Robin Matthews is professor at universities in London and Moscow; consultant with international companies; writes on business, economics; and finance: creative imagination techniques in management.
Bankers and Says Law: knowing what they do
Bankers and says Law: knwoing what they do
In capitalism, demand calls the tune. Supply is not the problem. Capitalism is enormously fecund. In the real sector, that is the non financial sector, supply does not create its own demand, contrary to Says law, (and contrary to contemporary growth theory and the BRIC report and governments and the IMF both plugging front loaded, debt reducing, demand reducing policies).
Perhaps, though in the banking sector Says law does work.
Currently there is a liquidity trap in the Eurozone and perhaps in the USA. Now we call a liquidity trap a credit crunch. Banks (governments and corporates) are deleveraging. So quantitative easing (QE, which used to be called monetary policy) is hoovered up by the banking system, in the deleveraging process and a lot bank profit comes from interbank lending. They lend to each other, at interest rates that exceed the minimal rates at which they borrow, from QE.
People are surprised that funds are not channelled into productive investment (bringing growth, employment). But only about 3% of bank assets do this, in any case. Banks have four businesses. In the first, they channel savings into productive investment; in the second, they diversify risk; in the third, they gamble on inflation in the prices of the assets they create (via leverage); in the fourth, they create systemic risk for everyone.
What do banks do?
Banks (a) collect savings, (b) leverage them (interest earned on assets they create, exceeds interest paid to savers), (c) hold cash reserves and create a portfolio of assets (cash ratios and liquidity ratios), to hedge against a run on the banks. If (d) individual banks get their portfolios wrong, they can lend to each other, or they can borrow from the central bank (the lender of last resort). And (e) banks have tangible assets (from shareholders, ownership of property and so on), to hedge against insolvency. If (f), they have over leveraged, shareholders take the hit, but only if there are sufficient shareholder funds. If (g), there are not sufficient shareholder funds, either (h), the bank collapses, savers lose their money and through interlocking assets between banks, this spreads to throughout the banking system and into the real sector (lost output/unemployment), via the too big to fail problem and sheer interdependence between them: and/or (i), governments bail them out, making (j),the same thing more likely next time (moral hazard).
That is why portfolios only partly serve the purpose of diversifying risk. Beyond a certain degree of interdependence between banks, diversification increases the probability of contagion. Failure of a bank, or an asset, brings feedback effects (domino effects, contagion, percolation, as such effects are variously called), which threaten the entire system. In other words, diversification gives rise to systemic risk and the possibility of collapse of the entire (global) financial system.
The more banks leverage, the bigger the profit, the bigger the fees and the bigger the bonus. The qualification is that bonuses are somewhat disconnected from profit, in that they are based on the value of deals, rather than profit; deals and profit are linked but not perfectly so. So a loss making bank can still pay bonuses, provided there are sufficient deals.
By deals, I refer to assets that are traded within the banking system, mostly between banks and mostly they are financial assets that are secured on other financial assets. If asset prices as a whole are increasing, then there net profits in the financial sector and so there is an incentive for bankers to do more deals (mostly with each other), create more assets, and increase leverage.
Because financial innovation results in a hierarchy of assets, securitized on one another, such deals do not create cash, so the method of paying bankers (originate and distribute, it’s called), breaks the basic rule of incentivising salesmen; Don’t give them commission until the cash actually comes in. But that’s exactly what happens. Bankers are paid out of the inflation in the prices of securitized (over leveraged) assets.
If asset prices collapse, then there is a financial crisis, that spreads through the entire global economy. This is the essence of systemic risk. Currently the global economy is experiencing (perhaps) $200 trillion of systemic risk. At a personal level, it is experienced, for example, by feeling sick because you are one of the 2.8 million unemployed in the UK (or Greece’s 20%).
First, there is a real return on some financial assets. The 3% that is devoted to productive investment in the private sector, plus the amount devoted to productive investment in the public sector. Both create growth: the public sector via real output and social goods (health, welfare, infrastructure, security, even happiness and so on); a fact, widely denied.
Second, there is asset price inflation, stemming from the incentive to do deals, to create new assets, to employ clever mathematicians (who don’t understand banking) to devise spurious prices (for bankers who don’t understand mathematics), based on spurious mathematics, for spurious assets secured on spurious assets; spurious prices because most of the assets are traded individually, not via markets. And these prices emerge from the models, because the assets are traded individually not via markets. The models are like maps that masquerade as the territory (the banks) they map.
When markets collapse, bonuses and profits from the asset price inflation are already pocketed by the banks.
Inflation is a tax; a tax on everyone who fails to, or is unable to anticipate the inflation. Usually inflation is a tax on people with fixed incomes. Asset price inflation is a tax on people outside the banking system. So we all pay.
Now banks are deleveraging. Deleveraging also involves more assets, more deals and bonuses (perhaps). Supply in the banking sector creates its own demand. Says law works there.
But bankers don’t know what they do.
 Spectacular global growth over the last 25 years demonstrates this.
 I use banks and the financial sector interchangeably.
 See Wilson, Dominic and Roopa Purushothaman, (2003). “Goldman Sachs, Dreaming With BRICs: The Path to 2050”, Global Economics Paper, No. 99, 2003.
 I got this information from John Kay, with thanks, but, of course, he is not at all responsible for my use of it, or for the contents of this note: See http://www.johnkay.com/2011/09/13/taming-the-banks-long-overdue-or-utter-folly
 See, Reinhart Carmen, and Kenneth Rogoff, (2009). This time is different: eight centuries of financial folly, Princeton University Press, Oxford and Princeton.
 See Haldane, Andrew and Robert May, (2011), “Systemic risk in banking ecosystems,” Nature,Vol. 469. 20 January, pages 351-355. See Haldane also on the costs of the financial crisis: Haldane $100 billion question at. http://www.bankofengland.co.uk/publications/speeches/2010/speech433.pdf (2010). Again, the use of the papers is my responsibility, as in 3 above. Also Battiston, S. Domenico Delli Gatti, Mauro Gallegati, Bruce cornwall and Joseph Stiglitz, (2009). ”Liaisons dangereuses: increasing connectivity, risk sharing, and systemic risk,” NBER Working Paper, No. 15611.. January.
 Spurious because based on Gaussian distributions: see for example Taleb, N. N. (2007) "Black Swan and Domains of Statistics", The American Statistician, August 2007, Vol. 61, No. 3: and/or other publications by Taleb.
 Minsky is the authority here and of course Keynes. See, Minsky, H. (1986). Stabilising an unstable economy, McGraw Hill, London.