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By Gordon Kerr, on 17 March 11
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.
Liquidation position:
- 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
By Gordon Kerr, on 26 January 11
In a speech last night in Newcastle-Upon-Tyne the head of the UK’s central bank continued on his admirable path of admitting that the banking bailout and policy of currency debasement have simply transferred the cost of the bank bailout onto the shoulders of ordinary families and, in particular, has drained the funds of those foolish enough to support our economy and banking system by saving in sterling.
How embarrassed do the Bank of England’s senior officials feel this morning on rereading their own confident and optimistic misrepresentation of money printing (quantitative easing) less than two years ago? The Bank of England’s own website still displays the following assurance that QE is a well conceived tool of monetary policy that has been implemented to stimulate the economy and control inflation:
The instrument of monetary policy shifted towards the quantity of money provided rather than its price (Bank Rate). But the objective of policy is unchanged – to meet the inflation target of 2 per cent on the CPI measure of consumer prices. Influencing the quantity of money directly is essentially a different means of reaching the same end.
The latest official CPI number is 3.7%.
As Jesus Huerta de Soto explained in his Hayek lecture in October 2010
The spontaneous reaction of the market against the effects of credit expansions: first the financial crisis and second the deep economic recession.
De Soto again from the same lecture:
The financial crisis begins the moment the market, which as I have said is very dynamically efficient (Huerta de Soto 2010a, 1-30), discovers that the true market value of the loans granted by banks during the boom is only a fraction of what was originally thought. In other words, the market discovers that the value of bank assets is much lower than previously thought and, as bank liabilities (which are the deposits created during the boom) remain constant, the market discovers the banks are in fact bankrupt, and were it not for the desperate action of the lender of last resort in bailing out the banks, the whole financial and monetary system would collapse.
Let us consider the UK format of this rescue: a transfer of wealth from savers and ordinary taxpaying workers, to banks. Surely this can only conceivably be justified if the bailed out banks cease to behave as independent profit seeking businesses with vast direct stakes in so many limbs of the UK economy (via massive leveraged loan portfolios and direct private equity stakes, SIV and securitisation holdings in almost all industries with predictable cash generation - utilities, PFI, social housing rental streams) that they treat other businesses in similar industries as competitors to be shunned, or worse, crushed.
Surely the direct investments should be sold to enable the banks to act as genuine engines of economic recovery by allocating resources to understanding and supporting UK businesses?
If banks returned to lending to businesses, rather than effectively buying so many, a behavioural shift might start to occur.
But there has been no such behavioural shift. In a paper which I am drafting for the Adam Smith Institute, I will focus on three trends which evidence the contrary:
- The continued increase in derivative and repo market activity driven by the ease of declaring as profit years of hoped for income which, against the banking crisis background is, unlikely to materialise;
- The brittleness of bank balance sheets caused by abuse of mark to market rules regarding illiquid transactions (both parties to transactions marking them at wildly differing prices in each case to favour the reporting bank)
- The enormous rise in Basel 2 regulatory arbitrage, highlighting the staggering incompetence of these regulations and their authors.
By Gordon Kerr, on 22 December 10
We at CC know that the story below is not actually a fair parallel. Students of the banking bailout are invited to submit answers in the “comments” section explaining the difference between this story and the bailout format…
It is a slow day in a damp Scottish town. The rain is beating down and the streets are deserted. Times are tough, everybody is in debt, and everybody lives on credit. On this particular day a rich German tourist is driving through the town, stops at the local hotel and lays a 100 Euro note on the desk, telling the hotel owner he wants to inspect the rooms upstairs in order to pick one to spend the night. The owner gives him some keys and, as soon as the visitor has walked upstairs, the hotelier grabs the 100 Euro note and runs next door to pay his debt to the butcher. The butcher takes the 100 Euro note and runs down the street to repay his debt to the pig farmer. The pig farmer takes the 100 Euro note and heads off to pay his bill at the supplier of feed and fuel. The guy at the Farmers’ Co-op takes the 100 Euro note and runs to pay his drinks bill at the pub. The publican slips the money along to the local prostitute drinking at the bar, who has also been facing hard times and has had to offer him “services” on credit. The hooker then rushes to the hotel and pays off her room bill to the hotel owner with the 100 Euro note. The hotel proprietor then places the 100 Euro note back on the counter so the rich traveller will not suspect anything. At that moment the traveller comes down the stairs, picks up the 100 Euro note, states that the rooms are not satisfactory, pockets the money, and leaves town. No one produced anything. No one earned anything. However, the whole town is now out of debt and looking to the future with a lot more optimism.
And that is how the bailout package works.
