With the banking sector almost permanently in the news these days I find myself wondering how a profession so evil has existed for so long. With all the grave robbing and infanticide I just can’t seem to see where it finds its recruits, or indeed how either of these activities makes any money. In truth though the bank has always been a bit of a go to bad guy; wealthy, fortified, ruthless and uncompromising it stands on every high street, with everyone in its pocket and little in their own. In the Wild West the gunslinger earned adulation for robbing them, modern reports of government clamp down’s earn political brownie points, and anywhere and everywhere they trip and fall we cheer. Mis-sold insurance policies, dizzying bonus schemes and fixing lending rates are just new sins to add to the original sin of usury, in what has become par for the course in an endless stream of PR kryptonite. Truly in the last few years the financial sector has found the tools to dig its reputation beyond rock bottom, all the way to Hell.
Things really came to a head after 2008 when the smoke and mirrors accounting that escalated unchecked over the previous decade was exposed. Essentially, central banks like the Bank of England and (especially) the Federal Reserve in the U.S. provided excessively cheap money to commercial banks, who then advanced credit to uncreditworthy customers, amid a haze of complicated financial instruments. The Fed in an effort to slow things down raised its benchmark lending rate from 1% to over 5% in the two years from 2004, and then maintained it at the new level until late 2007. The change was too dramatic, house prices plummeted as credit became unavailable again, and with it the liquidity of the banks for which so much of the credit had been assured against. The property bubble was burst, waitresses inevitably defaulted on their helipad repayments, and like the biblical cities of Old Testament, the banks began to lose favour with the almighty markets, one by one falling to their insolvency.
Bloated and ‘too big to fail’ the banks had been worshipping false economics, issuing household debt far in excess of total incomes, without even a fraction of the capital needed to cover their liabilities. The arch toads at Lehman Brothers were some of the most creative in these accountancy dark arts and thus first to slip on their own slimetrails, alerting the world to its impending financial fall. With so few commercial banks controlling so much of the existing money supply the fall was going to be a heavy one; a ‘balance sheet’ downturn; more than just a small trough in a large peak. Propped up by one another, with each prop bringing with it ever more convoluted loan arrangements, the blight spread across the globe. And it was not just the banks who suffered; with money the basic medium of exchange this made them an intermediary for just about everything else and the capital overreach spared none. Businesses of all levels began to crumple and consolidate as credit leeway hardened, good faith died, orders dried-up, and invoices arrived.
Filtered through companies the slowdown less trickled down to the ordinary person as fell like a thrown bucket of water, and with much the same effect on his deep personal finances slumber. For the everyman the banks became more than just the unhelpful people behind the long queues and automated phone lines, and they did worse than overcharge on an unplanned overdraft or deny an extra loan. Their recklessness cost him dearly in ways he hadn’t even considered: over the coming years taxes would increase to cover the burden of bailouts, the cost of living rose as companies lost their margins, and job prospects vanished as both private and public sectors shrunk. Resentment climbed in concert with the realisation of what was happening towards fever pitch and, as the mob cast about in its quest for blame, the targets became clear – the silk and super 100’s draped citizens of The Royal Bank of Sodom and Gomorrah Sachs.
Overtaking estate agents, bouncers and even traffic wardens as the dinner party stink bomb, the banker became a social pariah in a class of his own. The cartoonish slicked back hair, Mercedes SLK’s and amphetamine abuse were gone, giving way to a new, nastier, more furtive sliminess. Good old fashioned arseholes turned into contemporary scumbags, sufficiently reviled that politicians and lawyers now have the stones to call them out publicly (hardly masking that it was really their absent policy and slack litigation which allowed circumstances to get out of hand in the first place). In fact so burning is the hatred for banks now that seeing the tearful denizens of Canary Wharf ejected, clutching cardboard boxes filled with stationary, we called for the pillory. And we laughed; throaty, happy laughs filled with the schadenfreude usually reserved for a Disney movie bully getting their humiliating just deserts.
Calming down for a moment though a few questions nag, taking the edge off the enjoyable self-righteousness. How infernal are banks actually? How terrible are the algebraic spells being performed over where all the fingers are pointing? How demonic is the creature left after sloughing off the slime and our own bristles of resentment? The difficult truth is ‘not very’ probably adequately answers all three.
During less propitious times it is only natural to look at the hundreds of feet of toughened glass and stainless steel with envy and anger, but two inch long toe-nails are natural and this doesn’t make them reasonable. They demand some cultivation, much like our hostility does in order to work. This is not a defence of the financial sector but a more objective look at what banks actually are and do. Some blame is confidently well deserved, but I think among the vilifications it has lost focus, losing sight of the real problems, and thereby hiding the possibility of redress. I’m going to start with a misleadingly simple question that I think the holy mob might struggle with: what actually is a bank?
