Our Banking Model is Unsustainable

Martin Wolf notes that banks current business model is predicated on a 15% return on equity, and this is fundamentally unsustainable:

According to a FT article last week, Lloyds’ bank has a target return on equity of 14.5 per cent. Banks like to argue that this is the level of return on equity they need to earn, in order to gain funding from the markets. Naturally, remuneration is linked to achieving such objectives. The question, however, is whether such objectives make any sense. The brief answer is: no.

Forget banks, for the moment. What would you say if someone offered you an investment with a promised real return of close to 15 per cent? You might say: “How much can I buy?” Alternatively, you might say: “What is the catch?” Sensible people must take the latter view. If you thought that you were being offered a reliable real return at such an exalted level, you would buy as much as you could. This must be particularly true now when real returns on the bonds of relatively safe governments are close to zero.

So what is the catch? The obvious answer has to be that the real return in question is extremely risky, because it is volatile and offers a significant chance of total wipe-out.

Indeed, it is perfectly obvious that these cannot be sustainable safe returns in economies growing at 2 per cent a year, for such a large and well-established industry. At a 15 per cent real return, the value of cumulative retained earnings would double in five years and increase 16-fold in 20 years. Pretty soon, bank equity would be the only real asset in the world!

He notes that at some point in the late 1970s, probably starting during the Carter era deregulation of the banks,^* their return on equity diverged significantly from the overall rate of growth of the economy, and the way that they did this was by the same way that anyone increases return, by increasing risk.

They increased risk by both increasing risk inherent in each individual investment, and they did so by becoming even far more leveraged, raising the risk that even small setbacks would leave them illiquid or insolvent.

This doesn't matter to the banks, because they are back stopped by government deposit insurance, so they are, in essence, gambling with the taxpayer's money.

We need banking to be dull again.

In any case, go read the whole post, particularly the bit where he figures that the additional cost of capital from this is just 15 basis points. (0.15%)

^*Yes, the last generation's Barack Obama was the one who initiated the dismantling of the depression era banking regulations, and who stood idly by as the savings and loans went insane. Reagan was worse, but Carter got the ball rolling.