By Gordon Kerr, on 8 December 10
The Daily Telegraph reports today that:
- About 60% of private sector pension schemes “have clear rules” entitling retirees to annual increases in their pensions in line with RPI (Retail Price Index);
- RPI is presently increasing at an annualised rate of 4.5%. The Government´s new price basket – the Consumer Price Index (CPI) – is presently growing at 3.2% per annum.
- Steve Webb, our Pensions Minister, is today publishing a “Consultation Paper” which appears to be a precursor to legislation to override the contractual provisions of such pension contracts. If the proposal is adopted, pension trustees will be able to substitute the term “CPI” for “RPI” in these agreements.
I have not read the Consultation Paper, but I would hazard a guess that the thinking behind this initiative lies in the belief that our business environment will benefit from this measure since many funds are technically insolvent, or close thereto. Business needs this sort of government help and, net net, we will all be better off.
As readers of any of my previous articles will know, I do not pretend that our economy or banking system is looking particularly healthy. However it seems obvious to me that the root of the present problems lies in the original distortions to the banking market in particular, and a raft of other economic clunking fist intrusions in other sectors.
When will our new leaders stop following in the footsteps of the Old Labour belief that the Government can regulate and legislate to fix the economy? Does our Government believe that the best of all worlds is one in which a civil servant interferes in every limb of business?
Many pension funds are insolvent. This is not a post-’08 crash problem. For decades actuaries have been optimistically under-estimating longevity of cohorts of retirees and the soon to be retired.
But a pension fund is no different from a stand alone business, it has shareholders, debtors and creditors. It is run by managers. Should it flirt with insolvency the present laws encourage negotiated solutions among its stakeholders. If a deal cannot be agreed then all sides know liquidation can be invoked. What is wrong with this legal template? How does Mr Webb come to think that there is a problem here to be addressed by further laws?
The proposal also grabbed my attention for another reason. Its authors assume that the present positive differential between the growth rates of RPI and CPI will continue for decades. I noted the bland reference to “Treasury forecasts” as some sort of authority. Goodness me! Have our new ministers learnt nothing in the 7 months since they inherited responsibility for our Civil Service?
As a believer in social cohesion I am also deeply concerned. The unions are belatedly waking up to the reality that the banking bailout of ’08 was a mistake, that its only long term effect will prove a mass transfer of wealth from workers and taxpayers to bankers and holders of bubble assets, whose prices remain artificially inflated by continued government market distortions.
If Mr Webb wants to be remembered as the Minister whose actions proved the final straw before a wave of strikes and civil disorder gripped Britain in 2011, he should press ahead with his proposal.
By Gordon Kerr, on 4 December 10
One interesting consequence of the UK’s submission to EU laws sprang to mind when reading a free copy of the Nov 28th Mail on Sunday delivered to my Lanzarote holiday complex from snowbound UK yesterday.
On page 40 we read that a Mr and Mrs Chatterton, despite owing about GBP 250k on their Wiltshire main residence (a cottage worth about GBP 300k), purchased in 2004 a bolthole in Spain. They financed the Spanish holiday home with the aid of a GBP (equivalent) 145k loan from Banco de Sabadell.
The couple now face a forced repossession and sale of their Wiltshire main home since Banco de Sabadell is taking steps to obtain a European Enforcement Order that will fast-track a repossession order on the ground that the debt is “uncontested”. The sale will repay the first mortgagee (Halifax) and presumably yield enough to make up any shortfall between the value of the Spanish property and the loan secured against it.
The solicitation of the European Order is branded “Unfair” by the couple, their MEP (Ashley Fox) and the Mail on Sunday (Mary Synon and Jonathan Petre).
The undisputed facts, according to the article, are as follows:
- the couple have failed for about 18 months to make any payments on the Spanish debt;
- the Spanish property is now worth less than the outstanding balance of the loan
- there is equity in the Wiltshire home and the Halifax will not object to a repossession order since it is confident of repayment of its loan.
Why is this action branded “unfair”? The newspaper and the couple are aggrieved on two counts:
- The treatment, for purposes of EU law, of Spanish mortgage loan documentation as evidence of “uncontested” debt, and
- That the couple’s offer to hand back the Spanish keys has not been accepted as a full discharge of the debt by the Spanish creditor bank.
And so, as Europe and its banks (and hence its taxpayers) slide ever deeper into this vortex of debt, this newspaper and the local MEP appear to believe either that it is “unfair” that home owning debtors should be denied the benefit of years of procrastinating court proceedings before any repossession order be granted, or perhaps that it is unfair that they should have to dip into their own assets to repay a loan voluntarily taken on in 2004.
