Seven fatal flaws in the financial system

By David McIlroy 20 Dec 2016

financial-crisis-1718437_640by David McIlroy, 20th December 2016

These seven observations were originally given as a talk at the launch of Jubilee Centre’s research report, Crumbling Foundations: a biblical critique of modern money, by Guy Brandon.

  1. There is far too much debt in the system

Guy in his report explains how banks lend money into existence. But they do more than that, they trade money into existence, generating complex debt instruments, pseudo-insurance contracts and other financial products which carry with them the potential for claims which far exceed their initial price.  This process, called 'Financialisation has created a vast edifice of financial claims built on top of a slim foundation of physical assets'.[1]  As one of the more perceptive jokes to come out of the financial crisis put it: ‘What is the difference between banks and hedge funds? Answer: Banks are more highly leveraged!’

Far more value was lost in the 2000 dot com bubble, for instance, than in the subprime mortgages that sparked the 2008 crisis.  However the dot com bubble did not cause a financial crisis, because tech companies were funded by shareholders, not short-term debt.

  1. There is far too much trading which takes place for the sake of trading

Who is more financially secure, the man who has £1 million of assets and no debt or the man who has £100 million of assets and £99 million of debt?  The answer is, of course, the man who has £1 million of assets and no debt.  The one with £100 million of assets and £99 million of debt may find that all their creditors want their money back at once and that their assets cannot be realized for their full value.

Yet our governments have allowed banks over the last 30 years to change from the first scenario to the second.  ‘The assets of British banks are around £7 trillion – four times the aggregate of the yearly income of everyone in the country.  The liabilities of these banks are a similar amount. … But the assets of these banks are mainly obligations to other financial institutions.  Their liabilities are mainly obligations to other financial institutions.  Lending to firms and individuals engaged in the production of goods and services … amounts to about 3 per cent of that total.’[2]

American Economist James Rickards puts a number to the scale of the instability, he claims that, 'If you double system size, you do not double risk; you increase it by a factor of five or more'.

  1. The financial system has become extractive of value rather than creating value

There are two sorts of economic transaction, those which add value, and those which extract value.  Too much financial activity has the intention or effect of extracting value from other parts of the economy, or putting it another way, of making profits at the expense of other people and industries.  Too little energy and enthusiasm has been devoted by banks to financing other industries in order to create value.

  1. There are far too many complex financial instruments which increase instability or which amplify the effect of shocks in the system

Do you know your CDO-squared from your CMBS?  What caused the financial crisis was, to a significant extent, a good old-fashioned fall in house prices in the USA.  But what made it global was the existence of complex debt instruments which transferred and amplified the risks into different countries and economic sectors.

There is one complex financial instrument in particular I want to mention: the credit default swap.  A credit default swap is like a life insurance policy you have taken out on a company even though you have no financial interest in that company.  If it was a life insurance policy it would be illegal because once you have a credit default swap you have an incentive to see that company killed.  Credit default swaps do little other than expand the financial claims arising when a business collapses.

  1. The system needs fundamental reform because there will be another major crisis

What is not in doubt is that there will be another financial crisis: the problems are that no-one knows when it will be, what will trigger it, how its effects will spread, or how widespread and long-lasting it will be. Natasha Sarin and Larry Summers of Harvard University published a paper in September 2016 saying that, if anything, the biggest banks were now more riskier than they were before the financial crisis.

  1. The banks and their regulators are in denial about the extent of the reforms required

There have been four phases of response to the financial crisis: a response which saw it as a technical crisis, then there was a response which saw it as a behavioural crisis and sought to identify individuals whose bad behaviour should be punished, then there was a response which admitted that it was a cultural crisis.  But now we are in a fourth phase of response: the ostrich phase.  Anat Admati and Martin Hellwig published a book in 2013 entitled 'The Bankers' New Clothes', which argued that the financial system has not been reformed, just re-varnished. The cultural crisis has not been solved, the behavioural crisis has produced very few scapegoats, and the technical crisis has only led to even more complex rules which the banks will be able to game.

  1. The existing tools have all already been used

City AM carried an article on Friday 2 December by James Rickards which argued that a financial crisis far worse than the last will occur within Donald Trump’s Presidency.  When it happens, 'Central banks will be unable to pull another rabbit out of the hat; they are out of rabbits.'  We’ve had ultra-low or even negative interest rates, quantitative easing, government takeovers and investment of vast amounts of taxpayers’ money into banks, and still the system isn’t working.  In this, of all years, making political predictions is a risky business, but it seems unlikely that electorates will countenance further bank bailouts on the scale we saw in 2008.

I welcome this publication as one which highlights the scale of the challenge which we face and the need to engage in radical re-thinking of the foundations of the City, of our country, and of the global economy.

David McIlroy is a barrister specialising in financial services law, and is Visiting Professor of Banking Law at SOAS, University of London.

[1] John Kay, Other People’s Money: Masters of the Universe or Servants of the People? (London: Profile Books, 2015), 177.

[2] John Kay, Other People’s Money: Masters of the Universe or Servants of the People? (London: Profile Books, 2015), 1.

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