“Who cares what banks fail in Yonkers
Long as you’ve got a kiss that conquers?”
– George & Ira Gershwin, Who Cares? From ‘Of Thee I Sing’, 1932
“It is impossible to exaggerate the sheer idiocy of the financial machinery of the 2000s.”
– Charles Morris, The Two Trillion Dollar Meltdown, 2008
The normal rules of a market economy do not apply to banks which are unique among commercial businesses because the government implicitly guarantees their solvency and the value of deposits. Banks also enjoy the protections and legal privileges conferred by the State of limited liability. And all for good reasons: in modern economies it is banks which provide the public money supply in the form of credit, without which no modern economy could function. It follows that because banks are effectively public utilities as vital as water or electricity that their activities should reflect that public purpose and the value or the economic rent derived from money creation be captured for public benefit.
However banks get up to all sorts of shenanigans and jiggery-pokery that have no public purpose whatsoever. They almost collapsed the world economy 2 years ago, triggering the severest recession since the 1930s, the consequences of which will be with us for a long time.
1. Banks lending to each other
Inter-bank lending bypasses the minimum reserve requirements set by banking regulators. Here’s how it works. Bank A lends to Bank B. Bank A now has a loan on its books that it can count as a ‘low risk’ asset and be part of its reserves. Bank B lends to Bank A, and now Bank B has a ‘low risk’ asset on its books. Both banks can now lend more or borrow from each other with the loans as collateral. However no real money has been created, only leverage out of thin air.
Banks create marketable financial assets out of loans on their books and sell them to other banks and investors. This breaks the link between the lender and the borrower. The loan originator has no incentive to check the borrower’s capacity to repay the loan. Securitisation means that a bank gets loans off its books but loans are sliced into horribly complicated tranches of varying risk. The US housing boom and its notorious ‘subprime’ mortgages created, according to the FBI, a fraud epidemic, which unravelled in 2007 with the bursting of the US housing bubble. This was how Northern Rock financed most of its (entirely legitimate) mortgage business until its source of short term securitised loans dried up, forcing a run on the bank and a multi-billion taxpayer rescue. ‘Securitisation’, said Joseph Stiglitz, ‘is based on the assumption that a fool is born every minute.’
3. SIVs, SPVs:
Structured investment vehicles and special purpose vehicles are corporate subsidiaries set up by banks, usually registered in tax havens, to hold securitised assets ‘off balance sheet’ as part of the high jinks described above. None of this is related to any real economic activity or indeed makes any sense.
4. ‘Propriety trading’
Proprietary trading is the euphemism for speculation, bucket shop operations in other words, in currencies, commodities, derivatives, financial markets and almost anything that can be traded for no other purpose than to make money for the bank. This is an unimaginably huge and ‘fatuous’ (Robert Peston’s term) business. Speculation in currencies alone is worth 1,000 times global GDP.
5. Credit default swaps
This is a derivative intended to ‘insure’ a lender against a borrower’s default, where the lender pays a premium to the counterparty underwriting the risk. A bank holding securitised assets can take out CDSs on its bonds and remove the need for reserves against losses. Magic. Except that what appears to be an ingenious innovation is just another means for leverage. With normal, regulated insurance only the owner can insure a house against fire. Anyone can buy a credit default swap on any financial asset, rather like allowing an arsonist to insure your house. An insurance company must hold reserves against claims. Taking money for insurance without having the means to meet claims is fraud; which just about sums it all up. Famously described by Warren Buffett as ‘financial weapons of mass destruction’.
Leveraged financial claims amount to the equivalent of ten times global GDP. Bill Gross, one of the world’s leading bond investors has described this as a ‘chain-letter pyramid of leverage’, while the FT’s Martin Wolfe has called it a ‘Ponzi scheme’.
Pyramid schemes and their Ponzi variants are based upon an exponential expansion of financial claims to infinity which is impossible and amount to stealing. All pyramid schemes collapse and only the organisers make any money. Eliminating the unregulated highly leveraged activities which have no value but have the capacity to create havoc in the real economy is essential to banking reform. A condition of a banking licence and limited liability should be the phasing out of all socially wasteful and pointless activities. Individuals who want to speculate can still do so but only with their own money and not with state-sponsored privileges.
The Banking Commission would do well to use the basic principle set out by President Roosevelt in his great Inaugural Address of 1933:
“There must be strict supervision of all banking and credits and investments. There must be an end to speculation with other people’s money.”
- Charles R Morris – The Two Trillion Dollar Meltdown (2008)
- Charles Ferguson – Inside Job, winner of 2011 Oscar for best documentary – highly recommended
- Joseph Stiglitz – Freefall (2010)
- Pyramid and Ponzi schemes explained: http://en.wikipedia.org/wiki/Pyramid_scheme http://en.wikipedia.org/wiki/Ponzi_scheme
- President Franklin D Roosevelt, Inaugural Address 1933
- Of Thee I Sing, Pulitzer prize winning political satire http://en.wikipedia.org/wiki/Of_Thee_I_Sing
- And “Who Cares”? http://www.youtube.com/watch?v=xHgxiC6W67M