My friend and colleague Pro Prem Sikka has a great artcile in the Guardian today. At its core is this paragraph:
The UK's GDP is about £1.5 trillion. Just three UK banks — Barclays, HSBC and Royal Bank of Scotland (RBS) — alone have a derivatives portfolio, with a face value totalling nearly £100 trillion. Barclays leads the way with £43 trillion. It has recently reported a third-quarter loss of £47 million, but its balance sheet points to a more serious position. Barclays' last full-year accounts show assets of £1.56 trillion and capital of only £65bn, meaning that its gross leverage is nearly 24 times its capital base. A decline of just 4% in asset values would wipe out its entire capital. Barclays' balance sheet shows gross exposure to derivatives of £539bn, though the bank could argue that this is offset by hedges of £528bn, leaving a net exposure of £11bn. The difficulty is that the hedges, as Lehman Brothers, Bear Stearns and Northern Rock have learnt, do not necessarily work in the desired way and always depend on the position of the counter parties in a highly unpredictable environment.
There's a time bomb sitting under banking. The problem is no one knows how long the fuse is, or how to stop it burning.
It's only time until the next crash; that it will happen is certain at present.
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The DT reports that ‘British banks are to be forced to raise tens of billions of pounds in fresh capital as a result of new accounting rules due to be announced early in the new year.’
The report says that:
New accounting rules require billions in fresh capital
and
Financial lobbies will oppose move to transparency
http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/9653529/British-banks-face-new-crisis-as-a-result-of-accounting-rules.html
One wonders why the resistance towards greater transparency. What are the banks really hiding? Could this move be the spark for the forthcoming crash of all crashes? Could this reveal the real reasons why LIBOR was rigged?
The shadow banking system means that slight changes in LIBOR will have huge ramifications. “Unlike the conventional banking system, the shadow banking system is largely unregulated… That is what happened in September 2008 following the bankruptcy of Lehman Brothers, a major investment bank…it was a run on the shadow banking system that caused the credit collapse that followed. Investors rushed to pull their money out overnight. LIBOR–the London interbank lending rate for short-term loans–shot up to around 5%. Since the cost of borrowing the money to cover loans was too high for banks to turn a profit, lending abruptly came to a halt.”
Banks seem to prefer to use the repo rate, as opposed to LIBOR, as their preferred measure of ‘true’ costs as this links up to the shadow banking system closely (think Collateralised Debt Obligations, Credit Default Swaps and all those other securitised loan deals, linked up with pension funds, insurance funds, etc, all that stuff that nobody, not even the banking sector, really understands) as this is usually a lower, longer term measure. The BoEs official interest rate is the repo rate.
There appears to be an axiom that the bigger the gap between repo rates and LIBOR, the larger the market stress. It might follow then that at a time when stresses in the shadow banking system were appearing, repo rates might start to be less attractive; manipulating LIBOR upwards would make repo rates seem more attractive in comparison, meaning that investment and dealing continued to take place in the shadow banking system, the world of sub-prime deals, CDOs, CDSs, etc. And of course, LIBOR linked loan deals, especially business loans, would yield more for the banks at the same time, which in turn fed into the connected shadow banking system as the loans came on stream.
While soaring LIBOR rates were a key indicator of market stress during the credit crunch, the best indicator of collateral crunch intensity is instead the repo rate. The lower the rate, the greater the crunch. The wider the spread between LIBOR and the secured (repo) rate, the greater the general distress in the market. Because markets view a big gap between repo and LIBOR as an ominous portent, banks, in order to hide that fact from governments and the markets, would then have sought to manipulate LIBOR down to reduce the gap between repo rates and LIBOR to downplay market stresses, hiding their own exposure to toxic debt and the wider market, in the hope that LIBOR linked rates would seem more attractive compared to repo rates, distracting attention from the exposure to shadow banking debts. However, it seems that banks were then involved in a Mexican stand off; they all knew, or suspected, how exposed they all were to these debts and the effects that would have on the wider economy. Yet at the same time, they still wanted to hide the true scale of the market stresses, knowing that to reveal the true extent would weaken their position and lead to flight from the banking sector. Hence their unwillingness to loan. Hence their love of QE.
The shadow banking system is worth many trillions; the worth of European repo contracts at the close of business on June 8, 2011, was $8.57 trillion. That was up from survey totals of $8.19 trillion in December 2010 and $6.42 trillion in December 2008, the post-crisis low.
