ETHICAL BANKING AND RELATIONSHIP BANKING FOR THE NON- AGRICULTURAL SECTOR: As I had written some time back: 'Economists have recently theorised about a fact which bankers had recognised all along, viz., that credit markets are necessarily imperfect and that rate discrimination and credit rationing are universal phenomena. A third dimension of imperfection in credit markets concerns the length of time for which particular creditors are prepared to extend loans to particular borrowers'.
Bankers and the central bank overseeing their activities have to exercise discretion and judgment along all these different dimensions. Hence the question of morality becomes pre-eminent in banking and finance.
The question of morality starts with gathering the information itself. In many cases, the lenders simply refuse to lend money on the basis of what has been styled as 'probabilistic discrimination' that is, depending on stereotype of a whole group without closely inquiring about the actual creditworthiness of the potential borrower. One way of minimising the impact of asymmetric information is to establish a close relationship between the creditor and the borrower. Banking under such a close relationship has been characterised as 'relationship banking', 'i.e., a setting involving repeated, bilateral relations between banks and borrowers'.
Relationship banking, mainly within extended kinship networks had, for example, promoted the development of industries, mining and power generation in New England of the USA in the nineteenth century.
The financing of small and medium-sized enterprises (SMEs), which in the beginning of the twenty-first century still accounted for more than 90 per cent of all firms, and employed about two-thirds of the workforce, in industrialised countries took place under relationship banking. In Germany, the financing of Mittelstand enterprises was performed by usual commercial banks as well as local or regional level regional savings banks. The German SMEs are supported by explicit official policies and the decentralised structure of the German banks 'containing a large number of regional and local banking institutions like sparkassen (mutual saving banks) and volksbanken (cooperative banks) whose key asset is being near local [Mittelstand] clients. This closeness helps in better assessing [Mittelstand] loan risks and conserving long-term business relations'.
I would like to devote some attention to the German Mittelstand or SMEs, because Germany remains the largest economy of Europe, and belying the predictions of the naysayers, the German SMEs have prospered under globalisation. In Germany, from the nineteenth century, large, vertically integrated ('autarkic') firms grew up in steel industry and then in the automobile industry, e-electrical equipment industry. But under a system of decentralisation of some legal and financial powers to the constituent Länder or regional governments, craft-based SMEs also grew up side by side with the giant firms even under the Wilhelmine Reich and the Weimar Republic. This order resurfaced after 1945, and made for much of the dynamism of German growth in the 1950s and 1960s.
It appeared at first that the SMEs would not survive under neoliberal globalisation. But in fact, the gradual erosion of Fordist ('autarkic') industrial organisation and outsourcing of parts of automobiles and machines of all kinds, the German SMEs acquired a new lease of life.
One of the principal foundations of the dynamism of the SMEs is the educational system of Germany which provides compulsory, state-funded education up to the age of fourteen and partially state-funded, compulsory higher secondary education up to the age of 18 or 19. The majority of students undergo vocational education from the age of fifteen, and most of them then join one skilled trade or another, although even among the vocational students some may go on to university education in a subject of their choice. Many of the skilled workers join family-owned SMEs, which nurture long-term relations with their workers and support social responsibility projects for their locality. This type of firm organisation directly contradicts the Anglo-Saxon, neoliberal model of 'shareholder-is-king' firm structure and behaviour. The work of the SMEs is technologically upgraded through contracts with the Fraunhofer Society, Germany's organisation for applied research, which had a budget of 1.66 billion Euros in 2013, co-operating with about 6000 enterprises and generating around 400 registered patents every year. In several of the industrialised East Asian economies, especially in the People's Republic of China (PRC) and Taiwan, SMEs play a very important role in generating income, employment and exports. In the PRC, for example, 'SMEs account for 60 per cent of GDP (gross domestic product) and 82 per cent of the workforce'. In Taiwan, even though that small country boasts of some of the giant world leaders in semiconductor manufacture, in 2009, 'there were 1.2 million SMEs in Taiwan, accounting for 98 per cent of all businesses. They generated 31 per cent of the nation's total sales and 17 per cent of its exports'. As in Germany, the success of the SMEs, as indeed of today's giants, has been due to the strong government support in terms of allocation of funds, protection of the domestic space of operations and state-supported R&D (research and development) in targeted sectors.
