openDemocracy, 22 November 2013.

Frankenstein's Bankers

Alas! I had turned loose into the world a depraved wretch, whose delight was in carnage and misery.
(Mary Shelley, Frankenstein)

Like most human creations, money and banking can, when misunderstood, turn against their creator, taking on a destructive, out-of-control life of their own. Thus, after the collapse of the US banking system in 1929 and the following international economic depression of the 1930s, economists and politicians of the era came to understand the inherently volatile nature of money and banking, and they implemented strong measures aimed at taming and harnessing the financial sector in the service of the common good. However, over time this knowledge faded from memory, and economics, though aspiring to the status of science, actually regressed; as a senior economic analyst at the International Monetary Fund (IMF) put it recently, “for many decades in the interim, banks have almost been completely off the radar screen of macroeconomics. So we're starting again at a point that's almost pre-World War I.”[1] As a result, from the 1960s the national and international regulation that had helped maintain a relatively stable banking system was dismantled, while new financial developments and innovations received minimal attention from outside the financial markets and, despite warning signs, elicited little regulatory response – culminating in the immense financial crash of 2007-8.[2]

Possibly the most striking revelation to emerge from the financial crisis is how detached from reality mainstream academic economics had become. Most astonishingly, it omitted any serious study of money and banking.[3] The IMF's chief economist admitted, “We assumed we could ignore the details of the financial sector”[4]; the Governor of the Bank of England noted, “money, credit and banking play no meaningful role” in standard economic models[5]; and a professor of finance acknowledged that economists “simply didn't believe the banks were important.”[6] The reason for this was that in contrast to economists of the 1930s to 50s, later economists reverted to very simplistic, and fundamentally misleading, ideas about money and banking.

Current mainstream economics regards the state, or central banks, as controlling the supply of money in the economy and views commercial banks as functioning essentially as intermediaries between savers and borrowers. In fact, in the prevalent system of what is known as 'fractional reserve banking', about 97% of money is created by private commercial banks. This act of money creation takes the form of banks' extension of loans to borrowers, whereby a bank simply adds the amount of a loan to the borrower's account, held on computer (or, in earlier decades, in written ledgers). Thus, banks are fundamentally money creators rather than intermediaries. Savings ultimately derive from loans, not the other way round; in other words, debt is necessary for 97% of our money supply. Furthermore, this process of credit-creation is constrained only by banks' judgements of the likelihood of repayment of loans, and not by the monetary policies adopted by the state or central banks.[7]

The implications of these, unbelievably largely forgotten, fundamental facts are huge, encapsulated in the statement of one of the few prominent figures who are beginning to remember, the former chairman of the UK Financial Services Authority (FSA), Lord Adair Turner: “The financial crisis of 2007/08 occurred because we failed to constrain the private financial system's creation of private credit and money.”[8] The central problem is that this system of money and banking is inherently economically unstable. Banks have an incentive to create as much money as they can, due to the interest they earn on the credit they issue. Ironically, it is often more immediately profitable for banks to lend to non-productive sectors, such as for mortgages and to other parts of the financial sector, than to the productive economy. This generates a mirage of prosperity, encouraging further demand for, and issuance of, credit, in what becomes an unsustainable, credit-induced bubble.[9] As the chief economics commentator at the Financial Times put it, “the essence of the contemporary monetary system is the creation of money, out of nothing, by private banks' often foolish lending.”[10] The bubble will inevitably burst, or at least deflate, creating economic and social fallout, particularly if banks themselves collapse in the process; as Turner says, “Banks which can create credit and money to finance asset price booms are thus inherently dangerous institutions.”[11]

