Banks are run badly, say bankers.

From City AM:

THE TREASURY is preparing to water down a key recommendation in the Vickers report that would protect savers in the event of a bank going bust. Investors and banks have argued that Vickers’ suggestion that retail depositors should be paid back before all other creditors if a bank collapses could risk destroying the market for bank debt and cause corporate deposits to flee the UK...

HSBC and Standard Chartered, the banks most likely to leave the UK, have lobbied against the requirement that they issue billions in bail-in bonds – bonds that can be written-down in the event of the bank’s collapse. The measure would cost HSBC $2.1bn a year, its chief financial officer Iain Mackay said recently, which he added would be "too high" to justify staying in the UK.

i. A bank holds financial assets, i.e. money lent out at interest, and all financial assets require corresponding financial liabilities, i.e. ownership. So a bank can finance itself with a mix of deposits, bonds/loans and share capital/retained profits (to use three broad categories, there are of course huge overlaps between them).

ii. In proper free market capitalism, there is a balance between risk and return. So if a bank has £20 in assets and generates £1 in gross income, the senior staff swipe 10p for themselves and the rest is dished out between the three classes of financiers (depositors, bondholders, shareholders).

iii. If the bank were funded solely by £20 in deposits, they would receive 4.5% interest and bear the whole risk; if it were funded entirely by bonds, they would also receive 4.5% and bear the whole risk etc.

iv. But people's risk preferences are different, so some are prepared to accept a lower return in exchange for bearing less risk, and 'risk' for these purposes is where they rank in priority of repayment. For example, if the bank is financed with a third from each category, the depositors are paid 1%, the bond holders 5% and the shareholders 7.5%.

v. Remember also that how a bank is financed has little impact on that £1 gross income, it's just a question of how it is split up. The whole point of Vickers is to release the taxpayer from the burden of bailing out banks.

vi. Simplest would be to increase their share capital/retained profits, either by issuing shares, paying out less as dividends or paying out less in obscene bonuses. Or we can invent a new category of finance called 'bail-in bonds' which are a hybrid of bonds and share capital. So if the bank is financed with a quarter from each category, the depositors would be paid 1%, the ordinary bondholders 1.5%, the bail-in bondholders 5.5% and the shareholders 10%. And so on; but the total cost of finance from the bank's point of view is exactly the same, it always adds up to 90p.

vii. I don't know how HSBC calculated their $2.1 bn a year cost. Using my simple examples, this would be the extra which they have to pay to those bondholders from iv. who choose to subscribe for the slightly riskier 'bail-in bonds' in vi. These bond holders receive 27.5p interest(£5 x 5.5%). But we can minus off from that the 1.7p less which depositors are getting and 25.8p less which ordinary bondholders are getting (£6.67 x 5% minus £5 x 1.5%). Whatever you do, it always adds up to 90p.

viii. Unless, of course, what HSBC are really saying is that their bank is not particularly well run, i.e. risky, and that if their bondholders are expected to bear some of the risk (clearly the share capital is not enough, or else there'd be no risk to bondholders at all), they will expect $2.1 bn more a year in interest or dividends. They could of course just run their bank properly and get the interest cost down that way or they can fob off the risk onto the taxpayer (i.e. you) and keep the rewards to themselves.