Banks should focus on real investment to support the economy

A key topic for discussion at this week's Two Sessions meetings will be how to carry out financial reform to reduce the risks of overcapacity in industries such as steel, cement, and real estate sectors and also to limit shadow banking and the so-called wealth management products - high return investment products that are often sold, but not guaranteed, by banks.

Recently, President Xi Jinping underscored that the financial reform should deepen supply side structural reform and strengthen the financial sector's ability to serve the real economy.

So, it is important to consider the effects on the real economies of the US and UK of the banking liberalizations carried out by those countries in the 1980s and 1990s. These reforms allowed banks to pay interest on deposits, created national mortgage markets, and deregulated prices of financial services.

Throughout the 2000s, I had the opportunity to talk frequently with senior executives of major US banks, regulators, and other financial companies as part of my job teaching finance in an executive management course at an American university. I must admit that, at that time, I taught my students that one of the key strengths of the US economy was a financial system that efficiently transferred individual's savings to the most highly productive user.

Since the big banking liberalizations, savings rates in the US have declined sharply, real wages have stagnated, and the rate of startup businesses in the US is at an all-time low. The manufacturing sector has been cut in half.

Before the reform, financial experts were paid salaries comparable to similarly skilled people in other professions such as medicine or law, but now they are paid much more. The liberalized financial markets have created great wealth for a few people in New York and London.

Most strikingly, the US banking sector, which once consisted of over 15,000 banks, has been consolidated into a few big banks. As we saw in 2008, these banks are so big that risky behavior on their part threatens the world economy.

What surprised me most in my discussions with banking executives is that, contrary to what the textbooks say, these banks don't make their profits by lending to companies looking to make real investments. They have moved from a business model based on making loans to one based on transaction fees and consumer fines.

You might think that large banks' business strategies focus on making loans to major corporations. But, executives of all the major banks said they really don't want to do this. They offer loans only as loss leaders to attract fee-based business carrying out transactions or arranging deals.

If major corporations need to raise money, they do so by issuing bonds. The banks take fees for arranging the bond issue, but don't actually lend money on the bank's balance sheet.

The traditional US bank is thought to have deep roots in their community - knowing small-business men and making loans to support these businesses. Not any more. Now, banks see low returns from lending to small businesses. They are willing to do this only in the expectation of getting other, more profitable business from the owner, such as fees from home loans or from payment services.

So, what is the core business model of US banks? A regional president of the Bank of America, the largest US commercial bank, told me that his best customers are people who almost can't pay every month. The bank makes high fees if they overdraw their checking accounts or run up credit card debts.

The US has many people who save a lot. But, the banking system takes the savings of those people and lends it to others who are consuming beyond their long-term means. So, the net savings rate has declined steadily since the banking reforms of the 1980s and 1990s. The old model in which banks redirected savings to real investment is gone.

Outsiders often argue that China actually over-invests. But, actually, market forces lead to social underinvestment.

When a business makes a capital investment, its workers get new opportunities and learn new skills. One company's investment often benefits nearby companies, for example, by strengthening the capabilities of an entire cluster of related businesses. There is no way to calculate the exact optimum amount of real investment, but we do know that focusing only on the returns to the capital owner, not society as a whole, leads to systematic underinvestment.

China's massive infrastructure investments are key enablers that make many private enterprises possible. Even many State-owned enterprises, especially those in energy, telecoms, and materials, can be seen as a kind of infrastructure investment that supports a huge array of businesses.

Over the last 40 years, China's success has been undergirded by a financial system that created a lot of savings available for investment. Of course, some of this investment had low returns. But, some of it had high returns, as shown by the rise in living standards.

The financial system must develop the capability to meet the needs of private businesses. Plus, it needs to move away from a banking focus to further expanding the already large venture capital and private equity systems. Plus, a move away from pure banking toward equity and bond financing will give Chinese savers more places to put their money.

However, China must be careful not to destroy the key strengths of the old system - promoting savings and investment. As President Xi stressed, the purpose of a financial system is to support the real economy.