Good idea - if we can't beat 'em let's join 'em.
The trouble is that it's not so easy, as Dave Fishwick discovered when he tried to set up a non-profit making bank in Burnley to help local businesses, savers and charities (Fishwick 2012). The first problem is obtaining a banking licence from the BoE. It is the banking licence that allows a company to take deposits and lend money. These are very difficult to obtain as you will discover if you read Dave's very entertaining and enlightening book - Dave wasn't able to get one. In fact one bank that did manage to get a licence in 2010 was Metro Bank - which was the first for 150 years! However since then changes have been made to make it easier to obtain a licence (though still very far from easy), and new entrants are starting to apply.
Let's overlook those difficulties for now and say we've somehow managed to get our banking licence. We already have a few million pounds in equity (i.e. we have put this money into the bank to start it up) because having that capital is one of many conditions of the banking licence. Now we open the bank and await our first customer. Along comes Joe Bloggs who wants to borrow £200,000 for a house. Joe looks like a sound bloke so we say certainly, just sign this contract where you agree to pay us a large fortune in interest and repayments over the next 25 years. Joe signs and we carefully file away the contract and then credit his account with £200,000 that we've magically created out of thin air - marvellous - big smiles all round! Joe immediately buys the house, transferring the money to the seller who of course banks with a different bank. That bank then asks us for the money to be paid to them in BoE reserves, and we only have a day or so in which to pay depending on the form in which the request is made. No problem, we have plenty of reserves bought with the millions we started the bank with, but the fact that we created Joe's money out of thin air is already starting to seem a bit less magical as we have to part with £200,000 of our own money to pay the other bank. Not to worry, we'll have lots of money coming in in due course from Joe's interest payments and some savers will be along shortly to deposit money. Remember that when savers transfer bank money from another bank that bank sends us reserves, which is what we want.
In order to attract business we have to offer savings and loan interest rates that are typical of the current market, hoping to make profits that are typical of other banks. In due course more borrowers come along and also some savers, but the amounts saved by the savers are normally very much less than the amounts requested by borrowers, and practically everyone the borrowers pay for whatever it is they want the loan for bank with other banks, so over time our equity diminishes, until it is down to the minimum permitted by the banking regulations. At that point we can no longer use our own equity to pay other banks when they demand reserves, we have to borrow them, preferably from other banks because they charge lower interest rates than the BoE, or failing that from the BoE. Still, the interest we pay the banks or the BoE is still considerably less than the interest we receive from borrowers, so we should still be profitable. But, and it's a big but, before banks or the BoE will lend to us they want collateral. They don't trust us to pay the money back without a guarantee, and the loan agreements that we have from Joe Bloggs and fellow borrowers won't serve the purpose because they can't be sold on the open market and aren't liquid enough - they aren't easily convertible to cash. Also the lending bank doesn't know what the risk of the borrower defaulting is.[171] Hence we have to offer government bonds or other high quality tradable assets as collateral, and where do we get them? We have to buy them with our equity, but our equity is already down to the minimum, so we're stuck! Recall that the banking system as a whole can buy government bonds with created money (see chapter 44), but an individual bank can't buy them with its own created money, so that doesn't help us either.
In fact it is clear now that we needed a lot more equity to begin with, enough to buy not only plenty of reserves for interbank transfers but also plenty of collateral for interbank loans for those times when we are temporarily short of reserves. We needed enough in fact to tide us over until we have built a high enough share of the market of all bank current account holders. When we have a high enough share then the reserves that other banks send us (when borrowers who bank with them pay people who bank with us) will come in at a high enough rate to balance the rate at which we transfer reserves to other banks over a reasonable timescale.
