The core claim of the Big banks and those who support them is that the financial system, as it is presently constituted, is not only fair and fit for purpose, but essential for our continued welfare. People should therefore stop complaining and knuckle down to suffer whatever deprivation is necessary. All must serve the greater good. Or as it should really be known – the Good of the Greater.
The banks are not frightened by a bank failure or two. As long as governments are prepared to force their people to bleed for the banks’ welfare it can actually be an opportunity. A bank failure is just a chance for the better connected ones to predate. Neither are they worried by a case of fraud here or an indictment there. They will settle for a sum which is of no significance to them, in return for a “no admission of guilt” clause. If necessary they are even prepared to throw one of their own to the baying crowd. No one in banking shed a tear for Fred the Shred. And why should they? Call him greedy if you want. See if he cares. He’d already sucked his millions from the wreak he left behind.
What scares the banks is any criticism that goes beyond claims of greed or fraud or even incompetence, and instead questions the system itself. The sanctity and perfection of the system and its right to ‘regulate’ itself, is what they are totally committed to protect. The system is what gives them their status and wealth. Question that and you threaten them where they are vulnerable.
It seems to me therefore that it is high time we questioned not just the probity, or even the solvency of the big global banks but their very intellectual foundation. It is time for us to wrench back the initiative from the banks. The financial elite have spent all this last year rewriting history so that blame for the banking crisis has been turned away from them and laid instead at the door of ‘people’ and then entire nations who ‘took’ on debts they coudn’t afford . It is time to counter-attack and make the case, that it was and is the way that banks and banking go about their normal business that caused this crisis and are still causing it. We have to show that it was not a break down in an otherwise fine system which caused this crisis but that it was a result and consequence of a system which is an utter failure at doing what it prides itself most on being able to do – managing risk. Not just a onetime failure but a systemic failure which presents an on-going danger to the rest of us.
So let’s be clear. There is no systemic risk at all in welfare spending, no matter how large it becomes, for the simple reason that there is no surprise in welfare spending. It does not jump out at you unexpectedly. Welfare and social spending are a slow moving behemoths that can be seen coming for decades ahead. The only danger is they will trample you to death if you are stupid enough to stand there for decades listening, slack jawed, to the competing teams of witless cretins whose flatulent play-acting is all that remains of our political process .
There is, I suggest, a very clear, present and on-going systemic risk and danger from global banking. It was, after all, banking not welfare which gave us the phrase ‘systemic risk’. Bankers deal in risk. The welfare state deals in…welfare. Like it or loath it, there is no ‘risk’ in welfare or in social spending. They are linear and entirely predictable problems. Banking on the other hand not only deals in risk, it manufactures it. Risk is what bankers bank on.
Don’t take my word for it. Andrew Haldane is the Executive Director for Financial Stability at the Bank of England. In his speech at the London ‘Future of Banking’ conference held in July 2010 he said rather clearly (Page 14),
…banks are in the risk business…’
His entire paper was analysing the ways in which banks create risk and then systematically mislead us and even each other about what they have created. He goes on to say (Page 14),
…it should be no surprise that the run-up to crisis was hallmarked by imaginative ways of manufacturing this commodity, with a view to boosting returns to labour and capital. Risk illusion is no accident; it is there by design. It is in bank managers’ interest to make mirages seem like miracles.
The mirage he refers to is the contribution banks claim to make to our over all economic well-being and security. [I would like to thank Peter Mountford-Smith for bringing this and other recent speeches by Mr Haldane to my attention].
So let’s go straight to where the banks think they are strongest and where I think they are actually terrifyingly vulnerable – their assessment of risk, in both their assets and their liabilities. I have written about risk before, but this time I want to use the bank’s own figures against them. Stay with me. You won’t regret it. We’re going to reach inside the bank’s world, take a firm grip and then yank the whole thing inside out.
We’re going to use a series of graphs from a paper given at an the annual IMF research conference in 2011 by Princeton economist Hyun Song Shin. The stats he uses come in turn from Bankscope which compiles and sells very reliable statistics on banks. The first two both refer to Barclays Bank from ’92 to ’07; the years in which the credit and debt crisis was incubated. The first is a graph showing how Barclay’s Liabilities have grown. The second charts the growth of Barclays’ assets over the same period. Together they are the two sides of the bank’s financial health. Assets and Liabilities. Money in, money out.
The above is what too Big To Fail looks like. It’s also how it got to be that way. That curve, ascending in a steepening upward trajectory, is what is loosely called hyperbolic. It is what disaster looks like. Some time between ’92 and ’07 Barclays and all the global banks became not only Too Big To Fail but also So Fundamentally Unstable that it was Inevitable They Would Fail.
