The Bankers’ New Clothes

The Bankers’ New Clothes marries macroeconomic circumstances with basic microeconomic principles.

The London Economic

By Jack Peat

It is all too easy in modern finance to forget basic principles of prudency under the shroud of brazen suits and ties, but after years of mopping up the financial meltdown, it is high time for bankers to change their clothes.

The banking boom was justified under the misconception that new tools had been invented to handle what previous generations would have regarded as impossible risks. “Never before have so few lent so much to so many so recklessly,” the New Statesman’s Will Hutton explains, pointing to the ditch of insurmountable private debt which was accumulated by creating a “mountain of lending underwritten by a molehill of equity”.

Fundamentally, bankers would not have been allowed to orchestrate such devastating principles without an accompanying ideology,such as capitalism, which vaunts the efficiency of private markets and promotes personal selfishness over the good of the majority. It would seem that the bankers, the politicians and regulators worldwide may have been sporting the same corrupt clothes, which Anat Admati and Martin Hellwig argue are in dire need of an overhaul as the rest of the nation battles the unfashionable prospect of austerity.

Where Does Money Come From?

Quantitative easing, LIBOR and the Eurozone sovereign debt crisis are macroeconomic problems (or solutions to problems) created because of a lack of basic principles regulating an out of control industry. For the average lender of mortgages or credit cards these terms may seem somewhat irrelevant, but in understanding how money is corrupt, we must understand how money is generated.

On examination of the UK monetary system, Where Does Money Come From? – a book compiled by Andrew Jackson,Richard Werner,Tony Greenham,Josh Ryan-Collins – the authors conclude that the most useful description is that new money is created by commercial banks when they extend or create credit, either through making loans or buying existing assets. In creating credit, banks simultaneously create deposits in our bank accounts, which, to all intents and purposes, is money.

Keep in mind that physical cash accounts for less than three per cent of the total stock of money in the economy, so while you may think you understand where money comes from, you are likely overlooking that commercial bank money – credit and coexistent deposits – makes up the remaining 97 per cent of the money supply. Many people, even in the banking realm, struggle to comprehend this notion, which makes regulation difficult as a result.

What’s in Vogue?

By now this must all seem like macroeconomics spiralled out of control; a reasonable conclusion by all accounts. But what we are seeing is that in order to rectify the situation, it is not banking morals or increased regulation that should be enforced, but rather a complete overhaul of macroeconomic principles driven by basic microeconomic common sense and prudency.

Western banks, Admati and Hellwig believe, borrowed far too much with far too little equity in their balance sheets to act as a buffer if things went wrong in any part of their business, from trading on their own account in the multitrillion-dollar derivatives markets to extravagant and reckless lending on real estate. Liabilities as equity shrunk to less than three per cent by 2008, which would appear to anyone with the slightest bit of sense as reckless and dangerous.

And this is precisely what thought mode we should be returning to; Basic principles. Banks are no different from any other organisation or individual, and to nip the counterargument in the bud immediately, having more equity is neither more expensive nor a deterrent to new lending. Today’s problem is that because debts are so easily written off by the state, there is no incentive to create such buffers. To instigate change, we must insist on new clothes.

We need banks to be run with more equity. We need them to act responsibly and pay the consequences if they fail to do so. We need them to act in the interest of the wider economy and society, rather than for their own benefit, and we need to instigate these changes under a  wider reframing of the principles on which firms are constituted. As Mr Hutton eloquently concludes: “Excessive private debt does not just imprison economies – it suffocates personal lives.” Let’s not wait around for the next global downturn to rectify the fundamental problem.