As the repo market, and the wider shadow banking system, is so interconnected and interwoven with funds and investments that we all rely on, the true effects of the manipulations on the finances of the majority of the public may be very difficult to quantify, with so many investments, funds and loans involved; small changes in base LIBOR rate that might not seem significant to the new mortgage or loans market could have bigger ramifications elsewhere.
“GEAB N°60”
http://www.leap2020.eu/The-future-of-the-USA-2012-2016-An-insolvent-and-ungovernable-United-States-first-part_a9750.html
Interesting Richard. This appeared on our ABC 7.30 report last week:
http://www.abc.net.au/news/2012-11-01/former-wall-street-man-says-gfc-lessons-not-learned/4348472
Very interesting comments David. I’m just about hanging on the coat-tails of your argument. However the biggest takeaway I myself read from your explanation is that the spreading of risk, the hedging of positions, all of this complexity is one gigantic waste of time and mental energy. There have been a few lone voices (the NEF was one I think) stating that the City was just one great drain on the UK economy and at the moment it certainly seems to be functioning as a system to steal resources from pension funds, from interest rate spreads (borrow cheap, lend dear or foreclose), and from savers. Although it will cause extreme panic, this system has to go. Putting on my dunce hat for a moment…is there no way to shut down most of this useless activity by nationalising banks for as long as it takes, by guaranteeing deposits up to a certain level with the proviso that people can only take out so much per month in order to maintain some relation to the level of economic activity of today, larger sums would need approval in much the same way as a loan works, so that everyone can continue to go to work, get paid, no queues for bank runs, all business accounts are allowed to continue based on an average of recent activity, govt. can provide the basic backstop through the Bank of England as per normal (I’ll stop now because my ignorance must be making people want to trash this), but each bank’s books get fully inspected as bankrupt organisations to see where the malfeasance lies and so a whole load of notional value, stolen by elite bankers can be wiped out in order to bring on a new generation of professionals to run these things properly.
I see all this complexity and desperately trying to understand what’s going on, I don’t want these things to fail but what is going to stop this? If the mother of all crashes occurs because of the complexity of what should be a dependent system then the aftermath is so eminently unnecessary that it beggars belief we are headed this way.
Apologies for showing my ignorance but is there no middle way between the let’s buy some land in Canada and await the end of civilization of the doomers who comment at Zerohedge or the business as usual of these criminals running the financial system?
Will the Courageous State have to step in I wonder?
Of course, I am also a layperson so my comments only relay my views and observations of the current terrain and how that will affect our future journey. I hope I’m wrong. I never thought I’d say this, but I could do with gaining a close acquiantance who works in economic analysis to tell me completely truthfully the real likelihood of my hypothesis. However what seems to be agreed is that our country seems to be the one most stubbornly refusing to budge on any kind of meaningful reform; even the much called for act of splitting up banking operations is seen as an impossible and dangerous move by many in government/commerce. Yet, the UK seems to the epicentre for some of the worst practice, from PPI mis-selling to LIBOR fixing and large scale, big bank facilitated money laundering. Together with the fact that the size of the UK financial services sector is over 5 times annual GDP (compared to two-thirds annual GDP in the USA) we can see that if what I’m saying does have any element of truth about it, the UK will be the sparking point, the epicentre. Liam Halligan makes some good comments in his DT column here.
http://www.telegraph.co.uk/finance/comment/liamhalligan/9653286/A-man-with-the-vision-to-lead-the-Bank-of-England-forward.html
What I’m essentially saying is that during the early stages and at the height of the crash, LIBOR manipulation could have been used by the banks as a panic measure to save face and muddy the waters on their debt exposure.
PhilJoMar
I think we’d would like to see such an option. I think it was Stiglitz in his book Freefall who said that if the shadow banking system chose to operate outside the auspices of the regulator. then their contracts should not be enforceable. this sounds good but could it be done?
However, almost all of this wealth is digital and if it all disappeared tomorrow the real wealth in form of skilled people,plant. land and raw materials would still be there. Money is a claim to resources and a store of wealth. Is it feasible to wipe out the derivative obligations and distribute a limited amount of purchasing power to prevent chaos? This would imply a strong-or desperate- govt. Or a number of governments working together. It is difficult to see how a bottom up movement could work unless it could take political power. Sounds like I’m advocating revolution but they usually lead to enormous suffering. So we need a new movement bringing together a coalition of those who can create a practical program of radical change. Two party and first past the post voting systems-could they deliver change? I wish Is had more answer and fewer questions.
Excellent blog David.