And why not just let the couple off their debt? In this bailout wonderland it is raining milk and honey for bankers and their shareholders, so why not also for customers?
By Gordon Kerr, on 19 November 10
Britain and the Eurozone hover on the Brink of Banking and Monetary Collapse. Our response? More Regulation.
The European Central Bank’s head, Jean Claude Trichet, appears to have realised what a mistake he made in single-handedly engineering the bailout of Greece only six months ago.
As I pointed out at the time this was simply a massive transfer of wealth from taxpayers to banks, funds and other investors in Greek Government bonds. Those smart and wealthy investors are now banking these profits very rapidly as we can observe by noting the rises in credit default swap prices.
Yesterday M. Trichet announced plans to raise Euro interest rates and decrease long term support for the banking system. It will be interesting to see if and by how much rates are raised since the Spanish banking system will probably collapse if Euro rates rise by even 1 per cent.
Why will this happen? It was a poorly reported consequence of the bailout two years ago that a significant consequence of forcing rates to zero is to inflate asset prices. Both effects are forced and hence, to use the popular term of the decade, unsustainable. The crash that we are about to experience will be far greater than that which would have occurred if the ordinary rules of capitalism had been allowed to operate in 2008. Sanity could have been restored to the banking system had governments stayed out of the mess. Liquidations would have led to changed business models and the appreciation by consumers of banking products that governments cannot protect them from losing money.
And what has the UK Government’s response been during this joyous week, which has already been widely reported as a good time to bury bad news?
In addition to pledging that we will donate several billion to the Irish cause, it has been announced that those who make their living by selling us mortgage products must take a course in mortgage loans.
This is yet another example of what Kevin Dowd has labelled “sham regulation”. The presence of an accreditation mark on an IFA’s business card is intended to imply that the consumer should trust his mortgage advice and sign up for the loan he recommends.
Let me recommend that sellers and buyers of these products take a very short education by reading and understanding the rest of this article. If enough of you lobby the FSA, these few words might even be adopted as the new FSA official mortgage education qualification.
When considering mortgage loan offers there are only two relevant criteria:
a) The length of the fixed interest period;
b) The all-in cost of the loan.
I would mention a third, but much less important point: break costs. Borrowers’ circumstances may deteriorate and the consumer should be aware of the costs of defaulting or switching lenders during the fixed period. Simply ask and compare.
Let us consider point a). Why do I focus on fixed rate loans, when historically in the UK and today in many countries like Spain floating rate loans were / are much more common? The answer is simple. The financial risk of a home purchase is usually considered to comprise only the risk of up or down variance in the house’s value after purchase. This assessment only applies to houses bought for cash. If a loan is required the consumer should quickly decide whether he wishes i) to take this amount of risk or ii) twice this risk.
Buying a house and borrowing on a floating rate basis amounts to taking roughly twice the house price risk because if rates rise not only do house prices usually fall but of course your payments rise as well. Therefore borrowers who wish to expose themselves to one times the risk of the house price variance should borrow on a fixed rate basis.
Point b) the all-in cost, can be calculated by entering all payments into either an Excel spreadsheet or even some calculators. All fees at inception and redemption should be included. Then press the “Net Present Value” button and compare the offers. (For the less financially savvy reader, NPV is simply a way of expressing a stream of payments over time as a cost today. For example, if the interest rate is 5% you would be indifferent as to a choice between paying £100 away today or £105 in one year’s time).
That is the end of the mortgage loan training course. Set out above is a universal guide. No other criteria matter – least of all the identity of the lender, unless you take a floating rate loan and expose yourself to being gamed by the bank. Many lenders brazenly jack up the rates they apply to loyal customers and offer “discounts” to new borrowers. These banks rely on lethargic consumers not to refinance quickly. This risk is almost impossible to assess in advance and is another reason to fix your rate for as long as possible.
It would be wonderful if the FSA’s official course were to comprise no more than the above few paragraphs, but sadly I fear the actual course will be replete with mumbo jumbo and simply constitute yet another barrier to entry into the financial services business. Mortgage industry hucksters will thus receive state support for their present modus operandi, namely the maintenance of the pretence that, like a Savile Row suit, you are a very special customer and need an expert, like me, to tailor a loan to your specific requirements.
By Gordon Kerr, on 6 November 10
The assertion that dynamism and innovation are crucial to economic success is self-evident.
But whatever the priority ranking our Government places on the many challenges it faces, innovation and economic dynamism can surely be left to entrepreneurs.
Sadly, dynamism and innovation are being suffocated by three serious errors of government.
