Benedix Blog

By Simon Dixon of Benedix

As the credit crisis becomes more and more mainstream and people begin to feel it in their everyday lives people want answers. Everyone seems to want someone to blame – is it the investment bankers?, is it the FSA?, is it securitisation, the bank of England, or government, or the credit ratings agencies? When crisis occurs we ultimately search for blame.

The answer is none of the above. What is at the heart of the issue is the financial system that we currenlty use, and all of us have contributed to the crisis. In other words, we are all partly to blame. This may sound harsh but I have been presenting seminars for years now on the issues, way before the Northern Rock crisis came to light. Coming from a background of stock broking, market making, investment banking and now as Head of Training & Research for Benedix, as well as mastering in economics and dedicating myself to the study of economic history I have first hand experience of all the issues that have contributed to the credit crisis.

 So the natural question is – what is wrong with the system and who has contributed to the system? To answer this question we need to go back to the creation of the financial system and the completely unsustainable system that we created.

We’ll sum it up in very simple terms here. Think of the basis of our financial system: historically all the money in our economy was created and printed by our central bank, and backed by a limited supply of gold. The central bank  creates the money in our economy doesn’t ‘give’ money to our economy - instead it lends money to the government and private banks, with interest on top. The problem is that if the central bank creates all the money, where do we find the money to repay the interest to the central bank?

This is the foundation of the flawed system and a system that has nearly collapsed a number of times. However the current impending collapse may have been put off until another day through government policy and intervention.

This may come across as shocking but let me take you back in time to build a picture for you.

Fractional reserve banking

Let’s go back in history and look at the development of our financial system. We began in a barter economy where goods were exchanged when two people agreed - I have a sheep and you have a goat, but I like feta cheese and you want a wooly jumper, so we swap.

Trade can be difficult in a barter system (economics students will know of the problem of ‘coincidence of wants’). You must find someone who has what you want, and who wants what you have. Imagine a small medieval town with a butcher, baker, and brewer (who makes beer). Imagine the butcher wants to get a beer, but the brewer is vegetarian - the butcher has nothing to offer in exchange. 

Instead, the butcher could get a beer, and write a note promising to give anyone with that note the equivalent value in meat. Now the brewer can give that note to the baker in exchange for the bread, and the baker takes the note to the butcher to buy meat. It may seem a contrived example but these ‘credits’ were likely the first form of money. 

As time moved on people began to create money for convenience in the form of precious metals and gold become the recognised form of value for trade. Even though the money has no usefulness in itself (you can’t eat or drink a coin, and it doesn’t keep you warm or dry) people were willing to use it since they knew that most other people would also accept it in exchange for goods.  

Gold became the standard form of money. People deposited gold at goldsmiths, receiving a ‘note’ (ie. receipt) for their deposit (eg ‘I confirm that Jack Smith has deposited 50g of gold with me’). Eventually people started to exchange the notes instead of handling the gold (so I give you a note that tells the goldsmith to give you 10grammes of my gold). Once these notes became a trusted medium of exchange an early form of paper money was born, in the form of the goldsmiths’ notes.

As the notes were used directly in trade, the goldsmiths noted that people would never redeem all their notes at the same time, and saw the opportunity to invest the ’spare’ gold. As long as the goldsmith shared their investment return (interest) with its clients then they would be happy to leave their gold with them. This is how modern commercial banking works. Commercial banks like Barclays, Natwest etc. pay you a small amount of interest for depositing your money and lend that money out for a higher interest rate leaving a fraction of the money in reserve.  Today we operate out of what is known as a fractional reserve system.

When depositors started to suspect that the goldsmiths were a little  unscrupulous - in other words, wondering if there was really any gold left in the vault - they lost faith in the ability of the goldsmith to pay their gold. Many people would then try to redeem their notes at the same time (to get their money back as quickly as possible), forcing the goldsmith to call in loans. This was called a bank run and many early banks went into insolvency. The Northern Rock crisis is a modern example of such an event.

For the economy and the banking system as a whole, the practice of keeping only a fraction of deposits on hand has an important cumulative effect. Referred to as the fractional reserve system, it permits the banking system to “create” money. When a loan is made, all that happens is that numbers on a computer system are credited to the borrower’s account. The borrower then uses this ‘money’ in his account to buy, say, a house, by paying the money into the house-seller’s bank account. The money that lands in  house-seller’s account is recorded as a new deposit in the accounts of the bank - in other words, it’s ‘new money’. When you borrow £100,000 to buy a house, as soon as you have paid for the house the national money supply increases by £100,000. No new money is printed, but the 97% of money that exists only as numbers in computer systems is increased.

It’s a difficult concept to get your head around the first time you hear this, but I can guarantee that only a fraction of politicians, world leaders, and even finance professionals actually understand this. The vast majority are simply not aware that most money is created within the banking system and NOT by the central banks.

As history unfolded itself central banking was born. The Bank of England (originally a private company created to fund wars) and the Federal Reserve were founded to be a lender of last resort to commercial banks. This creates a real problem, in economics referred to as a moral hazard problem.

Moral Hazard

Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions. For example, an individual with insurance against car theft may be less vigilant about locking his or her car, because the negative consequences of automobile theft are borne by the insurance company.

It is like being in business with a backer that says, ‘Take some big risks in order to get large returns. If it goes wrong I’ll bail you out’. This is what central banks do -  Northern Rock followed a risky strategy that was destined to lead to a failure, but was sheltered from the consequences of its actions by the Bank of England. More recently, the same has happened to Bradford and Bingley. 

