Good banks pay price of caution

CONFLICTS of interest are a hot topic. Paul Myners' report on pension funds drew attention to them in the UK. In the US, they have been dramatised by the unsavoury behaviour of analysts. In bull markets, people are too busy making money to worry about such conflicts. Vengeance is the bear's consolation. Investors who have lost money want someone to blame.

Today's most obvious conflicts involve analysts. Research is tainted if it comes from inside investment banks. The banks have an interest in seeing the research supports their new issues and helps their trading.

This conflict is in need of resolution. Myners' answer, to stop research being paid for by commission, looks a good solution. Unfortunately, it is unlikely to be the one chosen in America, thus it will be hard for other countries to follow this path.

The precedents are bad anyway. Cleaning up after bull markets usually involves regulations which make matters worse. Deposit insurance is a classic example. Introduced in America to protect investors from banking collapses, it has greatly encouraged them. When depositors cannot lose money, they do not care if they deposit their money with a flaky institution. The result is that, once you have deposit insurance, bad banks can borrow money as cheaply as good ones.

Good banks, however, if the existence of such animals can be imagined, will be those which tend to lend to the sort of borrowers who do not often go bankrupt. These are the borrowers who command the finest terms from their bankers. Good banks will therefore make less money than bad banks when the economy is booming.

They will have their reward when things get tough. Bad banks will then find they have a lot of bad debts and, after a while, even with American accountants on the job, the bad banks will show bad profits.

In boom times, however, things will look different. The good banks will show lower profits than the bad ones. Their management will then appear to be incompetent and risk the sack. The longer the good times last, the less justified will seem their caution. The longer boom times last, therefore, the worse bank management tends to become.

If we had good financial analysts, they would, of course, stop the rot by pointing out that the cautious banks should sell at a premium to the rest. But so long as analysis is riddled with conflicts, we are unlikely to reach that happy state of affairs.

The last serious financial crisis in America was only a dozen years ago. It will be interesting to see if the memory of those troubled times has remained vivid among today's bankers. If it has, this bear market should spare the commercial banks. But there is already a worrying sign to the contrary. US bankers are trying to get the guarantee on deposits raised from the current $100,000 (£68,000). Why, we should all wonder, would they want to do that?

www.smithers.co.uk