Adair Turner on Finance

The Future of Finance and The Theory That Underpins is a talk given by Adair Turner at the London School of Economics. It is available on a podcast here. It is a bit technical at time, but is worth a listen for those who want to understand the GFC.

Turner described the problems with the modern banking system very clearly, which is unusual for an insider. They usually pretend that the system is better than it is. Unfortunately, although he understands the problem well, Turner believes that the problems with the system can be managed. I think he is wrong. A more radical solution will be required.

Banks facilitate unmatched intermediation between lenders and borrowers. Lenders and borrower can obtain credit and debt contracts for different terms, risk and return. This mismatch is managed through the bank’s balance sheet. On the liabilities side of the balance are short-term deposits. On the assets side are long-term loans, often twenty to thirty year mortgages. This creates a huge risk, as the bank ends up with many short-term debt contracts, which it could not honour, if all the depositors wanted to withdraw their funds at the same time. Banks depend on the central bank to act as a lender of last resort whenever this happens.

In addition to this liquidity risk, banks also carry the default risk. If a borrower default, the depositors still expect to get their money back. A bank needs sufficient capital to cover this default risk.

In the UK, business lending and borrowing net out. This means that most savings by households go in residential and commercial mortgages. This can create a self-reinforcing credit/asset price cycle. When real estate prices rise, banks are willing to lend more to mortgage holders. More mortgage money allows household to bid up prices. This self-reinforcing cycle creates frequent housing booms.

I describe a better solution to the liquidity problems of banks at Deposits and Loans and Money