The success stories of Germany and Taiwan also illustrate the point that banks and finance companies should, after all, be there to service the real economy rather than a deregulated finance industry, which sucks up funds to create more riches for the barons of finance and render the whole economic system unstable. It is not an accident that the licensing of deregulated finance has led to a severe decline in most finance-led economies in the world, including the USA and the UK, and such emerging economies as Argentina, Mexico and Turkey.     Â
DEREGULATED FINANCE AND WITHDRAWAL OF STATE FROM NECESSARY PUBLIC ACTIVITIES MAKE INCLUSIONARY RELATIONSHIP BANKING UNSUSTAINABLE: Relationship banking becomes unsustainable when essentially deregulated banks or finance companies are allowed to enter the business of financing, and firms are persuaded to access a deregulated capital market. An enormous slag-heap of literature was fabricated primarily by neoclassical economists to support four fallacious ideas:
* The first fallacious idea was that shareholders are the only stake-holders that matter in a firm, and neither the employees or suppliers of firms count.
* The second fallacious idea was that at any given moment, the stock market reveals the fundamental value of a firm.
* The third fallacy - closely related to the second - was that the stock market works efficiently, in the sense that nobody can make a profit by trading in the stock market.
* The final fallacious idea was that you can predict the prices of derivatives on the basis of fundamentals revealed by the stock market.
It was for producing a theory of the last fallacy that the Swedish Bank prize for economics (mistakenly called the Nobel Prize for economics) was awarded to Robert Merton and Myron Scholes in 1997 (for a survey of the multiple inefficiencies snagging the stock market. Merton and Scholes were major shareholders and members of the board of directors of Long-Term Capital Management L.P. (LTCM). The firm's highly leveraged master hedge fund, Long-Term Capital Portfolio L.P., collapsed in late 1998, barely a year after Merton and Scholes had received their Swedish Bank Prize, with an exposure of more than $100 billion. Under the leadership of the US Federal Reserve Bank, an agreement was hammered out on September 23, 1998 among 16 financial institutions, which included Bankers Trust, Barclays, Bear Stearns, Chase Manhattan Bank, Credit Agricole, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, JP Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, Paribas, Salomon Smith Barney, Societe Generale, and UBS of Switzerland, for a $3.6 billion recapitalisation (bailout).
The collapse of Long-Term Management stopped the use of the Black-Merton-Scholes formula for options pricing, but the elaboration of ever more derivatives such as collateralised (CDOs) and putting many of the banks' and hedge fund debts in off-balance sheet accounts did not cease. Many of the finance companies that had been involved in bailing out LTCM, such as Bear Stearns, Lehman Brothers and Merrill Lynch went bankrupt in the financial crisis of 2008. From the 1980s, the finance industry in the USA boomed. The profitability of the financial sector far exceeded that of the real commodity sector, and the pay of the average official soared to 181 per cent of that in the rest of the economy. Under the US system the finance industry could and did spend hundreds of millions of dollars in lobbying in White House and Capitol Hill and campaign funding for politicians who became naturally beholden to them. As the scope for funding real investment became restricted even as the finance industry soared, banks, conglomerate finance corporations and mortgage lenders began financing projects of lower and lower quality, always hoping somebody else would pick up the tab. The most notorious of these were the so-called ninja loans, that is, loans made to people who had no income, no jobs and no assets. A financial oligarchy had taken over the USA, and its condition was described by Simon Johnson, a former chief economist of the USA, as being no better than that of a 'banana republic', of Central America, where, for a long time, the US corporation, the United Fruit Company chose the government (generally a pliable dictator).
The power of the financial oligarchy in the USA became further evident when the government spent tens of billions of dollars bailing out banks, home mortgage institutions, and AIG, by far the biggest insurance company of the world without making the CEOs of those companies disgorge any of their ill-gotten gains, and without punishing them for culpable negligence, and in some cases, outright fraud.   As US Judge Jade Rakoff of the Southern District of New York pointed out, in the few cases in which a civil suit was brought against hedge funds, the prosecution was badly prepared and no criminal cases were launched by the Justice Department of the USA against any of them. It prosecuted Bernard Madoff for a $50 billion plus Ponzi scheme, in which the investors included some of the biggest names in the finance industry, and Rajat Gupta and Rajaratnam for insider trading, but not a single one of the CEOs of the companies that were primarily responsible for causing the financial crisis.
Dr Amiya Kumar Bagchi is Emeritus Professor at the Institute of Development Studies Kolkata (IDSK), Paschimbanga, India. The article
is based on his 14th Nurul Matin Memorial Lecture delivered at the Bangladesh Institute
of Bank Management (BIBM) on November 10, 2014.