Saturday, 11 December 2010

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

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