The Jabberwocky: Twas Brillig in the Shadow Banking

The title of this article is based on Lewis Carroll’s nonsensical work of 1872 “Through the Looking Glass”. In one world, money talks and bunkum walks and bankers are Masters of the Universe and are of high social value. This is a world where PIIGS (Portugal, Italy, Ireland, Greece and Spain) fly. The Jabberwocky is a mythical monster and Brillig is a nonsense word created by Caroll to mean broiling and banking is certainly feeling the heat. On the other side of the looking glass, the Jabberwocky is the Shadow Banking system and we realise that PIIGS don’t fly, bunkum talks and tax payers’ money walks. It seems that bankers are more like Dukes of Moral Hazard than Masters of the Universe.

The inconvenient truth is that many opinion formers do not fully understand the complexity of the system. The Federal Reserve has recently published a report with a flowchart explaining how the opaque world of Shadow Banking operates. If you were expecting a simple flowchart you are in for a disappointment. You need to view it on Poster Size A0 (36” x 48”) just to read the text. The cause of the banking crisis may not be the explosion of credit as what seems to be conventional wisdom. This alas is only the symptom and academics and policymakers have been slow to get to grips with the financial crisis. Some opinion formers including some non finance academics are not aware that banks can create credit (money) via the principle of fractional reserve banking. Under normal circumstances this is a stable mechanism and has served banking well for years despite low capital ratios. The principle of credit creation is not widely published in financial texts so my colleague Professor Richard Werner (the academic who coined the term quantitative easing) has kindly written a chapter explaining it in my forthcoming book. His paper argues for a levelling of the playing field by giving parity to credit unions to create credit via fractional reserve banking.

The problem with the banks is that credit creation has gotten out of control because of the warping of fractional reserve banking (loan to deposit ratios greater than 100%). The complexity and opacity of “Shadow Banking” has hidden the risks and caused the balance sheets of banks to swell to unsustainable levels. The reality now is that money has to be pumped into the system to maintain the economy and this has been achieved through direct support, guarantees, credit lines and quantitative easing. The taxpayer has now become the lender of last resort, a fact admitted by Andrew Haldane from the Bank of England. His boss, Mervyn King recently revealed that three years after the beginning of the crash, three UK banks each still have balance sheets valued higher than the whole of the UK economy, i.e. £1,300,000,000,000.

You may begin to realise that it’s this warping effect which is the cause and the debt is the by product which builds this pyramid. This could explain why reckless decisions were made to allow subprime borrowers easy credit.

This should not be a revelation as my colleague Greg Pytel stated this when his essay was published by the Houses of Parliament Treasury Select committee more than 2 years ago. He warned that the banking model was fundamentally flawed and used emotive language to argue that it was either incompetence or wilful theft. In the meantime the issue gets clouded with blame apportioned to everybody and everything other than the real villain, the warping of fractional reserve banking.

Nevertheless, we are where we are and when you are in a hole the first thing you should do is stop digging. Academics and policy wonks are carrying out post mortems and picking Gnat droppings out of pepper to analyse the issue.

The academic community have been on the losing side of the debate with “Pracademics” such as Hugh Hendry, Dr. Nassim Taleb, Dr. Gillian Tett and Peter Schiff who have bested our eminent intellectual elite such as Professor Stiglitz, Professor Sachs and Professor Laffer in debates. Some of these debates have now passed into YouTube folklore. With over a million hits on a dry topic such as banking discourse, this should not be ignored by the academic community.

In the USA Professors Laurence Kotlikoff and Nouriel Roubini have been carrying the torch for academia and Professors Karel Williams and John Kay in the UK have produced some excellent work in analysing the financial crisis. Williams’ team point out that the majority of banking post mortems have been carried out by banking insiders or academics with a banking background. The late Professor Abraham Maslow once commented that “anybody who is good with a hammer sees every problem as a nail” and this perhaps should be a lesson in encouraging non banking academics to join the debate about the future of banking. The rush to regulate will not solve the problem as there is a revolving door phenomenon of banking and politics and powerful vested interests will ensure there is plenty of “wiggle room” in the regulations. You can guarantee that any forthcoming legislation will have more loopholes than a pair of Charlie Chaplin’s shoes.

As financial services are inextricably linked to the health of the economy and our ability to fund public services, this is undoubtedly a Gordian knot, an intractable problem with no easy solution. However, I believe Schumpeterian “creative destruction” is needed in the banking industry so that we are proactive rather than being continuously blown by events. It is essential that academia, including non banking academics are at the forefront of the debate.