A modern bank is a number of quite different operations under a common name. Most know of the split between retail and investment banking, but it breaks up way beyond that, making it unhelpful to talk of either banks or bankers generally. Roughly speaking: retail is your front of house, where you drop off your oversized whisky bottle full of coppers, negotiate a mortgage, query charges. Investment is an umbrella term sheltering a huge number of speculation activities, each of which with an even greater number of ways to do them. The divisions are linked to each other, a central reserve (the place where the money is printed, interest rates set etc) and, to complicate matters, often in syndicate or other agreement with competing banks. Nevertheless, with all the divisions, caveats and complications, the underlying function of a commercial bank remains unchanged since the ancient Assyrians bartered teeth: its role is moving money from where it is not needed to where it is.
For regular banking this takes the form of using money deposited by savers to lend to borrowers. The savers make money in the form of interest, the borrowers turn whatever it is they borrowed the money for into more than is returned as interest, and the bank skims off a percentage in either direction. Everybody is happy in theory if not in practice. Investment follows the same principle; people with more money than they are using at any one time part with it temporarily in return for the chance (risk varying with type of investment) to make a return in the future. The beneficiaries of the investment, having made lots more money using it, gladly pay the return. The bank in this case will either facilitate or bundle investments into packages and effectively sell those as individual ‘risk managed’ products at a profit to investors and other banks (again returning a slice for everybody and itself). We’ll spare the grisly details but let’s just say that this system is a cornerstone of the modern world economy.
What is important is that this does two related things beyond making everybody money: 1) it makes capital as a whole more effective (a basic economics principle about the efficiency of resources where it is inefficient for all the actors in a given system to have idle resources concentrated without a good reason), meaning more things can happen, better and more quickly. And 2) It creates opportunity. Loans in whatever terminology enable both a deferral of payment and the capacity to reach a potential not yet achievable, which allows for flexibility; and the capacity to be flexible is extremely important because the world is neither perfectly predictable nor perfectly fair. At its most mundane this means that you don’t have to worry that your Christmas pay check might not last 5 weeks because the bank will bridge the gap for you. On a larger scale it is the reason you can afford to buy a house before you die.
As the rewards magnify further so too do the risks. Investment has gathered a dirty quality to it but it is really just the same opportunity presented by loans on a larger, wider scale. It is therefore one of the great pillars of capitalism (also a dirty word among subscribers to the new Malleus Maleficarum) and is probably the single biggest reason a large project like a stadium or a powerplant can get off the ground. In fact whole countries depend on this same system of financial flexibility (usually through bond markets) to finance a war or for civil engineering projects, to construct the sewers under your feet, and the transport networks to get you between toilets. In a modern democracy it simply isn’t possible to achieve many of the things we take for granted without globally sourced private investment, and that means investment banks.
Investment banking has drawn attention to itself by making lots of money and using lots of slightly menacing terminology, but it is no more or less scrupulous than any other industry. If anything it produces industries; it’s a so called ‘market maker’, operating from the vantage of the most astute research and analysis available. It used to be that the investment arms of a bank concerned themselves with pretty dull domestic underwriting of corporate equity and debt securities, but it has since added: new divisions (e.g. mergers and acquisitions), new products (e.g. risk management tools like swaps), new ways of doing old business (e.g. securitization of illiquid receivables), new revenue streams (e.g. private equity, hedge funds etc) and engaged them all with an international community. The upshots for what the world economy is now capable of are staggering.
Part of the problem is that things like mergers and acquisitions sound sort of nasty (merging, acquiring), but whilst the aggressive exceptions grab the headlines the unseen majority are sedate affairs, with investment banks optimizing the price and the terms to satisfy each party. Leveraged buyouts, restructuring and reorganization all sound like shitting on the little guy but they are about making companies operate properly in the market they inhabit; there would be a damn side more bankruptcy’s and job loss if these functions weren’t performed. Risk management: swaps, futures, call or put options; all sound like carelessly playing pogs (or baseball cards if you are reading this in American English) using peoples’ life savings as the stake, but they are really just as the name suggests – risk management. These derivatives are about finding a more precise or reasonable level of risk for a given set of circumstances. A farmer might not like the way one crop is faring and enter a forward contract to smooth the effect a bad harvest has on his livelihood, returning the shotgun to its cabinet for another year. Banks are actually quite useful things – economic overachievers who do alright from themselves out of it to be sure, but not inherently bad as institutions.