Incentives

Couple this moral hazard problem with staff bonuses and commissions. When all staff in Investment and Commercial banks are incentivised with commissions and bonuses conditional on how many deals they put through you have a strong incentive to lend. Banks make their money based on how much business they put through and staff get paid on commission. The more debt you get people in the more you earn. It is natural to innovate ways to get more people in debt when your wage is contingent on meeting targets.

Investment banking and commercial banking and the 1929 crash

Now move forward to 1929 - the year of the stock market crash that led to the great depression of the 1930’s. Prior to 1929 the stock market was booming with more and more interest in sophisticated products being created and heavily marketed by investment bankers.

(For clarity the job of an investment bank is to securities debt and equity to trade on a market and sell it to investors as well as structuring complex debt products. They created derivatives products which simply put allow people to gain exposure to financial markets with a small amount of money on deposit called a margin. Much like a mortgage you can control a property with ten percent down and gain a higher profit or loss as the property market increases or decreases in value. Derivatives allow you to gain more exposure to financial products using debt).

Investment Banks created such products and commercial banks lent out deposits. In the late twenties investment banks and commercial banks were allowed to operate under one roof.

The market crashed in 1929 when people grew worried about their money on deposit at the commercial banks. Were the banks lending out my deposit through margined derivative products and how safe is this? As more and more people became fearful they started to run on the banks and withdraw their deposits. Investment banks recalled their derivative products, which resulted in a mass selling of securities and a stock market crash.

Policy Change

There was little faith in the banking system after this and credit became hard to come by. At the same time as banks recalling loans the central bank contracted the money supply massively. This lack of money led to the great depression of the 1930’s.

Nobel prize winning Economist John Maynard Keynes advised the government that the best way out of a crisis is through government expenditure - spend your way out of the crisis. As the government grew, debt financing become essential for growth. The investment banking industry grew and the level of debt surged.

This was aided by a key change in US legislation called the Glass Steagall act of 1933. This act prevented investment banking and commercial banking from occurring under one roof. It recognised the danger of these two activities occurring under one roof. In 1999 the US government decided that this was no longer important and re-appealed the act. They made the financial system self regulating and investment banks went on an acquisition spending spree. The banks merged and acquired and the universal bank was born that offered everything under on roof asset management, investment banking, commercial banking, broking and many more services.

How money is now created?

The process of fractional-reserve banking has a cumulative effect of money creation by banks. In short, there are two types of money in a fractional-reserve banking system:

1. central bank money (physical currency such as coins and paper money)
2. commercial bank money (money created through loans) -

When a loan is funded with central bank money, new commercial bank money is created. As a loan is paid back, the commercial bank money disappears from existence.

Money comes into a bank, a fraction is held on deposit (eg 10%), this money is spend and re-deposited into a bank which is lend out further subject to the fractional reserve ration until the money created can increase ten fold, creating ficticious money that has no real value and is only backed by debt.

 Although no new money is physically created in addition to the initial deposit, new commercial bank money is created through loans.

 The value of our economy used to be limited to the amount of gold we had, now it is limited to the amount of debt we can create. The result – sub-prime lending: lend like mad. We are constantly spammed with email, magazine fliers and advertisements of easy credit, debt consolidation, shark loans and all sorts.

So in an economy where 3% of our money is created by government and 97% from commercial banks we are in a situation where simultaneously families are in debt through mortgages and credit cards, corporations are in debt through equity and bank loans, small businesses are in debt through venture capital and bank loans and the government id in enormous debt through government bonds.

So where is the money?

Who has the cash. The reality is banks can create as much money as we can borrow and there is not enough money in the world to pay off all the debt.

Securitisation

While everybody was paying their debt due to a bull market the investment bankers securitised everything. Securitisation is the process of assigning a pool of loans to an asset backed security traded in a secondary market. What do banks securitize? Mortgages, car loans, insurance premiums, personal and corporate loans, credit card receivables, everything! Now imagine if you package this debt up into a sack (Structured Investment Vehicle) and then create the ability to buy the debt on debt through a derivative. Then you break this debt up into tranches of different risk profiles and create a derivative of that tranch (Collateralised Debt Obligation), and then create a credit default derivative too. Nobody knows what the risk of these obscure products actually is and what happens when people can’t repay – this is the current environment. But at an investment bank this is a structurer’s job and his livelihood depends on making such products.

So, who is to blame?

 This is the situation we are in:

 

• When the banks need to borrow money they go to the money market. 
• When everybody needs to borrow the money market dries up. 
• Now the public look to the government to rescue us. 
• When you are a politician with a short term mind set,  you are only looking as far forward as your next election. Naturally you don’t want to be the one that takes the blame for the system collapsing so you will rescue, print money and create record inflation. 

Who’s fault is this? Is it the politician or the democracy? We voted for the politician and no politician would get elected if they told the truth and really understood that system needs to be completely reformed to solve the problem.

Reforming the system involves getting rid of the fake money we have created. This will probably lead to a decline in our standard living, as we stop living beyond our means (courtesy of our credit cards and personal loans).

Is anybody going to vote for the politician who proposes this remedy? So in placing the blame can we blame the regulators, the FSA, the investment bankers, the way we are paid, the ratings agencies that gave poor ratings, the Bank of England, those who don’t manage their finances and take out credit cards and personal loans for over-indulgence.

Or do we all have to take some responsibility for creating this system?  We all have a role to play and should all take responsibility. We all need to contribute to a solution - as young professionals in the banking and finance sector, you will be a key part of this solution. 

We will be publishing more articles on the problems with the current financial system with a view to preparing the next generation of finance professionals for the financial crises that they will face over the next two decades.