At this point a digression is in order: it might be thought that since we only have a tiny market share of current account holders reserves will go out from us in much greater quantity than they come in from other banks. In fact this isn't true. Reserves transferred out and in should always balance over time, even with a very small market share. To illustrate why this is say we have 1% of the market of current account holders and there is only one other bank with the other 99%. Then 99% of all loans originate in the other bank and 1% originate in ours. For loans from the other bank, in only 1% of cases do the borrowers pay people (for the things they want the loans for) who bank with us. Therefore the reserves coming in to us from other banks are 1% of 99% of the total of all loans = 0.99%. For our bank loans, in 99% of those cases the borrowers pay people who bank with the other bank, so the reserves going out from us to the other bank are 99% of 1% of the total of all loans = 0.99%. Hence the reserves coming in and going out are the same - on average. And that's the big snag - on average. Although the average rate of reserves coming in and going out balance they certainly can't be relied upon to balance every day, every week or every month. So to be secure we must have access to enough reserves to cover the size of deficit that we can expect in practice, and the smaller our market share the longer the period we must allow for. With 1% of the market we can expect to have 1% of the reserves on average, and with 99% of the market the other bank can expect to have 99% of the reserves on average. But since the reserves coming in and going out are the same for us and for the other bank, the other bank has 99 times more reserves than we do to cover any deficit, so we are very much more vulnerable than they are because of our small market share. In our case we don't have even a 1% market share, it is more like 0.01% or less, so we might be without sufficient reserves for years!
All banks experience reserve deficits and surpluses, so those with a surplus lend to those with a deficit, and such loans are normally only for short periods because the situation changes over short periods, though they can normally be rolled over to allow for longer periods. Provided that the ratio of total bank money to total reserves is at or below that needed for security in the banking system as a whole then there will be enough reserves somewhere in the system to cover any deficit. Therefore provided that those reserves are accessible to banks in deficit then all banks can manage their cash flow. In effect this facility ties all banks together making them into one big bank from a reserve availability point of view.
With our new bank it will be a long time before we have the many thousands of current account holders that we need for the expectable reserve deficit to amount to significantly less than the total number of loans that we have made, so in effect until that time we have to be prepared to fund all loans with the money that we put into the bank to set it up, over and above the amount necessary to meet the banking licence requirements. Therefore in practice the only people who can realistically set up new banks are those with enormous resources, and even they rarely start from scratch. What they do is either buy up an existing chain of banks like Virgin bought Northern Rock, or they already have access to a large number of people who they can persuade to set up accounts with the new bank. Large retailers like Marks and Spencer, Tesco and Sainsbury's meet these requirements.
Market share in banking also brings considerable economies of scale. A bank that has a large market share has as customers both borrowers and those whom the borrowers pay, and in these cases no reserves are transferred at all because no other bank is involved. All that happens is that the borrower's account is debited and the payee's account credited, it's that simple and no costs are involved.
It is clear that a sizeable market share is vital for a bank, and that is why existing banks are so keen to attract new customers, often with strong inducements, and also why banks seek to amalgamate with or take over other banks. As a result 95% of the UK personal current account market (65 million active accounts) is held by only five banks and one building society - Lloyds TSB, HSBC, RBS, Barclays, Santander and Nationwide Building Society.[172] The remaining fourteen between them have the remaining 5%. Although there are many other banks that offer personal current accounts they do so as agencies of one or other of the above twenty, which handle, for fees, all payment and settlement services for them.
As is now hopefully evident, true market competition that arises from easy entry of new suppliers is completely absent for banking, even if the difficulty of obtaining a licence is ignored. It is very far from the ideal free market discussed in chapter 28.
Never mind, instead of starting our own bank why don't we buy shares in one or more of the big banks and wait for the money to roll in? Sadly that won't work either - at least not as well as we might hope. The real winners in banking were the original shareholders who set up the banks in the first place. Since then the market has determined the share price in competition with all other available shares, so the returns on average aren't any higher than other large company shares of similar risk - if they were the price would be driven up until they weren't.
Also, as you are no doubt aware, much of the profit goes to the directors and senior management of those banks. The ownership structure of large companies (many relatively small or institutional shareholders intent on making short-term profits from increases in share price rather than from long-term dividend payments), means that most owners don't care about the long-term interests of the business. Therefore they are happy with managers who seek to earn short-term profits at the expense of long-term viability, and who reward themselves enormously for doing so. This is known as the agency problem and is explored more fully in chapter 93.