The BASICS and CRISES of our BANKING SYSTEM

Banking is widely regarded as the world's greatest confidence trick. Does not the bank create money out of thin air with a simple stroke of the pen – or keyboard – then charge interest for its use?

The shenanigans of 2008 and onwards involving ultra high-tech gambling, bank failures, costly tax-payer bailouts and ensuing recession of historic proportions have done nothing to enhance bankers' reputation.

Yet the basic principles of banking are both sound and simple. Bankers take fixed assets (like the deeds of your house) as security and give you an equivalent in liquid assets (cash or credit, or purchasing power) in exchange for the duration of the loan. No new wealth is created. The bank simply exchanges one type of asset for another.

Banking was, and is subject to certain basic rules of conduct. The bank must at all times remain “liquid”, which means that it must always hold enough cash and near-cash to satisfy the demands of depositors for withdrawals. Second, the Bank must assure itself of the true value of assets taken from borrowers in exchange for credit.

Since banks create purchasing power, either government or the central bank must regulate the total quantity of current purchasing power relative to demand and the capacity of the economy in order to control inflation.

Go back thirty or forty years and banking very much reflected these ideals. High Street banks housed themselves in imposing buildings, the interior presented a mood of seriousness and solemnity. Banking was a privilege which the customer should accept with deference and respect.

Anyone wanting a loan would be ushered into the Manager's Office where, behind the privacy of frosted glass, he or she would be subjected to a procedure much resembling a bad boy's interview with a disapproving headmaster. Personal loans would be the major business, mortgages, small business loans, home improvements, all subjected to careful scrutiny.

Purchase of stocks and shares would be a personal, private matter, individual investors making their own choices which they would finance out of income or savings. The growth of professionally managed investment funds allowed individuals to buy into a fund or mix of funds according to the fund's focus and objectives.

How, then, did a major part of the world's banking system reach a state of bankruptcy and total collapse?

THE GREAT BANKING CRISIS OF 2008

Though it is quite natural to regard a nation's banking system as a vital, if not the most essential element of its infrastructural services and facilities, banks are in fact privately owned and as such, their primary loyalty is to their shareholders. Not only must they show a handsome profit, these days performance is monitored on a quarterly basis, and market expectations are very demanding. Hence the drive is on to find ever more new and increasingly exotic ways of maximizing profits.

Standards for the calculation of “safe” mortgage commitments have slowly declined, as banks, and in the USA especially less-than-honest mortgage brokers, allowed increasingly untenable mortgages. Again going back a few years, the calculation was simple: your mortgage payment shouldn't be more than a quarter of your gross income. This was also a simple calculation because few people had revolving credit or any debt other than a car payment.

In the USA by 2007, mortgage debt to income had reached into the 40-60% levels before considering any other debt and living expenses. The “safe” mortgage in the USA passed the affordability curve long before sub-prime became an issue. Factor-in non-mortgage debt – for cars, domestic appliances and credit cards – and simply put: people were carrying much higher consumer debt loads than ever before, and devoting a larger share of their income to servicing that debt than ever before, all with the active encouragement of the banking and finance sector. In Britain, the situation was no better. In 1999 British households were already the fourth most indebted among the G7 economies. By 2002 Britain had taken the lead, with a debt burden equivalent to almost double disposable income, the money you have to spend after essentials are covered.

Another “old tradition” of mortgages was that the bank would lend up to 80% of the assessed value of the property, the applicant having to raise the rest. But Northern Rock – the small bank with the big impact – found that too limiting for its customers. Northern Rock is a relatively small British bank. Yet its spectacularly imprudent mortgage strategy caused the first run on a British bank in more than a century.

Northern Rock's first mistake was its willingness to relax normal lending criteria. It granted mortgages at six times the applicant's income, and lent up to 125%t of the value of a property, despite already inflated property values.

Secondly, it depended on borrowing money short-term in the interbank market and lending it long-term as mortgage finance. The bank's dependence on the wholesale market - around 70 per cent of its funding came from this source - was a catastrophe waiting to happen. It was a fundamentally irresponsible strategy, which presumed an unending rise in property prices, perhaps punctuated at worst by brief 'corrective' falls of up to 5%. But the UK property market was already grossly inflated, and the collapse of the sub prime mortgage market in the US led to a cascade of bad debts through the banking system. Interbank lending froze, making it virtually impossible for Northern Rock to raise fresh funds as its loans fell due.

