So far in Propaganda Wars we have looked at the Bank’s version of reality in which the banks were blameless victims of unscrupulous and fiendishly clever paupers who ‘took’ loans from the banks against the bankers better judgelment and will. In the next part we began to turn the tables and attack the banks where they feel they are strongest – in how they manage risk. We began with “Netting Out”, where Liabilities and Assets are supposed to cancel each other out leaving the bank, no matter how huge its balance sheet, no matter how seemingly exposed to losses, just this side solvent at all times. I suggested this sort of cancelling out is fine on paper but in reality is more akin to people trying to swap sides in a rowing boat. I further suggested that this was why, despite the lovely graphs showing how it would all “Net Out”, in the event, nearly all the major banks went bust and had to be bailed out.
But in the spirit of fairness I ended by asking if the people moving about in a rowing boat analogy, fun as it is, was fair or a cheat? Are banks really that unstable? To answer that we have to look again at the graphs. These graphs show the history of Barclays Bank in the ‘bubble years’ of 1992 to 2007. They plot the massive growth of Barclays bank, its Assets and its Liabilites. The over all shape of these graphs and what I have to say about them would apply equally, however, to almost any of the big global banks (as we see later).
Assets and Liabilites are two sides of a bank’s “balance sheet”. So what exaclty is being balanced and is it a stable?
To answer both these questions we are going to have to move back and forth between the two sides of the balance sheet.
Don’t panic! Its a story of idiots, drunk on their own assurances of safety and brilliance but almost totally devoid of common sense and responsibility.
First thing to notice is how incredibly the bank has grown. The size of the bank is the height of the graph. It has grown from about an 180 billion pound bank to one of 1.2 trillion. It has grown in almost every respect but one – the base upon which it sits. In the Liabilities graph to right take a look at the aptly coloured ‘thin blue line’ of Equity. This is the money investors have put into the bank. It is the bulk of the bank’s capital. As you can see it was never big, but as the bank has grown it has become smaller and smaller relative to everything else. Relative to the size of the bank’s total liabilities (money the bank owes to others) on the one hand, and its total Assets (money it is owed – which means money it has lent OUT Mortgages etc. ie Money at risk) on the other, the equity base of the bank has become vanishingly small. Which is a problem because that equity is the base upon which the security of the bank rests; It is money the bank would need to call on if – in the most unlikely event – some of the loans it had made didn’t work out. Unlikely I know but bear with me.
Bankers and their regulators will often refer to a bank’s ‘equity base’. If you remember in the last part of this series I imagined a bank as a tank of water with money flowing in from assets/loans and out to pay liabilites. The Equity base would be the base of the tank and the reserve of money that remains in it, as funds flow in and out. The overall size of the graph relative to that very thin blue line of equity means we have a very, very large tank standing on a very, very small base. Not only that but there are massive pipes pushing and pulling huge volumes of money in and out. Basically Barclays is an upside down pyramid trying to remain upright while it contends with the forces of the flows in and out, which are orders of magnitiude larger than the volume of tank itself and even larger than the puny base upon which the whole thing rests. Stable? Not terrifically.
If you look at the growth of this and other banks over the last century, which Andrew Haldane, Director for Financial Stability at the Bank of England does here, you find that at the start of the 20th century the equity base of US and UK banks relative to the size of their balance sheets was 15-25%. By the end of the 20th century this had fallen to about 5%. The base was 5% the size of what it was supporting.
This same ratio, of the base of the bank’s equity base relative to its operations, is also what is meant by the ‘Leverage’ of the bank. An equity base 20% of the size of the the balance sheet it underlies is a leverage of 4 times equity base. Equity which is only 5% the size of the balance sheet is 20 times leverage! Which, it seems to me, does serious violence to the word ‘balance’.
But dramatic and stupid as this sounds, and is, it falls far short of describing the real predicament, because these figures are based only on what appears ‘on-balance-sheet’ and does not count the bank’s ‘off-balance sheet’ assets and liabilies. When these are counted as well leverage at the peak of the bubble was on average 50 times the equity base! And some insitutions (think Fannie and Freddie and AIG to name a but a few) were even higher.
Now to be fair we do also talk about a banks ‘deposit base’ because, even though deposits are a liability (the money belongs to their customers who can withdraw it) it is usually a fairly stable pot of cash which banks rely on. But even being generous and adding in the deposit base the picture doesn’t get much better. In 1992 Barclays’ deposit base and its equity together were larger than their total liabilities. A very safe and stable bank at little risk of disaster. Begining in 1998 this began to change with liabilites and assets outgrowing the equity and deposit base. By 2004 the real bubble began to grow and by 2007 equity and deposits were less than a third of the size of the bank’s business and its liabilities. This change in stability was overseen by both the very clever and well paid bankers and their very trustworthy regulators.
How unstable is this kind of leverage? Well to put it in terms of our analogy of the water tank, the equity base is the volume of the reserve that remains, separate from the in and out flows. With huge leverage (very large in and out flows) you can see that any decrease in the inflow (money coming in from loans or from the bank itself borrowing) and the reserve will be run dry in a no time at all. Which is precisely what happened in 07-09 at various banks and Insurers.
The strucutre of Barclays bank and all those like it, is simply unstable. Not only that but the banks and the polticians they bought and paid for have, over the last twenty years deregulated and dismantled almost all the safeguards that might have given the banks any robustness when it came to absorbing losses. The size of Barclays bank’s internal reserve (capital base) relative to the flows of assets and liabilities which run through it, make it shockingly unable to deal with fluctuations or shocks in flows of money in and out. In short the bank is structurally at enormous risk of failure – all the time.
The obvious questions are why are global banks like this? How did they get like this? And who let them? Sadly, the answers only make things worse.
First yet another analogy to keep in mind – Boeing Jumbo jets are huge, over-engineered, immensely stable, robust and safe aircraft. Three engines can stop working and the thing can still fly and land. They are airworthy in every respect but are about as agile and resposive as they look – a Lazeeboy chair with wings. The modern jet fighter on the other hand is almost unflyable it is so unstable. Jet fighters are as agile as they are preciesly because they are on the edge of disaster all the time. They are engineered to be unstable – right at the edge of failure. The modern jet fighter is responsive in the same way as a pencil on its tip. Banks used to be built like Jumbos – for safety. Now they are engineered like jet fighters. It’s an analogy that might appeal to the testosterone addicted, morality-cripples of the banks, but it bodes ill for the rest of us.
So what are the ways the banks ditched safety and robustness in favour of performance, profit and bonus package?
Once again I hope you’ll forgive me for breaking here. I have to go away for work and thought to get at least this posted before I go.