The costs of this system to society are immense. Most obviously, and absurdly, it means that since nearly all money is actually debt, we are having to pay vast sums, in interest, to private banks for creating money out of nothing, simply so we can have enough money in circulation for a functioning economy.[12]  Secondly, since we are so utterly dependent on banks for 'holding' our money and enabling us to make and receive payments, they enjoy a further huge hidden public subsidy for being too important to fail, a subsidy that becomes painfully apparent when they have to be bailed out by the state.[13] As the Governor of the Bank of England put it, for the banks it is “a case of heads I win, tails you – the taxpayer – lose.”[14] Further ways in which the financial sector is a drain on society include its tendency to raise house prices far ahead of wages, due to the high proportion of credit that it extends for mortgages rather than for socially beneficial economic activity[15]; and the tax avoidance schemes it devises, that allow large corporations, wealthy individuals and the banks themselves to shift the collective tax bill over to ordinary businesses and citizens.[16] Ironically, a highly profitable financial sector is often lauded as a major contributor to a nation's prosperity, when in fact these profits are accrued almost entirely at everyone else's cost. Overall, the financial sector is – as currently structured – parasitic upon society at large.[17]

How was it that mainstream economic thinking forgot the lessons of the 1930s, of how banking could become so destructively dysfunctional and dangerously unstable? It was due to a complex interplay of ideological bias, financial sector influence and complacency.

The Cold War encouraged a simplistic polarisation between the ideas of individualistic, free market capitalism on the one hand, as opposed to collective, state planned communism on the other.[18] Among those defensive of capitalism, it became a matter of almost religious faith that the less business was regulated and coordinated by government, the better; the liberated forces of entrepreneurship and competition would spontaneously produce the best possible economic and social outcome. In synchrony, academic economists in the 'west' incorporated this idealised view of capitalism into the very foundations of their discipline, by assuming that the economy could be modelled essentially as the interaction of fully rational and informed economic agents, the sum of whose individually self-serving actions would translate into an efficient, stable system delivering the maximum benefit for all.[19] Crucially, it was assumed that money would flow frictionlessly through this system to where it would be best put to use, as water naturally finds its level under the simple force of gravity. The business of banking, seen as a merely passive conduit for money to the underlying 'real' economy, could therefore be ignored.[20] Unwelcome consequences of the free market – particularly in the financial sector – were pretty much defined out of existence[21], and economists who studied such 'market failure' came to be dismissed as maverick.[22] Mainstream economics, aping rigorous science, devoted itself to the elaboration of sophisticated mathematical models – based on assumptions about human economic behaviour, however, that were quite unreal.[23] “As I see it,” wrote a Nobel Prize-winning economist a year after the height of the financial crisis, “the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.”[24] According to a former member of the Bank of England's Monetary Policy Committee, “the typical graduate macroeconomics and monetary economics training received at Anglo-American universities during the past 30 years or so, may have set back by decades serious investigations of aggregate economic behaviour and economic policy-relevant understanding. It was a privately and socially costly waste of time and other resources.”[25]

Even in the decades immediately following the Great Depression, the powerful, well-connected banking lobby had managed to resist prudent financial regulation.[26] But as mainstream economists – many of whom received funding from, and worked for, financial institutions – began to ignore the overall structure of the financial system, current and former bankers came to be seen as the only real 'experts' or possible candidates for official posts, despite all the obvious conflicts of interest.[27] In the words of an unusually free-thinking former IMF chief economist, “A whole generation of policy makers has been mesmerized by Wall Street, always and utterly convinced that whatever the banks said was true.”[28] Banking legislation and accounting rules were written by and for bankers[29], and financial innovation was encouraged, based on the universal justification that competition and market forces would inevitably render the financial sector stable, efficient and socially beneficial.[30] Ironically, the contribution of prudential regulation to the relative stability of post-1930s banking added to the sense of complacency towards that very legislation. US Federal Reserve Chairman Alan Greenspan was typical in arguing that “modernization” of the financial sector was needed “to remove outdated restrictions that serve no useful purpose, that decrease economic efficiency,” and that “the self-interest of market participants generates private market regulation.”[31] In this spirit, a US regulatory agency's 2003 annual report featured a photo of a group of regulators and bankers taking a chainsaw, pruning shears and loppers to a stack of financial regulations.[32]