Before we go on we need to be clear about what is an asset for a bank, and what is a liability. This requires making a sketch of how a bank works but it is not difficult and will allow us to understand clearly what bankers love to keep mysterious.
In essence if you want to understand a modern bank think back to those dark days you spent in school mathematics class looking, with a heavy heart, at problems which said, ‘There is a tank with water pouring in the top while a hole in the bottom is letting water out…etc” Remember those? Hideous. But a modern bank, in once sense, is nothing more than that tank of water. It is all about flows in and out.
An asset for a bank is money that other people owe to the bank. Which means the loans and mortgages the bank has extended to others that they will pay back. Those are its assets. The more loans the bank has made, the greater the flow of payments in to the bank, the greater its assets. So ‘assets’ are agreements that direct a flow of money IN to the bank. The bank’s liabilities are agreements that direct the flow OUT of the bank. Money it borrowed from, and thus owes to, others. Assets and liabilities. Flow in, flow out. Money owed to the bank. Money the bank owes. It’s quite simple. It all works so long as the in-flow matches the out-flow.
Which brings us to the first of the bankers articles of faith that I want to question.
We are all now familiar with the fact that all the banks have vast debts which they often owe to each other. We also know how they are dependant upon each other for funding. And we know how, thanks to the multi trillion dollars trade in various kinds of derivatives, the banks are also exposed to huge bets on everything from currency values, to insuring each others debts. BUT, whenever the banks are questioned as to the stability of such huge debts and bets they will say, ‘Don’t you fret, it might look out of control, but our various debts, bets and assets all net out and what’s left is perfectly balanced.’ Which leaves most of us none the wiser. What they mean is that within any bank, the liabilities side (the left hand graph above) balances out with the assets side (the right hand graph), so that however huge the bank’s debts, they are balanced by what it is owed. When you cancel the assets and liabilities out against each other you find what the bank is owed is just a tiny bit more than it owes to others. If you look at the two graphs above you will see they are almost always identical with the assets fractionally larger than the liabilities.
What is more, the banks will also say that when you take the vast trade in derivatives, where the banks insure each other’s debts and make huge bets with each other, and compare who has bet what with whom, these trades also ‘net out’ across the system as a whole. That is, one bet cancells another so that the actual potential losses are small. This is often what is meant by ‘hedging’, where a bet one way is balanced or offset by a bet the other.
However, have you ever been in a rowing boat when two passengers sitting side by side have tried to change places? Taken as an idealized mathematical problem there is in fact no net change occurring, the total weight in the boat does not change. On paper, at least, equal masses simply swap over and at all times they cancel each other out. In reality however as soon as people start to move the whole boat is in danger of capsizing. On paper this never happens because it is just numbers moving and cancelling. But in the real world large weights are almost impossible to balance. There will always be a moment when one person’s weight is not balanced by the other’s. And so it is in finance. Assets and liabilities in a bank, let alone in a vast system of banks, do NOT net out in perfect unison. And that is why, no matter what hedging they claim to have in place, no matter what netting-out ‘should’ occur, banks fail. As one bank fails or simply starts to lurch, tip and rock from side to side, that instability propagates through the system. This is real-world non-linearity at work. Netting out is a fiction maintained because on paper, in the idealized word of mathematics (linear mathematics that is), perfect netting-out works. However in the real world, even electronic debts of zeros and ones, move at different speeds, which in a crisis makes a mockery of the entire notion of netting out.
Netting out means the banks are tied in to a web of obligations to each other. They would like you to understand this as an arrangement which makes them stable. They talk of spreading the risk. In fact it does exactly the opposite. It propagates and amplifies the risk. One boat on its own, rocking violently is a problem, but probably manageable. Now tie lots of boats together. As one rocks, it sets off others. Those other set off yet others. And they all create waves of instibility that buffet each other, in a more and more unpredicatble manor. Now we have systemic risk and ‘contagion’.
It is the failure of netting out across the financial sysytem that causes the otherwise mysterious ‘contagion’ we hear about. Bankers warn about the dangers of ‘contagion’ whenever someone appears reluctant to bail them out, but they are coy about what causes this ‘Contagion’. Contagion is the failure of netting out.
Of course I used the analogy of a rowing boat with people moving about. The question is was that a cheat? Are banks that unstable? To answer that we have to look again at the graphs.
Because I have been working so painfully slowly at the moment I will break again just so that I can get something posted and not extend this long silence. I will continue in other posts. At the moment I think there will be at least two more parts to this series. I will try to get more done. I promise. There are just other things pressing upon my time just at the moment.