Banks need a new business model that once again encompasses prudence and putting money to good use for all of society. Trust of the people must be earned by doing the right thing, which cannot be only the good of shareholders. So argues Professor Sten Jönsson and traces the argument for prudence back in history and explains how, and when, it was lost.
Having spoken recently about “responsible banking and business models” at a conference (part of the celebration of Copenhagen Business School 100 years) in Copenhagen, I feel loaded with good advice to the younger generation of management researchers seeking a challenging cause.
The difficulty with banks when it comes to the choice and application of the right business model is that banks are “at the end of the food chain” as a manager told me in an interview many years ago. The implication of being at the end of the food chain is that all the good ideas are already been had, projects constructed, and design chosen when the bank is asked to grant a loan. The credit process of the bank may be meticulous, but still the sitting at the end of the chain, as business cycles vary, will mean that the ups and downs will strike with a whiplash effect. This is the problem for banks: it is very nice to run a bank in good times – whatever you do will turn out right – but when bad times strike with credit losses increasing costs rapidly, few options remain. Further, those credit crises (bubbles bursting) come far between (10 years?), and the bank organization tends to “forget” earlier experiences, chiefly because managers have been promoted to other jobs.
In the old days, the inspectorates of nations kept a close watch on the credit portfolios of banks and regulated currencies as well as borrowing abroad. Then we had deregulation stemming from Thatcher wanting to keep London competitive in the financial markets (and neo-liberal thinking). Some say that it was really re-regulation with international standards telling banks what to do in order to keep the financial system stable. The problem with international standards, as we have experienced during an earlier period in the EU when “harmonization” was the key word in accounting research conferences (1980s). It was found, then, that member countries varied a lot in the speed with which they included Directive X and Directive Y in their legislation. Furthermore, oversight varied, and there were plenty of loop holes in other laws that permitted practices to vary wildly. Accounting research in the area died out fairly quickly. (And now when we believe that assets are best valued by the market we cannot possibly have any problems with “harmonization”, can we?).
This has come to be a religion – invest in risk! This comes very close to betting.
Now the European Central Bank (ECB) tries to stabilize the European economy by pouring out ever-more money into ‘the market’. Maybe ECB should read its Schumpeter (1954) and learn that in a non-growing economy the interest rate will be zero because there are no investment opportunities with a positive return on investment, so the economy will continue its non-growth (just like the monks writing under scholasticism some 700 years ago thought). We fix our hopes on financial markets generating enough “financial products” for us to invest our pension money in to secure a decent living in old age. But the problem with “financial products” is that they are, more or less, promises on a piece of paper (or in digital form for increased speed) where one person’s gain is another person’s loss. (How is your “risk appetite”? the financial adviser asks – Well I prefer large gain at little risk!). It has gone so far that financial advisors seem to believe that you cannot have gain without risk. This has come to be a religion – invest in risk! This comes very close to betting – and there are experts on horses too, advising you on what horse to bet on every day in the newspapers.
If you believe in the market’s infallibility (despite thousands of cases of evidence against it!) then the way for regulators is to focus on the money supply for maintenance of a stable economy. I have grown somewhat doubtful. Let me illustrate by a picture from a completely different research area: Kirsten Hastrup (University of Copenhagen) did one of her studies of farmers in Iceland. She found that they talked to her like a child (who did not know anything), which did not give her access to the material she needed. To gain the trust of the farmers she had to show that she was a competent milkmaid. Then they would provide useful information about the farming culture. One of her experiences on her way to competence was about how to hold the flock of cows together when you move it from one place to another. She found that if she looked upon the flock as a flock she could not control it. Only when she looked at every cow as an individual she could herd it properly as a flock. I believe that this insight – to keep an entity together you have to ‘see’ its parts – has something to say about finance as well.
Where did we lose it?
One question, then, is to investigate how it all started. Where did we lose it and focus only on money supply? My answer is ‘in Spain almost 500 years ago. It was the “doctors of Salamanca” analysing what went wrong when Spain’s decline started in spite of the large flow of precious metals from America.
Langholm (1992) provides us with a thorough study of how the scholastic monks of Paris University and colleagues at other places discussed value, money, and ursury on the basis of Natural Law (scriptures) and Aristotelien ethics. This was in the 13th and 14th century. This discussion centred on free will for both parties in a transaction. To lend money against interest to a person in need was an infringement on that person’s free will and could not be accepted. Langholm describes how, over time, there was a drift toward viewing prices as generated in collective markets rather than in negotiation between individuals in single transactions.
There was, however a more significant development in a second wave of scholasticism with its centre at the University of Salamanca a couple of hundred years later (Grice-Hutchinson, 1952, Baeck, 1988, de Soto, 1996), which can give us an idea about the interaction between monetarism and bank management.
In the 16th century, Spain’s golden age, there was a steady flow of precious metals from America, landed in Cadiz and deposited in Sevilla. The King would get 25 percent of what was landed, but he conducted war in the Netherlands, Germany, and Italy on credit as well. There was a general credit expansion with the attached price increases and lack of investment in production capacity. At this time, the doctrine was that bankers must hold 100 percent in reserve for the on-demand deposits. This was deposits for safe keeping and it was quite alright to charge depositors for that service. But it turned out that the bankers had used the entrusted money for their own business, lending to others and investing themselves in more ships to bring in more gold. There was a financial crisis, with Sevilla banks going bankrupt as well as the King (Philip II).