On 14 September 2007, the Bank sought and received a liquidity support facility from the Bank of England. 22 February 2008, the Treasury was forced to rescue and then nationalise the bank to protect the wider financial system.

And that was just the start.

Property mortgages were not the only cause of economic troubles. Credit Card departments of banking institutions advertise actively for business – “no credit checks, instant acceptance guaranteed”. Why such rash promises? Surely there will be defaults. Yes of course there will be. But there will also be the “poor but honest” who maximize their card debt then have to pay interest at an annual 19% plus. Encouraged by multiple credit cards, consumers committed their incomes weeks, months even years ahead – always assuming of course that their jobs and incomes would outlive their commitments. When downturn and redundancies struck, the incomes dried up, but the debts lived on. While governments desperately tried to restart their economies by encouraging consumers to “spend, spend, spend”, ordinary folk apparently knew better, devoting what money they had to running down their debts.

In the pursuance of profits, major banks take substantial risks in financial speculation on a huge scale, or at local level, in unproductive ventures operated by relatives or thinly disguised associated companies. The history of banking provides numerous references to major banking scandals where banks have made substantial loans to dubious real estate companies, or, more recently, where banks have played the foreign currency markets using complex high-risk gearing techniques. The situation remains unchanged, and a new major banking scandal can break at any time. The complete collapse in 2008 of major banking, investment and insurance institutions, though the worst to date, is only following a long-established tradition of profit-seeking risk.

Traditional banking practice is founded on “reserves”, with loans based on and secured by those reserves. But experiences in 2008 have proved conclusively that banks' “assets” as security for their high-stakes gambling have been woefully inadequate. Reserves are in effect insurance, insurance against bad loans. But as any insurance assessor knows, insurance must be weighed against risk, and bankers' gambles and their investment “devices” have become so complex that risk is almost impossible to estimate.

In the autumn 2008 global financial storm, UBS, Switzerland's biggest bank, got itself into serious trouble. Not only was the bank gambling wildly, it also grossly underestimated the risks it was taking. Before the beginning of the crisis, UBS calculated its credit risk at SFr 800 million. In the event it had to write down SFr 40 billion – that's 50 times more. The government had to step in and save the bank by putting in $5.3 billion to take a 9.3 percent ownership in the bank. The “reserve of last resort”, it turns out, is the unfortunate taxpayer.

The Great New Idea of twenty-first-century banks was known as “originate and distribute.” The notion was that by packaging loans into securities that were sold to investors all over the world, the banks wouldn't get stuck if loans went bad.

Citigroup had pioneered entities called “structured investment vehicles,” or SIVs. In essence, mortgage loans were sliced into pieces, with some sold and others kept in these stand-alone units. The SIVs borrowed money by selling short-term IOUs on the market, making them vulnerable to a change in investor appetite for short-term lending. And SIV loans frequently were not shown on the banks' books.

Off-balance sheet financing is any form of funding that avoids placing owners' equity, liabilities or assets on a firm's balance sheet. This is generally accomplished by placing those items on some other entity's balance sheet.

A standard approach is to form a special purpose vehicle (SPV) and place assets and liabilities on its balance sheet. Also called a special purpose entity (SPE), an SPV is a firm or legal entity established to perform some narrowly-defined or temporary purpose. The sponsoring firm accomplishes that purpose without having to carry any of the associated assets or liabilities on its own balance sheet. The purpose is achieved "off-balance sheet."

Off-balance sheet financing is attractive from a risk management standpoint. When assets and liabilities are moved from one balance sheet to another, the risks associated with those assets and liabilities go with them. For example, if a firm transfers credit risky assets to an SPV, the credit risk goes with those assets, and therefore does not need to be “covered” by insurance capital.

A bank has to set aside capital – a cushion to absorb losses – for every loan it makes and every bond it buys. By parking the loans and securities in SIVs off the banks' balance sheets, Citibank and other banks that used SIVs didn't have to set aside capital to absorb any losses. That made the potential profits far greater than if the loans had been on the banks' books. But it also meant there was no capital cushion to absorb losses if the banks ended up taking back the losses, either because they had legal promises to the SIVs or felt maintaining reputations required them to bail out the SIVs.

