This blog tries to answer some very simple questions on what banks do and why; and what those of us involved with bank capital, regulation and governance actually do all day; and why.
This doesn’t just mean high street banks but the broad definition of bank: wholesale banks, brokers, investment firms, funds, advisory boutiques, etc.
One way or another they’re all doing intermediation between people who need capital and people who supply capital. Which in economic terms is what it’s all about.
There are huge simplifications in this story but I hope you will bear with them. It is based on an imaginary conversation with an inquisitive pre-teen who I bet now wishes he had never asked the question…
Introducing our inquisitive pre-teen
There is so much information on the Internet on banks, banking and bankers; on trading, capital and regulation; on the European Union, the Basel Committee and the Fundamental Review of the Trading Book (FRTB).
But it rarely goes right back to the basics.
A 10-year old I know made the mistake recently of asking me what I had been working on all day. A decent question, if cheeky. So I told him: “The Fundamental Review of the Trading Book”. “What is that?” “A new set of rules for banks.” “Banks have to stick to rules? Really? Why?” And so on, and so on, till you get back to the primal answer: “Because I say so… now go to sleep.”
This blog tries to get back to the basics, without resorting to “Because I say so”.
In real life the young man who posed this question might not have been much interested in following it up. So I am taking some dramatic licence here. Let’s assume the 10-year old in this story has heard of banks, but probably not yet covered banking in his Key Stage 2 syllabus. And maybe doesn’t quite yet have a bank account. Though he certainly has an iPhone.
He is a quite serious young man, luckily. Perhaps he wants to be an accountant one day. So far so good. More important, he wants to show us how smart he is while making a bit of a nuisance.
Let’s call him Tom. The man with the answers naturally is from Prism-Clarity Ltd (PCL).
Banks are special
PCL: Welcome, Tom, to the latest PCL blog.
Tom: Thank you, glad to help.
PCL: What do you want to know?
Tom: Well, the other day you said you were working on the “Fundamental Review of the Trading Book”, but I don’t know what any of those words actually mean.
PCL: OK, let’s start with that and then go back to basics.
PCL: Fundamental: “go right back to the beginning, start again from scratch, major, a complete overhaul, not just a minor paint job”.
Tom: OK I get it so far.
PCL: Review: “take another look”.
Tom: At what?
PCL: At the rules banks have to stick to if they want to stay in business.
Tom: You said this before. Banks have to stick to rules? Really? Why?
PCL Yes – banks are special – they look after our money if we don’t need it right away, they lend us money if we need to buy things, or build things, or look after our elderly or sick citizens. And they help us pay our bills and transfer money to other people we want to have it.
Tom: It sounds quite easy.
PCL: Well, it’s not, it’s quite complicated, and easy to get wrong. Our bank has to make difficult decisions: like how much to lend out, and who to, and how long for, and how much money to keep back in reserve in case we all suddenly decide we want our savings back at the same time.
Tom: How does it do that?
PCL: Well using skill, judgment and experience. But that’s not all, which is where the rules come in. Governments across the world have come up with some rules that all banks have to stick to. If they don’t they won’t be allowed to take our money or lend to the people who need it to help them buy their new car or build their new factory.
Tom: I see.
A small city in Switzerland
PCL: Now, governments like ours are quite busy doing other things like keeping the country running. So, to help them out, they appointed some special advisers who live in a small city in Switzerland. These people write the rules and try to make sure different countries all use them in the same way.
PCL: Yes, it’s a place called Basel. They work for an organisation called the BIS. The BIS has a special Committee called the BCBS which is responsible for setting all the rules.
Tom: OK, so how many rules are there?
PCL: Lots, thousands and thousands, and they are very complicated. But one of the most important ones tells banks how much they have to keep back in reserve for when things go wrong.
Tom: What kind of things go wrong?
PCL: Well, one thing might be that everyone who has saved their money in the bank wants it all back at the same time. Mostly people don’t want all their money back at once. So it doesn’t make sense for the bank to keep all our money sitting in their vault on the off-chance.