Phil you put your finger right on the issue. The financial sector has become a massive uncontrollable parasite. It does not create real wealth merely an illusion of wealth.
Profits were taken on the back of this illusion, yet when it showed a modest wobble, the losses were socialised with states being coming lenders of last resort and hence the ordinary working taxpayers underwriting these losses.
The shadow banking system must be closed down. How can there be any justification for its existence? It displays all the worst facets of capitalism.
Years ago Warren Buffet quite rightly described derivatives as “weapons of mass destruction”. I would trust his judgement more than the so called “experts”.
I described the most recent crash as a wobble, when derivatives finally unwind, the mess will be on an unimaginable scale, given the size of the financial sector in comparison with the real economy, which underpins it. ,The latter doesn’t look too healthy at the moment!
What a brilliantly simple solution to put a brake on a whole lot of socially useless and economically dangerous activity. In effect it would simply mean disallowing certain activities being conducted through limited liability vehicles. Now, which politicians will be courageous enough to champion it?
Since the majority of secured loans are predicated on land values (think mortgages, equity release, business loans) it would be interesting, to know just how much of global debt is owed by landowners. Of course LVT would extract all this value for public benefit. The mind boggles as to what this would mean for the global economy if enacted in one major economy.
Given all the above, is it not time a new term was created to describe the financial sector? Not, as they themselves and their useless fellow travellers in politics and the so-called ‘think tanks’ , as wealth creators, but as wealth expropriators, sucking the real wealth out of the real economy to pay for the collapses caused by their activities in a wholly false economy.
Maybe those not involved with it, in any way ?
Now, how many is that ?
Quite frankly this is just silly – the balance sheet amounts tell you nothing whatsover about teh derivative exposures – they are just the fair value/MTM values of the derivatives at the reporting date. The face value of the underlying derivative contracts also tell you nothing as to regards what the potential exposures are and how they may or may not offset each other. The gross leverage figure of 24 is meaningless – and given the way the capital rules work it could never be as much. There are plenty of criticisms of the level of bank’s risk exposures, how they might be measured, and the capital requirements fro such exposures – but a rather higher level of knowledge is required in order to understand the exposures and their nature if the criticism is to hit home.
Ah, so being a senior professor of accounting is not enough?
Or maybe it is- to say the Emporor is naked
The privilege of limited liability was first granted to companies and their owners some 150+ years ago. Not everyone thought it was a great idea at the time. But those arguing that it would promote economic growth and hence income and wealth creation won the day. And they were right. BUT limited liability for one’s losses is an immense privilege and benefit, to those who are protected. Perhaps it needs to be withdrawn where it is not serving its purpose of creating and distributing wealth acceptably, and is being used to enable extremely risky wealth extraction (great term, thanks for it!) ploys, which enrich the few when they work (recently even including Mr Buffett?), and impoverish the many when they do not.
If this sort of basic redesign of the company itself was coupled with other feature redesigns, including democratic accountability of the Directors and their financier chums, to all those categories affected by the company’s actions, then we might get this ridiculous financial bubble lanced and healed.
Anything in this systemic approach, or is it way off track?
Tim
Tim
It is was on track
Richard
David, the politician who does what he was elected to do, represent his constituency rather than capitulate in the face of extreme pressure from others. You may have been alluding to Prem Sikka’s article in the Guardian so our brave politician might sponsor an immediate Act of Parliament requiring all investment banking activities to be, within the shortest feasible timeframe, either conducted via an unlimited liability corporate entities, with full liability accepted by each and every one of its owners – a la Lloyds syndicates – or liquidated.
This would require substantial forethought and detailed planning to overcome inevitably dramatic consequences but surely it’s better to face down the problem before those consequences have to be aced with nothing already in place.
What problem ever got better through simply ignoring it?
Max Keiser says there is the potential for another meltdown and also that the City of London is the epicentre of financial corruption. Many of the worst US financial scandals happened via Wall Street’s back offices in London.
http://www.informationclearinghouse.info/article32936.htm
”
I have managed to get to this point without revealing that, due to the commercial property losses not fully revealed on our banks and likely derivatives losses, I think that they could easily be insolvent. Adding this to the list of problems above shows the scale of the problem that we face, especially as there is little or no sign of a genuine change of culture. I gave my views as to what we should do just over a year ago in the article linked to below”
http://notayesmanseconomics.wordpress.com/2012/11/02/is-there-still-something-rotten-in-the-uk-banking-system-i-think-so/