Third Sector Performance

Management and Finance in Not-for-profit and Social Enterprises

Richard Greatbanks, Graham Manville, Richard Greatbanks

• Publisher: Routledge
• Year: 2016
• Print ISBN:
  9781138251199
• eBook ISBN:
  9781317010593
• Topic: Business
• Subtopic: Business General
• Index: Business

Global financial crisis and colossal sovereign debt has resulted in the need for radical cuts in public expenditure in many countries. Against this background, the contributions in Third Sector Performance acknowledge that, as a result, more imaginative ways of delivering public services are being sought. In countries like the UK, the new concept of The Big Society envisages third sector, or not-for-profit, or charitable organizations and social enterprises stepping in to mitigate the loss of vital public services. This development also gives rise to the likelihood that third sector financial institutions such as credit unions and a possible 'Big Society Bank' will grow in importance. The performance of all these enterprises looks set to become a much more critical issue than it has been in the past. The editors have gathered in this volume, chapters reflecting the fact that third sector organizations are not the same as conventional businesses and are also subtly different from the public sector. There is currently a dearth of knowledge and a lack of research into issues around performance in the Third Sector or Civil Society. This book begins to fill a void in the knowledge base. The internationally sourced contributions represent a balanced offering of academic research findings and practitioner accounts from the Third Sector, together with a section devoted specifically to third sector finance institutions. This book will appeal, internationally, to policy makers within the third sector or involved in the management of n-f-p and voluntary organisations, as well as to those with responsibility for wider public policy, scholars teaching or researching in this area, and students of business and management preparing for roles in social enterprises.

PART I:

FINANCING THE THIRD SECTOR

Overview of Part I: Financing the Third Sector

The global financial crises of 2007 and 2008 have given rise to what Habermas describes as ‘steering media’, in the form of power, law and money which are hastening the reform of public service delivery. This is likely to result in significant cuts to funding budgets, and public services no longer being delivered by the state. However, there is a compelling case for the financial services sector to play a more pivotal role than they are currently playing. The future sustainability of the financial services, in particular the banking industry, was secured after governments around the world took on colossal sovereign debt to provide the liquidity for the global banking system. Due to a lack of global regulation and a very strong banking lobby, the pace of reform in the sector is now out of alignment with the reforms currently proposed in the state and civil society sector. A healthy, ethical and sustainable banking system is vital for the future prosperity of the world as the well-being of the banking sector is inextricably linked to the sustainability of public service provision. Nevertheless, many commentators still believe further reform is needed in the banking industry, and more research on possible solutions is required from academia. Such an approach may guard against the charge of epistemic arrogance which the author and academic Dr Nassim Taleb levelled against the banking industry in his best-seller, Black Swan.

This section considers the financial environment within which the third sector now finds itself, and offers three contributions which specifically explore the dynamic financial issues facing the third sector. The first chapter is a position piece, originally authored by Greg Pytel and submitted in 2009 to the House of Commons Treasury Select Committee as evidence in support of the enquiry into the banking crisis. This essay provides a provocative but credible argument to the lack of insight into the parlous state of the financial system, and is reproduced with permission of the UK National Archives. It provides a layperson’s introduction to the intricacies and potential deficiencies of the global banking and finance system, and explores the root causes of the 2007–08 global financial crisis against which this book is set.

The second chapter is written by the editors, Graham Manville and Richard Greatbanks, and develops the thinking presented in the first chapter to the creation of a social investment bank or ‘Big Society Bank’ in the UK. The idea was conceived by the previous Labour government and has been continued by the current Conservative/Liberal coalition government. The Big Society Bank will be a fully serviced wholesale lending bank for the third sector. It is an important first step for third sector financial services and its aim is to supplement the role of the state.

The third contribution to this section is written by Richard Werner, who provides a compelling justification for expanding the role of credit unions in financial services. He argues that currently credit unions cannot compete on a level playing field with commercial banks, who are able to effectively create money using the principle of fractional reserve banking. Werner calls for credit unions to have the same powers as commercial banks, which would give them the scale necessary to compete effectively. This view of credit unions becoming larger entities is not universally accepted by credit union policy-makers, but is offered as a thought-provoking position piece.

These three pieces explore the recent changes, and the subsequent potential opportunities or challenges, which have increasingly placed third sector organizations at the centre of social and economic change with many societies throughout the world.

1
The Financial Context for an Expanded Third Sector

Graham Manville and Richard Greatbanks

Since the GFC of 2008, the world economy has been experiencing a great deal of uncertainty and many governments, predominantly North American and European, have stepped in to become the lenders of last resort, providing both direct and indirect financial support and guarantees to prop up the banking industry which came close to collapse. Three years after the initial crisis, there is still a high degree of uncertainty and general reluctance for banks to reform. The report into UK banking (arguably the global financial centre) by the Independent Banking Commission chaired by Sir John Vickers published its findings in November 2011 (Vickers 2011). Among its recommendations were a series of eye-catching headlines, such as the separation of retail banking from investment banking, but no real reform until 2015 at the earliest and more likely 2019 when Basel 3 global regulation takes effect (International Law Office 2010). However, what the Vickers Report did not even begin to address was the issues resulting from ‘shadow banking’ (which includes collateralized debt obligations, credit default swaps, special purpose vehicles and hedge funds), and herein lies the problem, like an iceberg beneath the water.