Graham Manville is a Senior Fellow at the University of Southampton lecturing in Strategy and Entrepreneurial Management and his research area is corporate performance management. His latest book entitled “Third Sector Performance: Management and Finance in Not-for-Profit and Social Enterprises” will be published in 2011 by Gower Publishing, ISBN 978-1-4094-2961-6.

©Graham Manville, 2010. All rights reserved

Will Sassoon recommend a Haircut for the Banks?

I am not talking about Vidal Sassoon the famous hairdresser but a coalition Finance Minister. Many of you will not have heard of Baron Sassoon but his story underlines the phenomena of the revolving door of politics and banking. From 2002 to 2008 (immediately after Lehman Brothers went belly up to be precise) Sir James Sassoon as he was then, was Gordon Brown’s right hand man in the city. He oversaw recommendations for FSA roles as well as knighthoods (Brown admitted this under cross examination in the select committee meetings).
http://en.wikipedia.org/wiki/James_Sassoon,_Baron_Sassoon

At the outset of the financial crisis of 2008 he quietly crossed the floor with no fanfare and became David Cameron’s special advisor for the city. He has subsequently been rewarded with a ministerial position and a Baronetcy. This is not a partisan blog about bankers but bankers like red top newspapers back the winning side so it was not unexpected. With Baron Sassoon’s vested interest in banking will he do what is needed and recommend a write down of banks’ balance sheets (the city vernacular is “a haircut”)?

http://financial-dictionary.thefreedictionary.com/Haircut

With Ireland on the brink of sovereign default after pursuing a policy the UK government is now following, something will need to be done. This should not be a revelation as there have been warnings about this for years. The PIGS (Portugal, Italy, Greece and Spain) are very exposed and the UK is vulnerable due to its reliance on Financial Services.

http://www.youtube.com/watch?v=nuysYXlJ43I

If you are not convinced then look at the text of Mervin King’s speech in New York dated 25^th October 2010 which shows in tabular form that 3 UK banks two years after the crisis each still have a balance sheet greater than the whole of the UK economy combined. I find it bizarre that nobody is raising an eye brow about this. Contrast it with the US banks and it leaves some questions requiring answers.

http://www.bankofengland.co.uk/publications/speeches/2010/speech455.pdf

Have a look a this internal report from the Fed Reserve and its shows the sheer complexity of shadow banking which may explain why there has been systemic knowledge failure by opinion formers and academics.

http://www.ny.frb.org/research/staff_reports/sr458.pdf

The UK economy is far too reliant on banking, insurance and property and it is very exposed to both consumer confidence and the fragility of the banking sector. The recent news about an increase in jobs is welcoming but most of these new jobs are in those fragile sectors. The UK will eventually have to rebalance its economy to put it on a more stable footing.

The Banking Industry will argue that they constitute 10% of UK GDP and 15% of the corporate tax take and are of high social value. If this is true then the banking industry holds a loaded gun to the taxpayer and will implicitly argue that if you over regulate us we will move our operations off shore and the UK GDP will shrink. The forthcoming banking levy will be more than offset by the upcoming cuts in corporation tax.

http://news.bbc.co.uk/1/hi/8421312.stm

A counter argument put forward by Professor Karel Williams of the University of Manchester takes issue with this assertion of the Finance industry’s value to the economy and his team argue that rather than banks being net contributors to the economy the direct and indirect taxpayer bailout has negated the tax take.

http://www.cresc.ac.uk/publications/documents/AlternativereportonbankingV2.pdf

Rather than impose an opinion I will leave it to you to read both and make your own mind up.

The knee jerk reaction is to do the necessary thing and order the banks to come clean on the true value of their company. However, David Cameron is no fool and realises that this is a “Gordian Knot”, an intractable problem with no easy solution. http://www.alexander-the-great.co.uk/gordian_knot.htm

Order a banking “write down” and the UK economy could collapse. Keep feeding the beast (banking sector) with taxpayers’ money and it is a recipe for mortgaging collosal debt to future generations.

Until the Gordian Knot is cut, I don’t believe that the banking industry should be taking bonuses out (whether deferred, in cash or in shares) unless they are on a stable footing and are no longer too big to fail. I must stress that I am not against rewarding success with huge bonuses. However, a compensation ratio of over 40% of net turnover which constitutes the typical banking bonus pool doled out to its top bankers is very irresponsible in the 21^st century for several reasons.

Firstly – When it is impossible for a solvent bank to have zero turnover why should an individual be guaranteed a bonus irrespective of how well or badly they perform? I teach my students that turnover is vanity, profit is sanity and cash flow is reality. That should have been a lesson the banks learned when they initially asked the taxpayers to mortgage our futures to bail them out.