The “Doctors of Salamanca” discussed what had gone wrong. There were two transactions here; taking deposits (for which the banker should charge a fee), and lending money or using it in the banker’s own business (which was a sin and breach of contract). Investing other people’s money for one’s own gain! What horror! Bankers should be eliminated – and they actually were since most major banks in Sevilla went bankrupt (sooner or later).
There were a few academics in opposition, primarily de Molina, a Jesuit, who in 1556 claimed that a deposit is really a loan and the banker is therefore allowed to use the money while they are in his care – provided that he invests the capital prudently. Molina reminds the reader that the banker is still in mortal sin if he cannot pay back on demand from the depositor. It is also fair that the banker pays interest. Having thus accepted fractional banking (bankers investing other “people’s money” while they are deposited) and having admonished bankers to be “prudent” de Molina and his followers focused on the money supply as the cause of the decline of Spain. If, namely, the bankers invested depositors’ money the money supply would increase since credits were created. Money was used twice or more times. This money creation will, if there are not enough goods to buy, cause inflation.
Huerta de Soto (1996) claimed that Molina was wrong because “prudence” is not an objective criterion to be used in banking. Nonsense!
There was critique from another angle complaining that the money flowed out of the country (to empire building and wars) instead of being invested in small business and artisans in cities like Toledo, Segovia, Valencia. The mercantilist ideas had taken root and were boosted by a text by Bolero in 1598, a Venetian monk (Jesuit) who argued for the national interest of developing a balance between different sectors of the nation (agriculture, trade, industry). The new line of reasoning was given the label Arbitristas. They argued that the credits were directed in the wrong direction. A new nation building, mercantilist, era, was initiated in many countries towards the end of the 30 years’ war. The State apparatus built by Axel Oxenstierna, could serve as a model.
The need for prudence in business models for banks
There we have it all in a nutshell! Huerta de Soto (1996) claimed that Molina was wrong because “prudence” is not an objective criterion to be used in banking. Nonsense! It is just because banks have so much knowledge about the clients and their proposed projects that they are in a position to judge whether prudence is present! Molina argued that credit expansion is a good thing if banks use prudence. The monetarists did not trust banks with the task of allocating credits to good projects but resorted to ideas about regulating flows of money (which required a well-organized state). It was the monetarists that gained the upper hand and a development of prototypes for prudent banks was forgotten. In time Friedman came with his argument (at times against Keynes) for regulation of the money supply and neo-liberalism. It was also Friedman who claimed that the only duty for a firm (including banks) is to generate profit for its owners. (The Market will take care of the rest). In the process good old Aristotelian ethics was lost, the cornerstone of scholastic views on banking almost 500 years ago.
As I (and Molina) said, banks need to be prudent, but we have not been very good at articulating what prudence means for a bank and how it enters into a proper business model. Banks need a particular kind of business model that encompasses their particular role in allocating resources to good use in the economy. Indeed, banks receive money from people on trust and they allocate those resources (invest other people’s money) to foster “balance” in society. Otherwise the financial system will serve to transfer money from the not so wealthy to the very wealthy (through a large number of “tricks” that we hear of every day (Tax evasion being one of them).
Banks must earn the trust of people by doing the right thing, which cannot be only the good of shareholders.
The credit process must be in focus. Judgment of creditworthiness must be done in context and include weighing whether the proposed use is good for the wider society. Banks must earn the trust of people by doing the right thing, which cannot be only the good of shareholders. They must have good arguments that hold under the scrutiny of societal oversight. The task of management research here is to work out how the ethical dimensions (good arguments) can be combined with the instrumental aspects of ordinary business models (defined as models describing how value can be created and how customers will pay for the services). This is an overwhelming task since the road to where we are now have been laid out by simplifying assumptions about the nature of man, the stability of equilibria, and the fairness of market prices. Remember the milk maid keeping the flock of cows together? That is what the new task is about – stability of the economy by knowing the individuality of the banks and their clients. Banking principles get their normative power by the bankers’ will to live up to their identity (role in society).
Sten Jönsson, Professor emeritus, Business Administration. Professor in accounting and finance at School of Business, Economics and Law, University of Gothenburg 1976-1996. Researcher and former head of Gothenburg Research Institute. Program manager of the research program Bank Management. His most recent publication is Scholasticism, Fair Value and Ursury, According to Odd Langholm
Baeck, Louis, (1988), Spanish economic thought: the school of Salamanca and the arbitristas. History of Political Economy 20:3 pp 381 – 408.
Grice-Hutchinson, Marjorie, (19952), The School of Salamanca – Readings in Spanish Monetary Theory 1544 – 1605. Oxford: Clarendon Press.
Huerta de Soto, Jesús (1996), New Light on the Prehistory of the Theory of Banking and the School of Salamanca. The Review of Austrian Economics, vol 9, pp 59 – 81.
Langholm, Odd, (1992), Economics in the medieval schools – Wealth, exchange, value, money and ursury according to the Paris theological tradition. Leiden: Brill.
Schumpeter, Joseph A. (1954). History of economic analysis. London: Allen & Unwin.