very authoritatively citing 19 years experience in the industry.

Sounds like a whole lot, but it goes back to 1997, five years after our big bang financial deregulation—those of us who are a bit long in the tooth are wont to forget that 25 years ago is ancient history for a significant majority.

Interest rate along with exchange and a raft of other economic controls were imposed in 1973 in the wake of the oil price and deregulated in 1991.

Under the control regime, an account in a commercial bank was a status symbol.

Ordinary citizens had to make do with a Post Office Savings Bank account, which was okay as it was the only account that could be operated from any branch in the country.

Consumer credit from a commercial bank was as rare as chicken with teeth.

Economists use the ratio of monetary assets to GDP which we call financial depth as a measure of financial development.

Throughout the control regime, with the exception of the 1976 coffee boom episode, the ratio was stuck at 25 per cent.

This means that the economy did not experience any financial development.

After liberalisation, the ratio jumped 10 percentage points to 35 per cent over the next decade and another 10 percentage points over the following one.

What does this matter? Research suggests that a 10 percentage point increase in this ratio increases long-term growth by 0.2-0.4 per cent.

This means that the 20 percentage point increase ought to have increased our long-term growth by about half a percentage point.

INCREASE IN ACCOUNTS
This is not trivial. A GDP per head of $1,000 growing at 2 per cent per year will be $1,485 in 25 years, and growing at 2.5 per cent per year will be $1,640.

A 10 per cent per capita income difference is not to be frowned on, more so considering it is on account of a policy change, as opposed to investment, that is, it does not cost money to generate.

It is worth noting that a financial depth ratio of 45 per cent of GDP is nothing to write home about— it is in fact the norm for low income countries, while the average for middle income countries is in the order of 120 per cent of GDP.

But it is in expanding access — what is now referred to as financial inclusion — that deregulation is most visible.

The data on customer numbers is only available from 1996, but it still provides a useful baseline for the pre-liberalisation era.

In 1996, there were one million deposit accounts, or one account for every 15 adults.

By 2006, the number of accounts had tripled to three million, or one account for every seven adults.

By end of last year, banks held 35 million deposit accounts, which works out to 1.4 accounts per adult.

Technology has played a significant role, enabling banks to serve more customers without commensurate investment in brick and mortar.

But if this was the only case, there would have been no change of pecking order in the industry, as the incumbent dominant banks would have had the market advantage.

But this is not the case. It is largely a reflection of the disruptive “bottom of the pyramid” banking model pioneered by Equity Bank.

Equity Bank and its followers would not have been able to disrupt the industry if they were constrained to the same pricing as the dominant incumbents.

The irony is that my fellow Kikuyus whose constituency is the biggest stakeholder and beneficiary both in terms of ownership and client base is the one that is turning on the banking industry.

Funny world we live in.

That our banking industry has one of the highest return on assets in Africa has been presented as evidence of customer gouging.

Consider that over the two decades of explosive customer growth, bank employment only doubled.

Deposit accounts to staff ratio has increased from 60 accounts per employee to 1,000 accounts per employee, and accounts per branch from 2,700 to 35,000.

By contrast, interest rate spreads have stayed more or less where they settled after liberalisation.

It is these productivity gains, not interest rate spreads, that account for the higher than average returns.

As I argued in my last column, bank loans and deposits are not commodities like potatoes.

The argument that the spread is a trading margin in much the same way as a middleman buys potatoes at Sh1,000 a bag and sells the same at Sh1,500, is seriously flawed.

Bank loans and deposits are risky assets.

The interest rate has three components namely the cost of funds, the lender’s mark up and a risk premium.

Because a borrowers’ default risk does not vary with the term of the loan, very short-term loans become very expensive when rates are annualised.

A five per cent default risk translates into a risk premium of 5.3 per cent.

THE CHOICE

If cost of funds is 8 per cent and 4 percentage point mark-up, will price a one-month loan at 6.3 per cent, and a one-year loan at 17.3 per cent.

The one month loan translates to an annual interest of 76 per cent.

This explains annualised US credit card interest rates are as high as 20 per cent even though the benchmark rates are just above zero, as well as the seemingly usurious rates being charged on mobile phone based micro-loans.

A bank deposit is the same thing in reverse, that is, it is a risky loan made to the bank by the depositor.

The interest rate comprises the risk free rate, which is typically government paper rate and a risk premium.

Depositors perceive small banks as riskier than large ones, and the recent failure of three banks in rapid succession has heightened that perception.

This is in part on account of the “too big to fail” phenomenon.

Many years ago, one of my client banks explicitly set the goal of growing too big to fail — and did.

You can be sure that the Central Bank of Kenya would not have been as cocky had Imperial or Chase been a tier one bank.

A failure rate of three out of 30 odd small and medium-sized banks is a pretty high.

If, for instance, the perceived default risk of tier three banks is 5 per cent, and tier one banks default risk is zero because they are too big to fail, tier three banks ought to pay 5.3 percentage points more for deposits than tier one banks.

It turns out that the actual differential cost of funds in the industry is of that order of magnitude, that is 2 -3 per cent for the big banks and 6-9 percent for the small banks.

The floor on interest earning deposits means that the small banks will pay a premium on the wholesale funds they rely on, yet they cannot pass on to their borrowers because the lending rates are capped also.

They are boxed in between the hackneyed rock and a hard place. This is precisely the situation that precipitated the US S&L crisis.

What a century of credit market intervention has taught us is that the choice is between market failure and policy failure. Damned if you do, damned if you don’t.

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