Secondly - why such a high figure given the fragility of the industry? Without global regulation on harmonised bonus percentages/ reform of the turnover compensation ratio the banking industry have the taxpayers over a barrel.

Finally – Is the compensation ratio a suitable reward that is commensurate with the risk? Since 2008 pure investment banks no longer exist as they are now all “bank holding companies”. That means that all banks can benefit from both direct and indirect taxpayer support. Talk about heads I win tails you lose?

John Lennon: A flawed genius but we wouldn't have it any other way!

The last blog referred to the passing of time possibly changing the perception of Tony Blair. This blog is about one of the most famous 20th century icons, John Winston Lennon. Lennon was a member of the Beatles and the foremost song writing team in history. This month marks what would have been his 70th birthday and 2010 is the 30th anniversary of his brutal murder by a crazed lone gunman.

Lennon not only changed the dynamics of the music industry by storming the USA before becoming one of the most famous people in the world. Lennon and the Beatles were at the vanguard of a cultural revolution in the 1960’s which ushered in women’s rights, the permissive society, the erosion of class distinction, youth political protest and recreational drug use. The fab four “ordinary working class boys” were (with the exception of Ringo) grammar school boys, college educated and Lennon lived in an affluent part of Liverpool. But hey! Let’s not let facts get in the way of a good story!

Songs such as "Baby you can drive my car", "Norwegian Wood", "Day Tripper" and "Girl" where songs that described empowered women who had the upper hand. They were responsible for a musical phenomenon that effectively put his idol, "The King of Rock and Roll", Elvis Presley out to pasture and relegated him to Vegas. The Beatles 1966 record “Rain” sung by Lennon was pivotal in the “unique” sound of Beatles fan Liam Gallagher of Oasis (they initially named the band "The Rain") and was the precursor of the Psychedelic revolution.

Lennon’s post Beatles years were characterised by his life with Yoko Ono, Peace protests, fatherhood and his struggle with gaining his US green card. Some doubters claimed that Lennon was a spent force after the Beatles. Yet he has three post Beatles compositions in the Rock and Roll Hall of Fame: Instant Karma, Imagine and Give Peace a Chance. Most serious artists would kill to get one of their songs in this chart! Lennon is viewed by many people as the smiling joker in the pack of the Beatles who changed when he met Yoko.
http://www.youtube.com/watch?v=rvBCmY7wAAU

However a revealing and much maligned book in 1988 by the late Professor Albert Goldman was published which involved over 1000 interviews with friends and acquaintances of Lennon. The book was viewed as heresy on the Lennon icon and Goldman was demonised and his work was considered a character assassination. However with the passage of time more recent films about Lennon and the Beatles have been faithful to the Goldman book. Films such as: The Hours and Times, Backbeat, Nowhere Boy and Lennon Naked reveal the flawed genius that was John Lennon.






Lennon was a gifted musician and media manipulator with a dark sense of humour and an irascible manner. Listen to the humorous youtube anecdote by Tom Jones when he first met him when Lennon tried to provoke him into a fight before becoming good friends.
http://www.youtube.com/watch?v=lXhMTOLJWH8

Jones continues to recount his last public appearance with John Lennon where Lennon felt he was “blanked” by a member of the Royal Family. The show was honouring the late Lord Grade (Michael Grade’s uncle) who at the time owned the rights to Lennon and McCartney’s back catalogue having acquired them in 1969. Lennon being Lennon performed a little known rock and roll number called “Slippin’ and a Slidin’” and his backing band members were made up with two faces. I will let you draw your own conclusions on Lennon’s “Salute to Sir Lew”.
http://www.youtube.com/watch?v=wT6tm5BSY1M

In addition as his US immigration status and possible deportation was still hanging in the balance he had to insert “and no immigration too” into his iconic “Imagine” ballard. Perhaps it’s not a surprise that the late Lord Mountbatten blanked him at the backstage glad handing. Still the exasperated John Lennon felt he was done an injustice.

For those thinking this was barren time for Lennon he had just bagged a US number 1 with Elton John and helped David Bowie compose his first US number 1 “Fame”. He even sung backing vocals and played guitar on that track too!

Despite his flaws he was and remains an icon that transcended culture and politics.

Lennon was no doubt “edgy” and “cool” to anti establishment groups but there can only be one “King of Cool” and the next blog will shine a light on another icon who also died 30 years ago. Can you guess who it is yet?

Blair Vision: Will History be Kinder to the Former UK Premier?

