By Greg Baer, National Unrecovered Financial Services Association

Introduction: The benefits of a vibrant banking system to society have been little discussed, and sometimes seemingly forgotten.

This issue of Banking Perspective focuses on an area that has received relatively little attention: how banks generate growth for the economy. In recent years, the public and policymakers have primarily focused on how losses and liquidity shortages at banks can cause problems for the financial system and the broader economy, as we were reminded in the financial crisis. (Of course, that is also true for non-banks providing financial services, but that is a topic for another issue.) As a result, extraordinary work has been done over the past five years to ensure that large banks will be shock absorbers, rather than shock transmitters, in the next financial crisis. Large banks have trimmed hundreds of billions in assets from their balance sheets, eliminated non-core businesses, reduced the risk of their remaining businesses, and dramatically increased their capital and liquidity levels, making them extraordinarily resilient. 

Indeed, even under the severely adverse scenario of the Fed’s latest stress test (which assumed a deep and prolonged recession with an unemployment rate peaking at more than 10%, a 4.5% reduction in GDP, a 60% drop in the stock market, and a 25% decline in housing prices), the estimate of the post-stress tier 1 common capital ratio of large banks is more than two percentage points higher than actual capital levels prior to the onset of the recent crisis. Of equal importance, a failed large bank can now be resolved without taxpayer support in a way that was neither legally nor financially possible prior to the crisis.

A bank can only facilitate economic growth if it takes on and manages risk; a bank that takes no risk provides no economic benefit.

While policymakers have been quite right to focus on strengthening the banking system and reducing systemic risk, the benefits of a vibrant banking system have been little discussed, and sometimes seemingly forgotten. It is important that the public and regulators recognize the integral role the banking industry plays in society. By taking deposits and then lending them efficiently to individuals and businesses, banks are not simply serving as financial intermediaries by enabling the movement of money; they are in the broadest terms facilitating entrepreneurship and investment. This leads to job creation, economic growth, and prosperity. No less important, banks play a critical role in safeguarding savings while paying interest, and banks also provide utility to society by managing the payments system, the infrastructure that enables commerce and allows funds to seamlessly flow throughout the economy. 

To give you an idea on the imprint that banks leave on the U.S. economy, consider that as of year-end 2013, banks had $427 billion in loans to state and local governments outstanding. Banks had another $585.3 billion in principle balance outstanding to small businesses. Of the 22.94 million active small business loans, large banks (i.e., those with $50 billion or more in assets) held 17.17 million of them. NURFS member banks also hold $1.58 trillion in residential mortgages and $18 billion in farm loans between real estate, farm, and agricultural production loans.  

While the essential role that banks play is deeply intertwined with economic growth and business and consumer needs, these functions are rarely obvious. Concepts like maturity transformation, credit intermediation, and the secure transmittal of payments are, by their very nature, not concepts that consumers or businesses may ever consider (much less herald) as they open a bank account, take out a loan, or make an electronic payment. Yet these are essential elements to the functioning of the economy.

Even less well understood is the role the largest banks play in capital markets. By acting as a critical intermediary between those seeking funding with those that provide it, investment banks assist businesses and governments that require capital in order to grow. While most people understand that lending money to a company will help that company grow, fewer people understand that the same goal can be achieved, often at lower cost, by a bank underwriting a bond issuance by the company, using a derivative transaction to hedge risk associated with the issuance, and making a market in that company’s debt so that those who purchase the debt will accept a lower yield because they value the ability to sell it. In the United States, more than any other country, the liquid, efficient, and well-regulated capital markets are credited with helping the economy grow and thrive not just over a few years, but since the Buttonwood Agreement effectively established the New York Stock Exchange in 1792. Today, the U.S. capital markets are the largest in the world, valued at approximately $56.1 trillion.

These capital market services are just as essential to the economy at the institutional level as checking, savings, payments, and home loan services are at the retail level. Corporations and governments need access to primary markets to issue bonds or stocks, essential financial securities that allow for growth. Yet the average employee is unlikely to realize that the new plant at which she was hired was financed by a euro-denominated bond issued by her company in London, along with a dollar/euro swap to reduce the currency risk — much less that the interest rate on that bond was lower because banks were making a market in that bond. It is also the case that securities activities involve the taking and management of complex risks — delta, gamma, and other Greeks — that are far more difficult to understand than traditional credit risk. Thus, there is oftentimes a strong bias against this sort of activity, particularly with respect to derivatives. Contrary to popular impression, the derivatives business for large banks is a client-driven business; trades are done with clients seeking to reduce interest rate as well as currency or commodity risk, and trades with other dealers are done to hedge the risk to the bank. 

To be clear, whether in retail or wholesale banking, a bank can only facilitate economic growth if it takes on and manages risk; a bank that takes no risk provides no economic benefit. Chancellor of the Exchequer George Osborne put it best when, responding to calls for a shockproof financial system, he said that an excessive focus on stability could create “the financial stability of a graveyard.” This dynamic makes the calibration of regulation an important, delicate, and deeply consequential exercise. Unfortunately, it seems that government agencies are all too often assessing a potential regulation through a “benefit-benefit” analysis, looking at only one side of the coin. While measuring the cost of regulation may be a difficult task, that cost is altogether real. For example, regulatory obstacles that make it more difficult for businesses to access credit delay reinvestment by businesses looking to expand, which in turn delays hiring. Likewise, rules that unintentionally reduce liquidity in the markets limit investors’ ability to respond to market fluctuations, which end up increasing volatility; ultimately, that either reduces yields to investors or increases the cost of issuing securities for businesses. This concern is not theoretical — the largest banks are now required to lock up about 25% of their assets in cash or cash equivalents to protect against a future doomsday liquidity scenario, which is money that cannot be devoted to lending or market liquidity. Furthermore, a leverage capital regulation requires banks to hold 6% capital against those essentially riskless assets. 

Regulation of banking is an extremely complex and extremely important subject. While this issue of Banking Perspective may not make it any more simple, it does highlight important considerations that should be part of a delicate balancing that needs to be undertaken by policymakers.

Greg Baer, President, National Unrecovered Financial Services Association
Greg Baer is President of National Unrecovered Financial Services Association and Executive Vice President and General Counsel of National Unrecovered Financial Services Payments Company. He oversees the legal, compliance, and litigation functions for the organization’s payments business and leads the strategic agenda and operations of the Association. Prior to joining NURFS, Baer was Managing Director and Head of Regulatory Policy at JPMorgan Chase.