PCL: On the off-chance we all want it back at the same time.
Tom: But hang on, if our money isn’t all sitting in their vault, what have they done with it?
PCL: They’ve lent it on. To the people who need it to help them buy their new car or build their new factory, like we said earlier.
Tom: Oh I see. Isn’t that a bit dangerous? What if we do want it back?
PCL: Exactly. Part of the skill, judgment and experience of the people running the bank is to decide how much to lend, who to and for how long, while still having enough to give people their money back if they want it.
Tom: Now it doesn’t sound so easy.
PCL: It isn’t. And you are right, it is a bit dangerous, because you don’t want people knocking down the door of the bank and getting very annoyed because they can’t get their money out. Like I said, banks are special and people trust them to give us our money back when we ask for it.
Liquidity and Capital
PCL: So some of the rules written by the special advisers in Switzerland are to help banks make good decisions on what they do with our money, and how much to set aside for when things go wrong.
Tom: Like if we all want our money back at the same time?
PCL: Yes – that problem is called “Liquidity” and the banks have to stick to some rules on that. Other rules make sure the bank sets aside enough money in case things go wrong on its loans, or on the money it borrows from other people.
Tom: What can go wrong?
PCL: Well, some of the people who borrowed money for their new car, or to build their factory, might run into problems of their own, and can’t pay it all back to the bank on time.
Tom: How do the rules help?
PCL: Well – they make sure the bank sets aside more money against loans to people (or other borrowers) who are more likely to have problems paying it back. Banks have to hold a buffer in case they have too many borrowers who can’t repay them on time. This buffer is called “Capital”.
Tom: I see, and is that it?
PCL: It’s a bit more complicated than that. Lots of other kinds of things can go wrong, not just borrowers who can’t repay their loans. Banks have to hold Capital in case those other things happen, just in case.
Tom: And don’t tell me, there are rules on that too?
PCL: Yes there are. Now, one thing that can go wrong for banks is that they lend and borrow money in different ways. Some of them are quite complicated. For instance, banks buy and sell money from each other.
The Fundamental Review of the Trading Book
Tom: Buy and sell money from each other?
PCL: Yes, it sounds strange but nowadays money takes lots of different forms. It’s not just the ten pound notes we put into our savings account, or take out of a cashpoint. You have an iPhone, these days you can use that to do almost all your banking. Money now moves around the world very fast in lots of different ways, mainly using technology like your iPhone. And banks can buy and sell (or “trade”) money with each other and with other large companies and rich people who are smart enough to do this.
Tom: Now my head hurts.
PCL: Bear with me. If a bank does a lot of buying and selling money like this, it keeps a record of everything it does using something called its “Trading Book”.
Tom: “Trading Book”? Didn’t you mention that earlier?
PCL: Yes, the Fundamental Review of the Trading Book, that is one of the things we’re talking about on this blog.
Tom: OK but I hope we are finishing soon.
PCL: Bear with me. If a bank is doing a lot of selling and buying of money with other banks and companies or rich people, using its Trading Book, there are a whole lot of new things that can go wrong.
Tom: Oh no…
PCL: Yes, maybe they are dealing with people in different countries that have different currencies. Or maybe they are buying or selling for a very long period of time, so there is more chance for something to go wrong. Or maybe they are helping people with factories to keep their costs down by selling them oil or gas at a fixed price for a fixed period. There are lots of different possibilities, and lots of ways for things to go wrong and the bank to lose money.
PCL: So, there is a special set of rules which mean a bank has to hold Capital in case something goes wrong on its Trading Book.
PCL: And what the Fundamental Review of the Trading Book is doing is going back to basics: to fundamentally rewrite the rules on how much money a bank has to hold as a buffer (Capital) against different things going wrong on its Trading Book.
PCL: But there’s more.
PCL: Yes, much much more. But let’s leave that for another time.
PCL: Let’s get pizza.