In 2006, Citibank's off-balance sheet assets amounted to $2.1 trillion; its on-balance sheet assets were $1.8 trillion. Not only were these enormous loans hidden, but several top Fed staffers confessed later that they hadn't even heard the term “SIV” until the end of July. Neither had some senior Fed officials – even though they were charged with being guardians of the financial system. In fact, that was typical. An astounding array of derivative products had exploded across the marketplace over the preceding few years. Even market sophisticates faced a steep learning curve to keep up with what was happening, and that included Citigroup's own chief executive, Chuck Prince, who famously dismissed worries that his bank and others were counting unwisely on cheap and plentiful credit to make ever bigger and riskier loans.

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing,” he told the Financial Times in early July 2007.

In fact, Citiroup, in common to a greater or lesser extent with other banks, had little or no choice. A banker who didn't dance, who didn't make ever more risky loans, would find his bank's market share falling and near-term profits less impressive than his competitors'. Then the music stopped and the drama – or melodrama – took over.

And yet what might be considered honest miscalculation, however dire its results, was not to be the end of the 2008 and on-going financial disaster.

The global financial crisis, it subsequently became clear, was caused not just by the bankers' colossal mismanagement; it was due also to the new financial complexity, offering up the opportunity for widespread, systemic fraud. That the world's most famous investment bank, Goldman Sachs, was subject to civil charges for fraud brought by the American regulator was only one of a series of investigations into financial institutions around the world. A court-appointed examiner found that collapsed investment bank Lehman knowingly manipulated its balance sheet to make it look stronger than it was. In Iceland a dossier assembled by its parliament on the Icelandic banks – huge lenders in Britain – was handed to its public prosecution service.

Beneath the complexity, the charges are all rooted in the same phenomenon – deception. Somebody, somewhere, was knowingly fooled by banks and bankers – sometimes governments over tax, sometimes regulators and investors over the probity of balance sheets and profits and sometimes, as the Securities and Exchange Commission (SEC) says in Goldman's case, by creating a scheme to enrich one favoured investor at the expense of others – including, via Royal Bank of Scotland, the British taxpayer. Along the way there is a long list of so-called “entrepreneurs” and “innovators” who were offered loans that should never have been made.

Simply stated, the banks got in trouble because they gambled wildly, irresponsibly, and now it would appear, dishonestly with the resources at their disposal, bringing near-bankruptcy upon themselves, debts upon taxpayers, and serious recession upon the western economies.

Q: Are bankers Conservative or Socialist? A: Yes.

When they're on a winning streak taking in profits on bets the complexity of which few but the young whiz kids understand, when star traders and executives are taking home bonuses in the millions, the bankers are True Blue Conservative – and “Hands Off Private Enterprise!”

But when the bets turn sour and phenomenal winnings turn into ruinous debts, suddenly they're Socialists, standing in the lineup, their top hats held out for government welfare – and welfare on a scale which dwarfs unemployment benefits for ordinary out-of-work folks. And so the government steps in with a rescue package. For the banks, it's a win-win situation. And despite the enormous damage done during 2008-2010 and beyond, nothing has basically changed in the banking world.

Bankers and traditionally minded economists make dark threats about the dangers of governments running the banking system, but the reality is that a nation's banking and monetary system is a vital, indeed the most important element of its infrastructure, and the entire economy depends on its proper functioning for everything from day to day livelihood to investment and economic expansion. Furthermore, when the system breaks down, government is the banker of last resort.

Thus we return to the urgent necessity for a fundamental review of our banking and finance system, what we require from it and how best our needs for trade, and investment in commerce, industry and infrastructure can be supplied efficiently and cost-effectively.

The need for separation of “utility” and “investment” banking functions coupled with much tighter regulation are obvious remedies against future banking collapse has already been made.

But for the longterm investment needs of trade and industry, large and small, we need a new element, a new weapon: investment banking serving and supporting its clients through a longterm commitment to, and secured by, the business itself.


The Economics of Prosperity

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