Tackling the next banking crisis today

The global financial crisis has not changed the nature of economic transactions.  What it has shown is the shortcomings in risk assessment and quantification as well as the difficulties of legislating and regulating that risk.

The three main challenges faced by regulators, politicians and the institutions themselves are as follows: restoring consumer trust both in banks and service providers, as well as those who would regulate and guarantee trust in these institutions;  reducing financiers’ perceived lending risk to restore the availability of liquidity to businesses and entrepreneurs in order to encourage job creation and market growth; and, stimulating innovation and competition in financial services to consumers  to reduce market concentration by a few large banks.

The money lost in investment banks is remote.  The money lost in the bank down the road is immediate.  The worldwide collapse of the financial system has left enduring trauma on the consumer market.  What compounds the fear is that consumers do not understand quite what happened. 

That can result in poorly thought out political responses with concomitant unforeseen consequences.

The greatest concern is that unworkable, expensive but politically popular legislation is introduced.  Consumers, already frightened, will agree with politicians not because they understand the nature of what is being done but because “something” is being done.

Markets are a problem.  People do not move in straight lines.  Two people do not have two opinions, but many.  Consumers don’t buy exactly the same thing every day, even for the things they love.  You may watch two movies every month for years, and then change your mind.  Businesses need to find ways to manage these fluctuations.  So they hedge their risk by buying insurance on these transactions.

Farmers buy insurance against bad weather.  Miners buy insurance against currency fluctuations.  Banks buy insurance against home-loan defaulters.  And insurance companies buy insurance against insurance-claims.

Everything relies on calculating these insurance risks exactly.  Except people do not move in straight lines.  In short, markets are a problem.

Given the complexity of the financial interactions between consumers and businesses, banks and lenders now use aggregated financial models to rate consumer risk.  Individual consumers and small businesses often do not know their credit scores or how to influence them.

The desire to reduce costs throughout the process of banking has removed many consumer-facing roles even as risks multiply.  This means that banks - who used specialised derivative models to collateralise risk in the first place - struggle to assess risks on individuals and small corporates, so reduce lending overall.

Risk and ratings of consumers are now used widely, not just by banks but by retailers and high-street shops.  Individual consumers and small businesses have a wide variety of debt, much of which is unknown to each of the lenders.

There is a lot that can be done to increase transparency and accountability.  Better analysis of individual credit risk can also inform the higher levels of finance upon which such micro-economic transactions are based.

Existing banks are closely involved with new regulations of the industry.  This is anti-competitive and erects barriers to entry.  Innovation and competition suffers.  Worse, though, is that this further concentrates risk into a smaller number of firms.  If current banks were “too big to fail” then these new behemoths are “too big to contemplate”.

What limits new consumer banking innovation is the difficulty that consumers have in moving to a new bank.  A tongue-in-cheek study by Age Concern in 2008 pointed out that consumers are more likely to get divorced than change banks.  A simple solution I’ve mentioned before is to extend telephone number portability to banks.  This would increase the leverage that consumers have over their banks and improve the chances of small banks increasing their scale.

An industry that promotes competition and transparency is more likely to produce innovation and increased liquidity.

Time then for a grown-up discussion about risk.