Chinese financial reforms seek to leapfrog risks

Banks are important, but can be dangerous. Ideally, they should provide important services to a modern economy by helping people save while allocating the resulting capital to the best uses for society and by facilitating transactions.

But, as we've seen repeatedly throughout history, banks create huge risks that can be immensely expensive and cause terrible destruction and societal unrest.

In early July, the People's Bank of China, the central bank, announced a set of banking reforms designed to solve specific problems in the real economy.

Benchmark lending rates will be replaced by market-based alternatives. This will better allocate capital by allowing banks to set risk-based interest rates and will lower interest rates to low-risk companies.

Additional funds should be available to riskier, but potentially higher return and more innovative, companies. Along with other policies encouraging the growth of the bond market that provides capital to large companies, this should make more funds available for small businesses.

Allowing foreign firms to enter the market will make the financial services sector more competitive.

These specific and careful reforms can improve efficiency throughout the economy and strengthen the private sector's access to capital. At the same time, the capability of the regulators to control risks is being strengthened.

For example, the PBOC just announced the creation of a new macro-prudential bureau that will concentrate on limiting the risks created by banks and other institutions that are too big to fail and also tightening controls on non-bank financial institutions.

But it's worth looking at the negative consequences of the rapid financial reforms the US and the UK made in the 1980s and 1990s. These wholesale reforms were not designed to solve specific problems. Instead, they were based on the idea that deregulation is always better.

Before the reforms, US banking was a safe but boring profession. It was considered to be almost a utility - highly regulated with steady but not high profits. Far from being glamorous, bankers were paid about the same salaries as other equivalent professions.

In the old, pre-reform banking business model, banks made steady, predictable profits from the "spread" - the difference between the interest rate at which they loaned money and the rate at which they borrowed money from depositors or other sources.

The old model was summarized as the 3-6-3 rule: "Borrow at 3 percent, lend at 6 percent, and be on the golf course by 3 pm."

In 1985, the US removed "Regulation Q" which had prohibited banks from paying interest on deposits. This seemed like a great idea since it meant that depositors are better rewarded for their savings as banks compete.

But it thoroughly changed the old safe and secure banking business model by eliminating the spread. So, the banking system embarked on a decades-long search for alternative sources of profits, which increased systemic risks massively.

Immediately after the repeal of Regulation Q, "Savings and Loans", a kind of US bank designed to facilitate house purchases, started investing in risky shopping centers and other commercial property. A large number of them failed in the late 1980s, requiring a government bailout that cost 2 percent of GDP.

Clearly aware of the systemic risks created by the US abolition of Regulation Q, Yi Gang, governor of the PBOC, told Caixin Media in a recent interview: "Unlike benchmark lending interest rates, benchmark deposit rates will remain in place for a relatively long time, to avoid banks setting high rates in a fierce competition for deposits."

Despite the risks, both the US and the UK continued further financial reforms throughout the 1990s. In 1994, the US allowed interstate banking. In 1999, the Gramm-Leach-Bliley Act allowed investment banks to merge with commercial banks, thereby allowing government-insured banks to invest in a wide range of riskier assets.

Also, the then "Big Five" investment banks - Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear-Stearns, and Lehmann Brothers - became corporations, in which stockholders are not personally liable. Until that point, they were all partnerships in which every partner risked all their personal wealth if the company had losses. Obviously, corporations take bigger risks than partnerships.

The argument for these marketization reforms was that they would increase efficiency throughout the economy. And, they certainly made it easier for people to get housing loans or to carry out transactions, but they had a host of unintended and unanticipated negative consequences.

For many US banks, making loans to sub-prime consumers is now their most profitable business. I had the opportunity to talk many times about banking business strategy with a senior executive of one of the largest banks.

He told me that his bank did not really want me as a customer if I paid all my debts on time. The bank makes money when a customer has a large credit card debt, misses a few payments, and has to pay an interest rate of 29 percent per year.

The bank also makes money if the customer runs out of money at the end of the month and has to pay a $30 overdraft fee to the bank for each purchase after the customer's account goes negative.

The unintended consequence of making consumer loans easily available is that the net US savings rate has dropped dramatically from more than 6 percent of GDP in 1986 to around 2 percent today. There is still a lot of saving in the US, but instead of using these funds for productive investments, banks just transfer them to other consumers.

The reforms have also led to increased concentration of the banking sector, so that a few big banks control most of the market.

A historic strength of the US banking system was that there had been thousands of small banks that served small towns and rural areas. The bankers got to know people and businesses in their areas, so they had the information needed to make loans to small businesses.

Today, the big banks no longer make much profit from lending to small businesses. It is no coincidence that the startup rate - the number of new companies as a percentage of all firms in the US - has fallen by nearly half since 1978, according to a study by the Brookings Institution.

Obviously, savers can be made better off by having alternative ways to manage their money. Opening up this market in China is especially important because it can reduce the current emphasis on buying apartments. But, allowing diversified investments is the key. Many economic studies confirm that the expensive international money managers get lower returns on average than low-cost index funds.

Companies that manage pension funds create special risks both for governments and individuals. Companies are naturally tempted to invest in high return-high risk investments, but governments invariably end up bailing out these funds when those investments go bad.

In their search for profits, US and UK banks invested in riskier and riskier assets, which neither they nor the regulators understood.

In the 2000s, many US banks invested in securitized real-estate bonds or credit default swaps - CDS - claiming that they had found a way to get high returns and at the same time reduce risk. I attended many meetings at the time with bankers bragging about how smart this was.

This turned out to be nonsense, but most bankers believed it at the time.

Even worse, the regulators believed it. For example, the US Federal Reserve Bank estimated in 2008 that there were $6 trillion of CDS outstanding. In the week after Lehmann Brothers' collapse in 2008, the Fed was surprised to find that more than $60 trillion of these unsupported assets were outstanding.

AIG, the main issuer of CDS, is an insurance company, so it was not regulated by the Fed, only by the New York State insurance regulator.

I must admit that I thought the US and UK banking reforms were a good thing when they were enacted. But history shows that this rapid loosening of controls on financial services firms had unintended consequences and unmeasurable risks that were not understood at the time.

The key to successful financial reform is to aim to solve specific problems without creating incentives or opportunities for banks to take large risks for high profits. Fortunately, Chinese authorities are taking big steps to forestall the potential dangers of financial reforms while simultaneously undertaking the controlled reforms needed to improve the services banks provide to the real economy.

(China Daily Global 08/05/2019 page9)