If they aren’t bad by design though, with all the bad things we hear about in the news, the people who work in them must be turbocharged shit heads. ‘Surely we have found our wrongdoers now, the investment bankers. The people with the black cowboy hats, the horns and goat legs’, or so the assumption goes. But for all this conviction about who is at fault it is surprising how much people detest something they don’t really understand. ‘Investment bankers’ are themselves another fairly large group of different jobs but, at hate-knifepoint, one that can be split broadly into quants and the traders. As the finance geeks joke goes: “There are three types of bankers: those that can count, and those that can’t.” Quants are the ones that can, and brilliantly. Probably the largest single employer of physics and higher maths graduates, investment banking offers a natural playground for the numerically gifted. All day they analyse and calculate, submitting reports for investments which inform the banks’ and their customers’ operations. Retiring wallflower types their goal is to assess risk accurately and cautiously. All brains and no balls these aren’t our bad guys either.
The traders on the other are balls out, all three of them. Often young, aggressive and by job description motivated by money, these are the adrenaline junkies of banking with wildly fluctuating wages to match; bungee jumpers to the Sudoku champions elsewhere. Parochial incentives mean they exploit opportunities remorselessly, always looking for conflicts or crises to deliver the juiciest returns. Sometimes, when humanitarian crises are hard to come by, outright cheating becomes too tempting and they even bend the rules. At UBS in 2011 infamous rogue trader Kweku Adoboli manipulated a delay in a system safeguard fraudulently (allegedly), disguising the risk of his trades using forward-settling ETF cash positions, almost beggaring the UK branch. When petrol prices suddenly rise, this is often the result of traders artificially holding on to stocks of oil until the price has increased considerably in line with demand, then dumping stocks before the price mechanism has had a time to react. In the ichor of the oil markets stock owners do not have to declare their holdings making it very difficult for financial regulators to combat. There are of course countless other examples of these sorts of things.
However even trading is not characterised by these examples of wrongdoing, they are malign exceptions to a healthy rule. Hundreds of millions of trades happen all day every day and pass without incident. Like many of the other activities discussed, trading provides a vital role for the flow of capital and opportunity. In the case of trading the opportunity manifests itself as a secondary market for the quick ‘clearing house’ resale of equity, a bit like a used car dealership. This allows people to get on in life without grimly holding onto their old banger or necessarily running it into the ground. It also provides a safety net that stokes the primary market; if investors didn’t think they’d be able to sell it they may not buy the new car in the first place, and this again liberates capital from its stockpiles. Finally, while it sounds ridiculous, through what are called ‘short’ or ‘long’ positions (moving from low to high periods of demand) trading even allows money to ‘time travel’ (literally in the case of HFT).
The sum of all these banks, their divisions, their employees and their efforts is lots of money. Much of this is taken for the bank itself, but much much more passes through or is stored making us all richer. It is no accident that the early adopters of sophisticated financial systems subordinated their enemies throughout history: the Babylonians, Greeks, Merchant cities of Italy, the 18th Century Netherlands. Even today all the great financial centres are located in the wealthiest, most productive countries. The presence of banks means people and companies can find capital from anywhere in the world at any time, and choice means they can find better prices, strengthening the ties between countries and democratizing the flow of money internationally. Contrary to popular belief in a certain sense the modern investment banks even dampen risk as a wider pool of investment opportunities can mean a wider hedge. A company’s debt today need not be a death warrant and huge equity doesn’t have to mean monopoly as the banks blur the words in the middle. And these benefits apply to smaller levels of funds too; higher education isn’t reserved for the rich, you don’t have to sell your clothes for food when small mistakes are made, the class system in general is more not less transitory.
Even the banking crisis, whilst structurally speaking a banking problem, had at its root decisions closer to home. Any analysis which puts the supply of credit at fault is really hiding the direct line to demand; you can lead a horse to water … , fat people aren’t fat because biscuits are cheap etc. The point I’m making is that when house prices rose banks lent against increased collateral as they should. Yes it was shortsighted to not see that it couldn’t last, and yes some hid the extent of their vulnerability but it was our demand for things and thus credit which was the real driver. Remember that before the immediate run up to the recession the ratio of household debts to income was increasing beyond all precedent. Maybe, just maybe, we are partly to blame.
They may well be some of the most objectionable people, working in some of the most ostentatious places, but bankers and banks are really just a part of the swirling maelstrom of issues elsewhere. If anything their problem in recent years has been being too clever, becoming too good at what they do and getting noticed for it. In the always projective words of Nicholas D. Kristof: Just as Communists managed to destroy Communism, capitalists are discrediting capitalism.
To regain their credibility banks will need a more atavistic approach to their futures. They need to be forced smaller, maintain more capital relative to their liabilities, firewall their departments and keep out of the press. And fortunately the outlook is already good: regulations coming into force today should go some way to preventing repeats of the biggest blunders in recent years, and the rapid proliferation of the Islamic model (using money as a measurement of value and not as an asset in itself, greater ‘in it together’ obligations from investors etc) may offer much greater overall stability if it can become widespread. The devil will be in the detail and the banks will always be of the fourth circle, but banking itself is not a hellish business