Why We Need Banks

Why We Need Banks author Webmaster1 On: 06/17/2010 Views: 13

(Editor's note: This post forms part of the month-long HBR Debate, "Finance: The Way Forward." It is the second post on this week's topic: "Do we really need banks — and what might take their place?")

If only bankers had followed their Shakespeare, we wouldn't have had a subprime crisis. But then there wouldn't have been any banks, and take away the banks for the 400 years since Hamlet and we would still be riding horses, mixing eye of newt and toe of frog to cure our toothache and generally living nasty, brutish and short lives.

But banks are not only useful for innovation and wealth generation; they also make excellent scapegoats when things go wrong. Come famine, social unrest or economic downturn, the bankers are in the list of villains. Over the centuries there have been plenty, including bankers, who have stolen from widows and orphans. Bernie Madoff is only the latest in the list of the disgraced. But among the vast majority of the honest banks, many have done well, making rich some who worked in them. It's never nice when other folk earn more than we do. And when they earn ten times as much as we do, it's ten times as irritating.

Now let's move to the realities. Banks — including investment banks — are not an accident. They have developed over thousands of years to meet commercial needs and will have to go on developing to survive. They lend money on the basis of risk, which means some of it will be lost. And they are not homogenous. Some are truly excellent. Some are truly rubbish. Most are in between and operate on a modest scale, a world away from complex financial instruments. Banking is not all Goldman Sachs.

Do we need banks? Yes, or rather we need institutions to do what banks do. They need not be banks, and there is every reason to make sure that entry into a country's banking system is possible, including from foreign banks. All these new market entrants, whether existing financial institutions or not, need to have the same regulatory framework that makes sure that Society's interests are protected.

So will banks operate in the future as they have in the past? No. Banks in many countries are already required to hold more capital and the current tsunami of new regulation, new laws and new taxes will mean that banks will become more constrained than they are now. This will offer Society greater protection, though at a cost. For example, in relation to new higher capital requirements, the remaining capital will have to earn its keep and the costs of borrowing will almost certainly rise. Ironically, too, the new pressures of regulation, laws and taxes may make it more difficult and less desirable for new entrants to banking.

And finally, will the highest paid bankers pay come down? Unlikely. The sums are not being paid because of market failure, but because the market is working. Governments can make sure that the market keeps working and then levy appropriate taxes to take their share. But the earning ability of some individuals is huge. Even a very very small percentage of a very very large sum for the bank can turn into a lot in an individual's pocket.

Reaction to banks in the subprime crisis has been visceral and understandable. As in every previous financial crisis, the lessons need to be learned on the basis of dispassionate analysis, not gut reaction.





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