The recent publication of Tony Blair’s autobiography has divided a nation again. His decision to donate his £4.6 million pound advance to the British Legion has shone him in the public eye again. Charasmatic leaders are never universally liked but why is Tony Blair so devisive?

To paraphrase philosopher Machiavelli: innovators make enemies against the old order and only garner luke warm support from those who would prosper under the new order. Like him or loathe him he presided over ten years of economic growth and unprecedented social justice in absolute terms. However, what seemed to undo Blair was the Iraq war and his image of a poodle to theformer US President George Bush. Yet Blair was an advocate of “war as a force for good” before Bush came to power as evidenced by his speech in Chicago, 1999.
http://www.pbs.org/newshour/bb/international/jan-june99/blair_doctrine4-23.html

Perhaps his decision was tempered by the massacre of the innocents in Srebrenica in 1995 by Serbian backed forces whilst NATO and the UN sat on their hands.

http://en.wikipedia.org/wiki/Srebrenica_massacre

He had enemies on both the left and the right and despite vitriolic abuse by his critics, he never lowered himself to their level and rose above it.

When he was in power the critics were complaining that he will never repay his large mortgage on his house when he would eventually leave office and was only staying because of the money. Having been driven out of power by critics who he had previously dubbed “the forces of conservatism” they are now complaining that he is making too much money. The phrase damned if you do and damned if you don’t is perfect for Blair.

Perhaps history will be a better judge of the Blair years. 70 years ago Winston Churchill was stiffening our resolve and fighting the Battle of Britain which arguably saved western civilisation from the iron grip of Nazi rule. Yet during this time Churchill had warlord appeasers in parliament, the media and public life who were calling him a war monger and urging the UK to sue for peace. Churchill's reward for his wartime contribution was electoral annhilation by the reforming Labour government of 1945.

I am not comparing Blair with Churchill but people who benefited from the Blair years appeared to have cut off their noses to spite their faces. Blair was an electoral winning machine, he made Labour elect able after four successive defeats and consigned four Tory leaders “to spend more time with their family”.

Prior to Blair EVERY Tory leader became Prime Minister so his success was very much under rated and now Labour seems poised to return to perpetual opposition. What was more telling was on the day of Blair’s final appearance in parliament, David Cameron as leader of the opposition and his MPs gave Blair a standing ovation- an unprecedented event. Is it any wonder that Cameron called himself the “heir to Blair”.

I am not advocating an opinion one way or the other but in order to judge someone you need to see both sides of the argument before you make your mind up.

The next blog will refer to another person by the name of Winston.

Is one of our largest UK companies Obama’s whipping boy? You bet your sweet BP!

The title of this blog contains the catchphrase of one of the USA’s best loved comedy shows but I don’t think this is a laughing matter.

One of the UKs largest companies by market capitalisation, BP is bearing the brunt of the fallout from the gulf of Mexico oil slick which is now contaminating shorelines in several US states.

Does BP deserve to be the Obama’s whipping boy or should some other company be shouldering their share of the blame?

Some facts have been conveniently left out by the World’s media:

Does BP own the offshore drilling platform? No

Does BP employ the people who worked on the rig? No

Did BP staff cause the explosion? No

Well, who owns the rig, employs the drilling staff and who caused the explosion? The answer is Transocean, an American owned company which is the largest offshore drilling company in the world.

Isn’t it strange that nobody has heard of TransOcean and whilst BP is getting all of the flak? Transocean seems to be walking between the raindrops and not getting drenched by the media storm.

http://www.telegraph.co.uk/finance/newsbysector/energy/oilandgas/7806200/Gulf-of-Mexico-oil-spill-Transocean-silent-as-BP-bears-the-brunt-of-anger.html

However BP is the prime contractor and they did employ the services of Transocean and the Prime Contractor ultimately takes responsibility. Nevertheless, is it morally right that BP shareholders are losing tens of Billions in shareholder value, whilst the little known US company escapes scrutiny.

Surely BP should slope shoulder and blame somebody else, but this would not be a wise move with such a sensitive issue that affects the ecology, the economy and not to mention swing state votes needed for a second term?

I will leave it to you to formulate your opinion.

The Tectonic Plates have shifted.

No I am not talking about the volcanic eruption which has caused chaos to business and holiday travellers as well as to air importers and exporters. I am talking about last week’s political leaders’ debate.