And so, from the 1960s, the financial sector came to operate increasingly on the basis of unrestrained competition and became more globalised, as 'fire-break' controls on the permitted scope of banking activities, the scale of bank lending and international capital flows were removed[33] – the effects of which were magnified by the adoption of computer and communications technology. The structure of the financial system, therefore, became increasingly determined by whatever new innovations and schemes would generate the greatest profits for market players. In this rawly competitive environment, banks came under greater pressure to maximise profits by lending as much as possible and putting any available capital to the most profitable use. They were thus impelled to push hard against the financial, and remaining regulatory, limits to prudent, sustainable banking and to find to new ways to push ever harder against those limits.[34]

The key innovations to emerge were securitisation and credit derivatives, techniques of financial engineering designed to optimise lending and borrowing by dealing with the risks of repayment default in quite new ways.[35] By securitisation, loans or anticipated cash-flows are repackaged to produce bonds, or securities. Whereas in the past banks extended loans and then kept them on their balance sheet until repayment, now they could sell these loans on to third party investors in the form of bonds.[36] Similarly, with the use of credit derivatives third parties, acting somewhat like insurers, could take on the risk of repayment defaults, in return for a fee.[37] The general idea – promoted by bankers and institutions such as the IMF – was that, according to the notion of 'market completion', money could now flow around the world more efficiently, as investors and borrowers could be matched across the globe by any manner of means. Thus, it was said, with securitisation and derivatives the risk of loan defaults could now be dispersed widely among willing investors rather than being concentrated in banks, thereby – crucially – making the banking sector more resilient.[38]

The reality, however, was quite the reverse. Since the sale of financial products was driven by the increasingly short-term profit motive, financial innovations were actually aimed primarily at hiding risk rather than reducing it.[39] Banks could therefore get away with profiting from more reckless lending – for as long as “the delusions of this time” could be maintained, as the FSA put it.[40] Highly elaborate and opaque mathematical models, touted by bankers as allowing the risk of complex new securities to be carefully controlled, were systematically over-optimistic and achieved a merely illusory precision.[41]  While many such securities initially looked good by reliably generating a high return over the short- or medium-term, this came with the hidden cost of greater long-term catastrophic risk.[42] “IBGYBG,” short for “I'll be gone, you'll be gone,” became of a catch-phrase among these products' innovators and sellers, including the ratings agencies – primarily Moody's, Standard & Poor's and Fitch – who earned colossal fees from giving their 'AAA' seal of approval to these innovations.[43] When in 1996 the banks succeeded in having their own risk models incorporated into international banking standards (Basel II), this undermined precisely the kind of regulation that may have protected the banking system as a whole from those very models' biases and limitations.[44]

By using credit derivatives, individual banks profited from regulatory loopholes in the insurance sector in a way that collectively made the banking system less stable.[45] Derivatives were championed as increasing the 'price-discovery' powers of the market place, when in fact their use made the task of valuing companies, including banks, far more difficult. The proliferation of often complex and opaque derivative transactions – with many going unrecorded, 'over the counter' – meant that financial institutions became interconnected in such maddeningly complex ways that it became impossible really to know what types and levels of risk any bank – or the sector as a whole – was exposed to.[46] Derivatives turned out to be, indeed, “financial weapons of mass destruction.”[47]

With the competitive drive for profits pressuring banks into putting any available capital to the most profitable use, they reduced their levels of 'idle' working capital to the bare minimum. To this end, banks relied increasingly on cheap short-term loans in order to honour day-to-day payments – in the form of interbank lending, and with so-called commercial paper and repurchase agreements or 'repo'.[48] An executive at the US investment bank Bear Stearns recalled his firm's repo financing: “Our guys would borrow maybe $75 billion a day, ... most of it daily.”[49] Even many supposedly prudent high street banks across Europe began to adopt this short-term funding strategy. In other words, banks made money by maintaining only a dangerously wafer-thin buffer against cash-flow insolvency, or a liquidity crisis. Much of this bank borrowing derived from minimally regulated, and potentially flighty, money market mutual funds, bank-like institutions operating in a manner that avoids costly banking regulation.[50]

