August 18th 2012

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Articles from this issue:

DEFENCE OF MARRIAGE: Marriage, religious liberty and the 'grand bargain'

TASMANIA: Labor/Greens push for same-sex marriage

EDITORIAL: Olympic Games: end the hype and chauvinism

CANBERRA OBSERVED: Prime Minister Gillard seeks to make her mark on history

GLOBAL WARMING: Climate alarmism is alive and well

BANKING: Playing with someone else's money

EDUCATION: School learning dumped in favour of Google-and-tell

OPINION: Syria: Why are we encouraging chaos?

SECURITY AND INTELLIGENCE: Media shrugs while Russian espionage flourishes

FOREIGN AID: When aid money means killing money

OBITUARY: A humble man with a large vision: Mark Posa (1927-2012)


CINEMA: 3D super-hero takes to the big screen

BOOK REVIEW An admirable spur to further thought

BOOK REVIEW The divorce that shook Europe

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Playing with someone else's money

by Jeffry Babb

News Weekly, August 18, 2012

In one of the most remarkable turnabouts in recent years, Sanford I. (“Sandy”) Weill, the man who built the original financial supermarket, has changed his mind, saying banks “have to regain public trust”.

Weill built America’s second biggest securities business from scratch and parlayed it into control of Citigroup, one of America’s premier financial institutions. Blue-blooded Walter Wriston, legendary Citibank chairman and CEO from 1967 to 1984, could not have been further from Weill, who was born in Brooklyn to two Polish-Jewish immigrants. Wriston is known for the famously inaccurate quip that “countries don’t go broke”.

Weill was the first American to pursue the Bank-Insurance Model (BIM), often known by its French name, “bancassurance”. The aim of the scheme was to merge a bank and an insurance company to provide for the customer’s every financial need.

The main idea was that the bank, by cross-selling, could gain more revenue from each customer. Cross-selling means that if people go into the bank to make a term deposit, you also sell them a life insurance policy; or if they take out a mortgage for a house, you sell them property insurance. “Bancassurance” has never worked as well as its promoters said it would.

But what Sandy Weill is proposing now is truly revolutionary.

Until 1999, US banking was regulated by the Banking Act of 1933, better known as the Glass-Steagall Act. This legislation separated banking institutions into commercial banks (essentially deposit-taking institutions, such as Citibank and Bank of America) and investment banks (such as JP Morgan and Goldman Sachs).

US Congress did away with these distinctions in 1999 when it abolished Glass-Steagall and replaced it with the Financial Services Modernisation Act, better known as the Gramm-Leach-Bliley Act (named after the Republican Congressmen who co-sponsored it). The then Democrat President Bill Clinton signed it into law.

What had previously distinguished commercial from investment banking can be summed up in one word — leverage.

Leverage is quite a simple concept to understand. Say you want to buy an investment property for $100,000. You do not have $100,000, so you make a deposit of $20,000 and borrow $80,000 from the bank. A year later you sell the property for $120,000. If you had put up all the money yourself, you would have made a profit of only 20 per cent. However, as you only put up $20,000 and you made a $20,000 profit, your profit is 100 per cent. That is the magic of leverage.

As far as an investment bank is concerned, what they are doing is going to the races and betting with someone else’s money. They work on leverage of 30 times or higher. They have a small capital float and leverage it up with money borrowed on the short-term money market.

In the old days, when you went to the bank to buy your travellers’ cheques, there wasn’t much in it for the bank. They did the transaction, made a small margin on the deal and made some interest as they held your travellers’ cheques until you cashed them. Exchange rates were fixed. Exchange rates didn’t change much because the then Country Party (now National Party) didn’t like it. Then came the 1980s Hawke-Keating reforms and the floating of the Australian dollar. The dollar changes in value against other currencies all the time. The banks soon learned that they could make money trading the dollar.

There are of course two kinds of trading, such as currencies and bank bills. The first type is “good” trading. That is when you get some cash to go overseas and the bank does the deal for its customer. The second type is “bad” trading. This is known as proprietary trading or “prop trading”. The bank is in the market, not on behalf of a customer, but on its own account. This is very risky business. If a trade — or series of trades — goes wrong, the bank can blow up, as happened when Nick Leeson sent the venerable London bank Barings to the wall in 1995.

If it’s a really big bank, its failure can rock the world’s financial system, as happened when Lehman Brothers went bankrupt in 2008. Not only was Lehman Brothers overleveraged, its CEO Dick Fuld was not fully competent. The bank was almost, but not quite, “too big to fail”. (See Andrew Ross Sorkin’s award-winning book, Too Big to Fail: Inside the Battle to Save Wall Street, Penguin Books, 2010).

What then are we to make of Sandy Weill’s epiphany? Weill told CNBC business news, “What we should probably do is go and split up investment banking from banking, have banks be deposit-takers, have banks make commercial loans and real estate loans, have banks do something that’s not going to risk taxpayer dollars, that’s not too big to fail.”

In London, Bank of England governor Sir Mervyn King is pushing “ring-fencing” to separate retail and small business lending from investment banking. In New York, JP Morgan, the “good” bank with its risk controls in place, has just lost $6 billion on trading. It won’t break the bank, but it’s a nasty shock to shareholders and regulators.

We need finance to run our lives. Australia had several close calls in the early 1990s when we went through our own bank liberalisation. Are our financial institutions really “safe as a bank”? 

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