European Bailouts And The Structure Of The Financial System

There has been a lot of news recently about European bailouts, sit-ins and protests around St Paul’s (there is also an anti-capitalist camp by Grey’s Monument in Newcastle and probably elsewhere, but as usual London-Centric news of the UK largely ignores all those in the rest of Britain) and austerity measures in Greece, then maybe Italy, Governments changing in Greece and Ireland, soon Italy and so on.  But strangely very little is made of where all this money has gone – trillions of pounds, Euros and dollars have vanished, but where have they gone to.  I know that capitalism is about creative destruction but that is destruction on a colossal scale.

In any case since the crisis commenced in 2007 when the world woke up to bankruptcy at the heart the banking system and then later to poor credit of nation states like Greece, I have been pondering the causes and the solutions to the issues.  And while I have very few answers, I have changed my mind on a number of things and one of the main ones relates to the structure of the system, and in particular regulation.

Firstly, let me dispel an important myth.  At its heart, banking and investment banking is not a difficult area and is not that complex, nor is it that interesting and exciting.  Overall, it is a low risk and rather boring type of business activity; I expect some will take issue with that point of view however real banking is prudential and understated.  It does not make anything, but serves to facilitate other people to do things whether it is a government to build a school, or you or I to buy a house, or it looks after our wages until we can do the weekly shop or so we can save for our pensions.

This underlying dullness is perhaps the start of the problem as bankers and investment bankers have sought to make their lives more interesting, so they changed the nature of their business by taking on extra risk to make an excruciatingly boring way of life much more exciting.  The question then becomes how and why were they able to increase systemic risk within the financial system and so bring nation states to their knees with their reckless financial engineering.

I think the answer lies with the regulations put in place by governments, together with an unwitting collusion between governments, regulators and those in the financial sector.  What has happened is that unregulatable monopolies have been created by the regulations themselves; financial businesses appear complex because of the regulatory environment and as the regulations become more complex, financial institutions (whether investment bankers, bankers or auditors) work at ways to get round or benefit from the regulatory environment.  It is a bit like computer hackers and creators of viruses who are constantly trying to beat the firewalls and security systems that exist, appearing one step ahead as they seek mistakes and flaws in the Microsoft or antivirus programs.  And similar to the financial sector, because we (the uninitiated) do not know the language or understand the rules or know the players, therefore we cannot simply go up to them and say quite simply “stop messing with our computers” or “don’t use my savings or taxes as collateral for that”.

So my view is simple – reduce and simplify the regulatory environment for financial services, so that normal people can (a) understand what is going on; and (b) have a voice to be able to say “don’t use my money for that”.

Now most regulators and investment managers will pat me on the head and say “now, now, you simply do not understand the complexities, so why not go back to your day job”, but I say the problem is that those who are meant to be scrutinising the systems are actually part of the system nor do they own the money that is being used as capital, which belongs to depositors whether direct or indirectly via pension schemes or taxes etc, but benefit in terms of wages and salaries from keeping a complex status quo.  And to those who say it is complex – no it is not, investors are simply making judgments about what shares to buy when and where, or bonds or whatever – that is pretty basic stuff and is really a matter of investment quality, an understanding of human behaviour and, frankly, a good old punt*.  But it is a bet with other people’s money.  For example, MF Global collapsed because it made £4 billion in big bets on Eurozone sovereign debt that went wrong, while Bear Stearns collapsed due to overexposure to sub-prime mortgages.  The clue is that regulatory systems does not stop these investment banking collapses nor does it pick up credit issues due to poor loan quality with commercial banks until after the event like at Dexia, HBOS, Royal Bank of Scotland or the need for extra capital like at ING or WestLB – just as a few examples.  They are simply too close to the action, in fact they are part of the system itself and are not independent from it.

Will anyone change the system.  Of course not, because it would mean losing many highly paid and important people losing their jobs!  And also, because governments need these systems to create “money” for them to finance their own pipe dreams.

*  There are parts of the industry that try to minimise risks by manufacturing insurance-style instruments that seek to mitigate downside risk for some business areas or hedge, but most of these instruments are purely used within the financial sector to create extra return, or to use the flip-side of extra return to increase systemic risk.  It is that link between return and risk that most people seem to just ignore – to increase the profits of an essentially boring and low return business sector (accounting, banking, insurance) you need to increase the risk level, then the question is who gets the profits and who bears the increased risks, and it is this basic division between who has the upside and the downside that has created the problem we suffer from.



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