An additional danger accompanying both derivatives and repos is that they were granted exemption from bankruptcy laws, measures designed to avert mass panic withdrawals of funds from companies to allow, at the very least, an orderly and fair distribution of funds to their creditors. However, financial institutions that are on the creditor side of derivative and repo contracts with an apparently faltering bank have both the incentive and the right rapidly to withdraw their funds, along with sizeable penalties, before others do, in a vicious circle leading to a 'run' on the fund. This protection against the risk of counterparty bankruptcy also seriously undermines the basic 'market discipline' of carefully having to monitor the creditworthiness of those one enters into contracts with.[51]

Prudent regulation was evaded and risk concealed further by means of ever more elaborate accounting techniques (developed largely by the 'Big Four' accountancy firms, Deloitte, PwC, Ernst & Young and KPMG) increasingly deployed by corporations including banks, and even governments.[52] The widespread use of 'off-balance sheet' accounting – usually involving 'offshore' or low-regulation jurisdictions such as the City of London, the Cayman Islands or some US states – meant that company accounts, particularly those of banks, no longer presented a true picture of their financial condition, a basic requirement for averting fraud and enabling market forces to operate properly.[53] “Accounting has become a new exercise in creative fiction,” declared the head of a prominent investment firm, while a member of an urgent task force at the Accounting Standards Board went as far as to argue that the banking collapse was “a crisis largely caused by accounting.”[54]

Through the evolution and complex interplay of these financial innovations, there grew a vast 'shadow banking' system where banking activities are conducted out of range of even the light regulation covering standard banking.[55] In the shadow banking system in particular, the traditional checks and balances of prudent, sustainable banking, based on transparency and accountability, all but disappeared, enabling bankers to profit from deception on an institutional scale. The financial crisis was caused by a sudden collapse in this shadowy system of smoke and mirrors – essentially a bank run within the financial sector. High street banks, which had become increasingly involved, directly or indirectly, in shadow banking, were therefore brought down with it.[56]

Ironically, relative to the scale of the problem the causes of the crisis, in shadow banking, have barely been addressed at all, while the much trumpeted reforms of standard banking have been minimal[57] – largely due to intensive lobbying from the banking industry.[58] The major part of the government, taxpayer-funded, response to the crisis has been simply to re-inflate the bubble economy; most of the money supposedly pumped into our real economy through 'quantitative easing' has effectively disappeared into the financial sector.[59] Hence the widespread view that further financial crisis is inevitable; one financial consultancy report predicts that excessive private sector money supply, asset price bubbles and financial crises will plague the global economy for the foreseeable future.[60]

In supposedly democratic countries it is, in principle, the ordinary voting public that is responsible for how its society operates. However, the electorate has been denied the necessary analysis – whether from the news media or from genuinely informative public inquiries – of banking, money-creation, shadow banking and accounting.[61] Were this provided we might, for example, begin to recognise the ways in which free-market finance inherently tends towards instability rather than stability[62]; to consider the case for replacing our current private sector, out-of-control, debt-based system of money creation with a publicly accountable, prudent and measured system of money supply; to see a need radically to rewrite financial law from the ground up so that banking can rest on far simpler, solid foundations and reliably serve the public interest, rather than being a confused and frenzied casino that weighs down, distorts and destabilises our real economy[63]; and to bring accounting rules under democratic control as statutory legislation rather than being left to unaccountable, private bodies controlled by the accounting firms and their corporate clients.[64] Just as Dr Frankenstein was responsible for creating a tragic human monster, so are we collectively ultimately responsible for our severely dysfunctional financial system and the activities of its bankers.

By Keith Fisher, November 2013.
keith@flyingfish.org.uk