Firstly there is a continuing belief that our banking system is being nursed back to health when in fact it is both incapable of regulation and spiralling out of control towards another phase of the 2008 crisis that unhappily will show that all of the bailout expenditure was wasted.
Secondly our economy is struggling to cope with the debasement of our currency caused by QE.
Finally we appear to have views coming from within the Government and their advisers that Government can play a role in the creation of innovation. It can indeed play a role, but only by reining back its previous actions that have stifled innovation.
This article also creates the impression that a rather cosy relationship has developed between Google and the Treasury. I sincerely hope that that is not the case.
By Gordon Kerr, on 4 November 10
Consider two points:
- Last Week Mervyn King said in a now famous speech in Manhattan that of all the banking systems it is possible to have, our present system is the worst.
- In 2002 Warren Buffet coined the phrase “Derivatives are the Financial Weapons of Mass Destruction”.
I am not sure if the Sage of Omaha was conversant with all the regulatory aspects of derivatives, but I choose this enormous component of the international banking system to explain that our system is incapable of regulation and certain to fail again.
In principle, there is no difference between the regulatory capital charge applied to a risk held by a bank in derivative format from any other format, for example, loan format. Where the system has failed the taxpayer is in the accounting and regulatory treatment of risks that are bought and sold by a bank for profit on its trading book.
Let me draw a parallel with the business of my local second hand car dealer, Barnet Motors. The car dealer’s very simple business model is to buy a second hand Ford Mondeo from Peter for, say, £10,000 and sell it on to Paul for say £11,000, recording in its accounts the £1000 gross profit (before expenses) of the trade.
Consider how banks record purchases and sales of many kinds of risks in derivative format. Banks operate two books, a banking book and a trading book. The destructive arbitrage I am about to outline occurs entirely within the bank’s trading book.
Let us take a simple example of something that went very publicly wrong in the bubble leading to the crash of 2008 – banks buying and selling sub-prime mortgage risk in derivative format.
The parallel with the car dealer is on its face reasonable. The bank buys the asset (writes protection on a portfolio of sub-prime mortgages) in credit derivative format. Step 2, it sells the asset by purchasing a matching credit derivative from, say, AIG’s bank.
The accountants and regulators treat the asset as bought and sold and the margin in the middle is treated as profit earned today by the bank.
However there is a crucial difference between the derivative trade and the second hand car trade: nobody has paid for the derivative. There are indeed flows of annual premium income in favour of each writer of protection, but the recognition of the sale on trading book enables essentially all of the buy/ sell premium differential to be recognised by the bank as profit up front. But tinkering with this rule would not prevent the derivative asteroid about to hit the banking system. The problem is far greater, as we noted in 2008. When the bank was called to pay out on its derivative by the protection buyer, it discovered that AIG had assumed so much of this risk that the counterparty to whom our bank had “sold” the risk was insolvent.
This explains why banks choose to put so much business through their derivative trading books. They did not need to trade in the derivative, they could have bought and sold the underlying sub-prime bonds. The reason for the volume of business being put through the derivative trading book is primarily the “easy ride” of this unreasonably soft treatment of a matching derivative as equivalent to a sale, which in turn implies bank profits which subsequently prove to be illusory.
And therein we can see the absolute impossibility of regulating derivatives – the rules assume no linkage, no correlation between the probability of a default of the underlying assets (the mortgages) and the probability of default of the counterparty to whom the risk of default has been supposedly sold, but who has not paid for or collateralised the exposure.
As ever, this is a simplification of complex rules and hair splitters will point to commercial future collateralisation requirements, but as we saw in 2008 and in the other major banking crises throughout my career, these tweaks never protect the banks and their prime stakeholders, depositors and taxpayers.
What, you might ask, if our regulators asked how much of various risks AIG held? In practice it is impossible for regulators to monitor such matters and the trend towards confidentiality is on the increase, not the decrease. There will never be global banking regulation; there will always be a regime that allows AIG to operate in the future in precisely the way it did in the past. The only solution is a fundamental reform of the present banking system.
And so we have proved that the banking system in its present format is incapable of regulation.
By Gordon Kerr, on 14 October 10
Interesting news on the wire:
13 October 2010
Standard Chartered PLC
RIGHTS ISSUE TO RAISE GBP3.3 BILLION
Standard Chartered PLC ("Standard Chartered" or the "Company")
today announces a 1 for 8 Rights Issue to raise approximately
GBP3,258 million (net of expenses).
Highlights
· Standard Chartered has delivered seven successive years of
record income and profit, and the Board continues to see exciting
opportunities for significant growth across its market footprint in
the world's fastest expanding economies. The third quarter 2010
Interim Management Statement released today builds on a strong
performance in the first half of 2010.