In 2010 the Federal Reserve Bank of New York published a report explaining how the opaque world of shadow banking operates (Pozsar et al. 2010). Within the report is a flowchart which shows the sheer complexity of shadow banking (it has to be viewed on poster size, 36 × 48 inches/92 × 122cm, in order to read the text). Shadow banking has insidiously swelled the balance sheets of the world banks and despite the banking reforms post-2007 and -2008, it remains largely unregulated. The banking sector in the UK has risen from the stable levels of 50 per cent of GDP in the 1960s to over 450 per cent at the end of the first decade of the twenty-first century (King 2010). In addition, the key ratio of the loan to deposit ratio (a function of fractional reserve banking) has betrayed the fragility of the banking sector, having risen appreciably in recent years. As a result of securitization and other shadow banking activities, the loan to deposit ratios of many of the UK banks have risen beyond 100 per cent (Davies 2008, Pytel, 2009).

To illustrate how fractional reserve banking works we have reproduced, with permission, the essay by Greg Pytel, submitted to the House of Commons Treasury Select Committee (Pytel, 2009).

It is the most rudimentary money creation mechanism for banks, which if administered properly serves the economy and public at large very well. In the deposit creation process a bank accepts deposits and lends them out. But almost every lending returns soon to the bank as a deposit and is lent out again. In essence, when people borrow money they do not keep it at home as cash, but spend it, so this money finds its way back to a bank quite quickly. It is not necessarily the same bank, but as the number of banks is limited (indeed very small) and there is – or was – a very active interbank lending, in terms of deposit creation, the system works like one large bank.

Therefore, the same money is re-lent over and over again, however if all depositors of all banks turned up at the same time there would not be enough cash to pay them out. Such a situation is highly unlikely. Every borrower repays his loan and pays interest on it. In principle, the difference between a loan and a deposit interest rate is a source of the banks’ profit. Naturally, banks have to account for some creditors that will default and reflect it in the lending interest rate, or all the creditors who repay cover the costs of defaults. On top of it, the banks possess their own capital to provide security.

Fundamental to this deposit creation principle is the percentage of deposits that a bank lends out. The description above used a 100 per cent loan-deposit ratio, meaning that all deposits are lent out. In traditional banking this ratio was always below 100 per cent. For example, years ago, Westminster Bank (before it merged into National Westminster Bank), intended to lend out 86.5 per cent of every deposit. For every £100 deposited, the bank lent out £86.50, while the remaining £13.50 was retained in the bank’s reserve with a small portion of it kept in the Bank of England. In practice, this ratio was the bank’s control tool on deposit creation process, ensuring that the amount of money supplied to the market was limited. According to this principle, for every £1 deposited, a bank lends out £0.865. After only five cycles the amount is reduced to below £0.50 and after 32 cycles it is below 1 penny (£0.01). If this process continued forever the total amount of money lent out of a pound would be less than £6.41. With every cycle of deposit creation, a bank builds up its reserves, ultimately collecting almost entire £1 for every £1 initial deposit. Added to capital repayments, interest payments on loans and the bank’s own capital base this system ensured that that there was always enough money in the bank for every depositor. For years banks worked as a confidence trick, in that the notional value of deposits and liabilities to be paid by the bank exceeded the value of money on the market. Since only a very small number of depositors demand cash withdrawals at the same time and almost all these paid-out deposits are deposited in a bank again quickly the banks ensured that every depositor got his money while circulating money in the economy and stimulating growth. The loan-deposit ratio was a self-regulating tool. As with every cycle it multiplies, the reduction of amounts created decreases exponentially and quickly. The faster the deposit creation cycles occur the faster the reduction progresses, thus accelerating with every cycle. The total ‘created’ from the original £1 deposited in a bank is a finite, not more than £6.41 at the 86.5 per cent loan-deposit ratio, backed by nearly £1 reserve. It is effectively an inverted pyramid scheme starting from a fixed initial deposit base and quickly reducing through deposit creation cycle to zero.

