Imagine, for the sake of argument, that we discover a little-known, unpopulated territory within the EU, on which to establish a colony. Let’s call it “Ruritania” and allow it to use sterling.
We establish our fledgling colony on Ruritania with four people:
- a depositor, Alice, who arrives with £103;
- a builder called Bob;
- an entrepreneur, Matilda;
- and a banker (Mallory) with a colourful recent past in Iceland and Ireland.
Interest rates are 0.5%.
Mallory establishes a bank. He persuades the other 3 inhabitants of the importance of a healthy banking system, so Ruritania’s constitution contains a limited guarantee from future taxpayers of £10 in favour of the bank. Under European Banking Authority devolved authority, Ruritania classifies this guarantee as core Tier 1 bank capital.
Alice, seeking to keep her money safe, deposits it in a demand account at the bank.
Matilda, the entrepreneur, wants to start a business.
She approaches Mallory for a loan. He retains a reserve of £3 from Alice’s deposit and lends the entrepreneur, at interest, the remaining £100 of cash deposited by Alice.
The entrepreneur then employs Bob the Builder, who wants his year’s wages up front. So the entrepreneur hands over the £100 to Bob, which Bob deposits in the Bank.
Let’s set aside for the moment that the bank just doubled the money supply of Ruritania.
The banker now has two liabilities: a deposit of £103 from Alice and a deposit of £100 from Bob. Offsetting these, he has two assets: a 25-year loan of £100 paying 7%, plus cash of £103.
Mallory wants a Ferrari, today, which he can buy for £20. His compensation contract is 20% of bank profits. He needs to record an instant £100 in profit for his bank, and he knows how to optimise his profits under EU bank accounting rules.
He phones an insurer active in the credit derivatives market – let us call it ‘GIA’ – who agree to write a credit derivative known as a “Credit Default Swap” for a fee of 1% per annum.
The bank quickly establishes an off balance sheet company, an “SPV” which buys the future £275 loan cashflows. The GIA trade is executed directly with the SPV. The SPV finances its purchase of the loan from the bank by issuing two notes:
- a 95% senior note rated AAA by two US rating agencies because GIA is so rated
- 5% junior or “equity” note.
The bank buys the two notes for £100 in cash. These funds then flow back from the SPV to the bank to settle the purchase contract.
The equity note is a £5 deduction from the bank’s £10 Tier 1 capital. This capital is, you will recall, a future taxpayers’ pledge rather than hard cash.
Under marking to market rules, by holding the senior note on trading book the bank records an instant but unrealised profit of £105. After replenishing Tier 1 equity with £5 the bank shows a £100 clear profit.
The profit of £100 has been recorded even though the bank has not received any income from the loan. But the banker is not too concerned about that, as he has his Ferrari.
The banker and his shareholders have taken £100 of the £103 total money supply of Ruritania, declared it as profit and spent it abroad.
Mallory seeks to grow his bank and obtains liquid funds by repo’ing the Note at its market value of £205 with his central bank.
He receives £205, and uses the fresh liquidity as collateral for further bets, derivatives with other banks and low priced Irish bank issued bonds in the hope of more very fast profits.
Unfortunately the bank becomes insolvent when Matilda misses a loan payment. The central bank take ownership of the repo’d note. Depositors ask for their funds but the bank cannot pay.
- Two depositors have claims for £203.
- There is only £6 in cash – all other cash had been pledged as collateral.
- Nobody was aware that the senior note had been repo’d with the ECB. Under accounting rules amended in 2010 it remained on the balance sheet of the bank.
- Banker is laid off but enjoys his Ferrari.
The regulatory response to the 2008 collapse has not been effective. I would argue, as demonstrated above, that many of the post-2008 rules ostensibly intended to address the crisis are unfortunately exacerbating it.
The regulatory umbrella continues to encourage more exposures to be marked to market. The example above highlights the dangers.
Regulators need to be aware of the extent of these exposures in order to help avert any future threats. This requires the publication of parallel accounts with derivatives and other investments recorded at the lower of historic cost and their marked to market value. Steve Baker MP has introduced such a Bill in the UK Parliament. It should be supported.
With thanks to:
Steve Baker, MP for Wycombe
Kevin Dowd, Visiting Professor, Cass Business School
Margaret Woods, Reader in Accounting, at Aston University