Banks are not designed to innovate and this holds back growth

"The incentives for large banks are almost always geared towards reining in risk-taking and volatility in the economy and controlling the intermediation of savings, and it is probably not an accident that the most innovative periods in US or British economic history often coincided with periods of tremendous flux in the domination of the economy by major financial institutions."

Interesting observations from the always insightful comments of Prof Michael Pettis on China. Same theme is at work here in Australia as innovators plug the gap in financing Small-Medium Sized Businesses.

More detailed extract from his recent comments are shown below: 

"But even without crisis the insolvency of the banking system isn’t irrelevant. It will affect the evolution of China’s financial sector over the next decade or so, and will determine to a significant degree how successful China’s overall economic adjustment will be. Surprisingly enough a zombie banking system can actually be a spur to productivity growth if it forces enough of a relaxation of the grip of big banks over the economy. In that case the financing process can migrate to smaller and more innovative financial institutions that specialize in financing the more productive areas of the economy.

In the US during the 1980s, for example, when the largest US banks were struggling with their LDC and energy portfolios, and were more concerned about managing risk down and avoiding further trouble than about expanding to serve the changing needs of their customer base, it is not a coincidence, I would argue, that we saw an explosion of financial innovation, most importantly the creation of the junk bond market as a major source of financing, and including the emergence of new types of LBO and private equity funds, the beginnings of explosive growth in the financing of the high tech sectors in California, and the expansion of regional banks, most of whom weren’t crippled with LDC loan exposure.

The incentives for large banks are almost always geared towards reining in risk-taking and volatility in the economy and controlling the intermediation of savings, and it is probably not an accident that the most innovative periods in US or British economic history often coincided with periods of tremendous flux in the domination of the economy by major financial institutions. I have argued before many times before that we sometimes overvalue the economic benefits of stability within the banking system, and I often cite the great Belgian financial historian Raymond de Roover, who once explained that, in the 19th century, “reckless banking, while causing many losses to creditors, speeded up the economic development of the United States, while sound banking may have retarded the economic development of Canada”

Because a punch-drunk banking system spends more time managing its bruises than looking out for new opportunities, it often ignores the needs of its frustrated clients, who will then turn eagerly to new sources of funding. In a sufficiently liberalized financial system, financial innovators can exploit this attention gap to go after the most profitable sectors of the economy. But this only happens if there are no powerful institutional constraints, usually implemented by the political allies of the big banks themselves, to help them manage through their difficulties that effectively prevent innovation and destabilizing change.

A zombie banking system, in other words, does not always lead to financial innovation. Japan after 1990 also suffered systemic bank insolvency, but very conservative regulations and tough restrictions on financial innovation left the economy without meaningful alternatives to the large banks. Like their American and Japanese counterparts in the 1980s and 1990s, respectively, large Chinese banks have become zombies, even more so once they are forced into absorbing the smaller banks, whose asset quality is far worse and whose liabilities much riskier, something I think we are very likely to see over the next decade. We will have to see then whether the consequence is an explosion in financial innovation or a zombie banking system unable to finance new, productive businesses. My instinct is that given very powerful and closely intertwined banking and regulatory institutions, China is more likely to resemble Japan in the 1990s than the US in the 1980s.

But maybe not. Potential competitors – including several financial boutiques, private equity funds, internet-related financing companies, and the asset management companies created to resolve the bad debt of the 1990s – have positioned themselves for rapid growth in the decade ahead, and may even have the political connections that allow them to escape smothering by the large banks. It is far too early to say, but one of the things I’ll be watching over the rest of the decade, and investors should also watch closely, is whether the Chinese banking system retreats into a fortress mentality or whether Beijing will tolerate a greater role for the markets in the evolution of its financial system. This will tell us a lot about how successfully China’s economic adjustment sets the stage for long-term growth."