· The Board believes that the new Basel III arrangements will
see regulators raise requirements relating to minimum capital
ratio levels and they may accelerate the transition timetable. To
accommodate such increases, the Group may have to constrain
RWA growth, sacrificing these growth opportunities, unless new
capital is raised.
Note the arguments used to support the rights issue: that the Basel 3 increased capital requirements will prevent future growth so please invest more equity in our bank to enable us to seize these amazing growth opportunities.
A common character trait of most senior bankers I have worked with is their obsession with aggressive success. This takes no prisoners. It promotes an atmosphere among the more senior echelons whereby any questioning of the assumption that the bank will go from strength to strength will be a career limiting step for the enquirer.
Indeed many senior bankers actually believe the nonsense underlying announcements such as this. But they are also smart. Over a private coffee most of my senior banking contacts will smile and concede that bolstering the bank’s reserves in this way, at a time like this, makes a great deal of sense.
Why? Not for the reason stated in this circular. Most bankers know that we are in a kind of phoney phase (pre collapse 2), and that inflating reserves with genuine equity (as opposed to fake profits from derivatives trades booked previously, the income from which has not actually been received) is a good insurance policy. This rights issue could therefore help this bank emerge from the coming second collapse wave as one of the survivors.
By Gordon Kerr, on 26 July 10
A lifelong friend in a senior position at a major UK bank confirmed to me privately that last week’s news that banks were approving 4 out of every 5 loan applications from small businesses was nonsense.
Fortunately our Government has not been so easily duped.
The Daily Telegraph reports today that Vince Cable is considering plans to force banks to lend. It publishes this direct quotation from the Business Secretary:
What we would question is whether banks should be paying out dividends and bonuses when that money could be used to … support small business lending.
The original fuzzy thinking behind the bailout was to protect depositors and prevent a system meltdown and economic chaos. In late 2008 Kaletsky wrote passionately in praise of the bailout, claiming it was the only way to stave off the then threat of mass unemployment and civil unrest.
Even those in favour of the bailout recognise that economic chaos now looms starkly on the horizon given the seizure in both the interbank funding market and in turn the trickle of bank loans finding their way to borrowers. The Government bailout team either didn’t consider this risk at the time or were incapable of designing a bailout contract that would ensure that future loans were made. Therefore Mr. Cable has no choice but to act, or else the very economic chaos that triggered the bailout will ensue anyway.
Doubters of my conclusion that Cable should be praised may question how banks can declare such sizeable profits without making loans. The answer to this is that there are still massive quantities of debt available for purchase at below par prices in the capital markets. Why lend money out in the real economy in an accounting environment where the most you can recognise as a profit in your books, if the borrower performs optimally, is about 2% of the amount loaned every year?
If the alternative is to purchase a bombed out “alphabet soup” structure at say 60 pence in the pound then the annual profit can be enhanced by marking up the price (and adding this unrealised gain to your annual profit statement) since all the other banks are doing the same thing. The annual profit line is also greater since central bank funding comes at the “official” rate that is much lower than the interbank market rate.
In early 2009 the ECB and Bank of England invited banks to fund alphabet soup purchases from a separate pot of taxpayers money called the “Discount Window”. The Discount Window is not part of any market at all, so the banks were delighted to accept all such funding offers. Given the scale of this activity prices of such assets have risen gradually and steadily and so another bubble is inflating but the nature of the accounting regime (the ease with which a profit can be recorded without a transaction occurring) hides this bubble from the eyes of scrutineers.
And so our banks have been very active in the last 18 months, not in the real economy but in the world of alphabet soup bonds.
Therefore I conclude that Cable is brave and correct to design measures that force banks to lend or else banks will continue to operate as state backed hedge funds rather than drivers of the real economy.
But on the other hand, what about moral hazard? The notion of forcing banks to lend has been widely mooted in the press and usually dismissed on three grounds:
- How can the Government ever hold banks to account if loans which we taxpayers have forced banks to make go bad?
- Forced loans is a concept blatantly at odds with the official position that the government does not control banks, we taxpayers are merely substantial shareholders;
- Bankers are skilled market operators and therefore we cannot interfere with their compensation contracts. The more we define their role the more difficult it will be to maintain that senior bankers are not just highly paid civil servants.
All three points are entirely correct and prove that the idea of forcing banks to lend is ridiculous.
And so we have established that Cable’s plans to force banks to lend to small businesses are both commendable and ridiculous in equal measure.
This conclusion says more about the wisdom of bailing out the UK banks than any rant ever could.
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