The deposit creation process is at the heart of the banking system servicing the public and stimulating economic growth. The modern banking instruments of securitisation, hedging, leveraging, derivatives and so on turned this process on its head. They enabled banks to lend more out than they took in deposits. According to Morgan Stanley Research, in 2007 UK banks loan-deposit ratio was 137 per cent (Davies 2008). In other words the banks were lending out on average £137.00 for every £100 paid in as a deposit. Another conservative estimate shows that this indicator for major UK banks was at least 174 per cent. For others like Northern Rock it was a massive 322 per cent (Shaw 2008). Banks were ‘borrowing on the international markets’ and lending money they did not have but assuming they would have in the future. Likewise, ‘international markets’ were doing exactly the same. At first sight it might not seem so much different than deposit creation. Deposit creation is lending money by the banks they do not have on the assumption that they will get enough back in sufficient time in the future from borrowers.

On closer examination there is a remarkable difference. With every cycle of the 86.5 per cent loan-deposit ratio every £1 deposited is reduced becoming less than £0.50 after five cycles and less than 1 penny after 32. With a loan-deposit ratio of 137 per cent – lending £137 for every £100 – not to mention 174 per cent or indeed 322 per cent, the story is drastically the opposite. Assume a banker gets the first £1 deposit in the first week of a new year and lends it out. Assume that twice every week in that year the amount lent out comes back to him as a deposit and he sustains such deposit creation process with a ratio of 137 per cent twice every week for the year. This is a perfectly plausible, in fact a conservative scenario on the current electronic financial markets. By the following New Year’s Eve, the final amount he finally lends out from the original £1 is over £165 trillion (165 with 12 zeros, or over 16 times the amount governments have so far injected into economy, or more than 3 times the world’s GDP). The total amount lent out in a year by a banker is over £447 trillion. Significantly with a loan-deposit ratio 100 per cent or above no cash reserve is generated.

It is an acknowledged monetary principle that the lending interest rate cannot be below 0 per cent. This would allow borrowers to borrow money and banks would keep paying them for doing so. Indeed, there would be no incentive to lend and borrowing would have become a source of income for a borrower. Ultimately, lending would have stopped completely. It is a very similar principle that the loan-deposit ratio cannot be sustained at 100 per cent or above, as in such circumstances an amount of money coming from economic activities into deposit creation cycle would be multiplied very rapidly to infinity. Economic growth and inflation would not be able to catch up with it, which happens if the loan-deposit ratio is below 100 per cent.

The loan-deposit ratio below 100 per cent that traditionally served as a very strict self-regulating mechanism of money supply stimulating the economy becomes unsustainable above 100 per cent. The banking system then behaves in a similar manner to the classic pyramid scheme. But as with every pyramid scheme, as long as people and institutions are happy not to demand cash withdrawals from the banks it is sustainable. Any bank can always print an impressive account statement or issue a new deposit certificate. The problem is whether the cash is there.

The qualitative and quantitative difference between loan-deposit ratio of 0 per cent and 99 per cent is infinitely smaller than between 99 per cent and 100 per cent or 101 per cent. With ratios between 0 per cent and 99 per cent, we always end up with a money-making machine that creates a finite amount of money out of the initial deposit with a reserve nearly equal to the original deposit. If a ratio climbs to 100 per cent or above the amount of money created spirals to infinity, if above 100 per cent with exponential speed and no cash reserve is generated in this process. It is little wonder that Northern Rock which used the ratio of not less than 322 per cent collapsed before any of the other banks. HBOS with a ratio of around 175 per cent ended up in a meltdown scenario later, while HSBC that used the ratio of not more than 91 per cent was relatively safe (being a part of the global banking system, however, it has been at a risk stemming from the actions of other banks) (Shaw 2008).

Facing the inevitable

For years the impressive-looking British-based banks’ results brought a lot of confidence. The City was hailed as a beacon of the British economy. Bank executives, traders and financiers collected huge bonuses – not surprisingly, a lot of it in cash, rather than financial instruments. Influential economists and politicians alike justified stratospheric bonuses and hailed the City as the workhorse of the economy. Government strategic decisions were quite often subordinate to the objective of keeping the City strong. To quote a classic: ‘irrational exuberance’ triumphed. Ultimately, City executives, traders and financiers proved to be pyramid purveyors operating the same scheme, in terms of its mechanism design, as the fraudsters who bankrupted Albania with their innovative financial products in 1996–97 (Jarvis 2000).

The problem with the banks is that credit creation was out of control because of the warping of fractional reserve banking (loan to deposit ratios greater than 100 per cent). The complexity and opacity of ‘shadow banking’ has hidden the risks and caused the balance sheets of banks to swell to unsustainable levels. This has led to the need for taxpayer money to be pumped into the system to maintain the economy and this has been achieved through direct support, guarantees, credit lines and ...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• List of Figures
• List of Tables
• Notes on Contributors
• Foreword
• Acknowledgements
• List of Abbreviations
• Introduction
• PART I: FINANCING THE THIRD SECTOR
• PART II: ACADEMIC RESEARCH IN THIRD SECTOR ORGANIZATIONS
• PART III: REFLECTIVE PRACTICE FROM THE THIRD SECTOR
• Conclusion
• Index