What was billed as a bit of media froth which would appeal to the Westminster bubble turned out to be viewed by more than 9Million viewers.
http://www.youtube.com/watch?v=rk5HvJmy_yg

Nick Clegg’s polished performance put David Cameron’s otherwise competent performance into the shade. This was never going to be Brown’s strong card and his strategy must have been damage limitation. However, a quirk of fate of the first past the post system could yield some odd results. Gordon Brown could potentially remain as PM despite coming third.

http://www.ukpollingreport.co.uk/blog/

The result is potentially a seismic shift at the forthcoming election by Clegg achieving a dominant strategy. If current opinion polls hold up he could be in a position to force a game change in politics. His prize will be proportional representation based on single transferable vote or alternative vote system. With Westminster still reeling from the expenses scandal which was rife across all party colours, any party may get into bed with the Lib Dems to secure power. This will mean that future lib dem MPs will no longer be fringe players.

As an academic and consultant, I run a game theory exercise with my MBA students as well as with Company Executives and Senior Managers exploring strategic alliances, trust and ethics. My exercise uses 3 groups instead of 2 groups. Most game theory exercises only use two and students and alumni will remember the “prisoners’ dilemma”
http://en.wikipedia.org/wiki/Prisoner

If you would like to know more, please contact me.

There are two more rounds of this political game to run and where it will end nobody knows. Still it has energised a hitherto dull election campaign. So it’s now Game On!

A Greek Tragedy

This posting has partly a socio-cultural theme and partly a macro economic theme. The woes of Greece with their huge debt problem has parallels with western society’s own personal debt and our tendency to live for today and postpone repayment.

As a society we have been seduced into thinking we can have it all now. We are bombarded with celebrity lifestyles, “reality” TV shows and drip feeding of “affordable” credit card TV adverts.

Warren Buffet the philanthropic billionaire explained macro and micro economics in a very simplistic cartoon which some economists may say is too simplistic. However, consider the juxtaposition of this Youtube movie with the prospect of Greece having to sell off some of its Islands to balance its books.

http://www.youtube.com/watch?v=5DvuyvuHmJI

http://www.dailymail.co.uk/news/worldnews/article-1255449/Greece-debt-crisis-German-MPs-suggest-Greek-Islands-Acropolis-sale.html


Individuals are also getting themselves into greater debt, not so much to fund essentials but to chase the dream and enjoy a lifestyle that the magazines, soaps, credit card companies and the media shape for us.

When ignorance is not bliss

I don’t know about you but it seems to be open season with bankers now. Even some academics that were previously cheer leaders and yell captains for the banking industry are now sticking the boot in.

Some may say they have brought it on themselves. For example many people who have had minimal experience in a city bank or held a relatively junior back office role would wax lyrical to their friends about how they “were masters of the universe”. The worrying part is their level of understanding of their own business. Don’t take my word for it, ask one of your colleagues in banking to explain in simple terms how a collateralised debt obligation works, a credit default swap or the benefits to the greater good of a special purpose vehicle. I wish you the best of luck.

I had the pleasure of hosting a banking recruiter last year who gave a fantastic presentation, whipped our students into frenzy and looked immaculate in designer Prada wearing shoes that would cost more than high street bank teller’s weekly wage. At the end of the presentation we chatted over coffee and I asked her opinion on the Hank Paulson’s backing of AIG versus leaving Lehman brothers out to dry.

Naively I was expecting a robust defence in favour of the greater good of overlooking Hank Paulson’s apparent conflict of interest as a former CEO of Goldman Sachs which had over $10,000,000,000 exposure on AIG and minimal exposure with Lehman.

The response I got was “who is Hank Paulson?” Doh! Honestly you couldn’t make it up!

This part of the wizard of Oz better than any other summarises the arrogance of some individuals in the banking sector. The credit crunch of 2007 followed by the seizing up of inter bank lending in autumn 2008 cruelly exposed the hubris and narcissism of the banking industry.

http://www.youtube.com/watch?v=NZR64EF3OpA&feature=related

Dorothy: “you are a very bad man”
Wizard: “No my dear I am a very good man but a very bad wizard”

A colleague of mine Greg Pytel an expert on the banking crisis who has greater insight than most is a lot more scathing and equates the mid and lower level staff akin to African Child Soldiers.

http://gregpytel.blogspot.com/2009/10/economist-exonerate-bankers.html

As much as we would like to blame the bankers for everything, we need to look to ourselves. We all want cheap credit, we all want to keep up with the Jones’s, we want exotic holidays, we want that dream home. Where is the money going to come from?

A reformed banking sector with long term incentives is still vital for our future.

Eighteen months ago I posted on a banking blog about the need for global regulation rather than country specific or regional regulation. The news at Davos regarding this is very encouraging.

http://www.philly.com/inquirer/world_us/83184732.html


My next blog will focus on the changing expectations of society during the noughties.