Everyone is blaming greedy bankers for the credit crunch – unless they’re Tories, in which case they’re pinning all the blame on the Government. But who is really to blame? And more important, what can be done about it?
I decided to do some research on this and I have come to the conclusion that investment bankers, although greedy and irresponsible, are not at the root of the crisis. That particular honour in fact goes to one man who has barely got a mention in the debate so far: Bill Clinton. Allow me to explain.
In 1933, the US Government, led by Franklin Roosevelt, introduced the Glass-Steagall Acts, which separated banks according to their type of business. They did this in the wake of the Great Depression, which had been caused in part by investment banks using customers’ deposits to play fast and loose on international markets.
These Acts ensured the stability of the banking system right up until 1999 – when Mr Clinton, acting on the advice of Alan Greenspan, abolished them. He did this to generate a credit boom, creating quick wealth and boosting his poll ratings. Greenspan’s main cheerleader in the old country, Gordon Brown, quickly followed suit by changing the regulatory framework of the Bank of England to allow investment banks to take over and trade with high street banks’ assets.
What happened next was that investment banks started using commercial bank loans and deposits – along with their knowledge of how credit risk worked – to create additional funds to lend.
Here’s a typical example. A mortgage bank with £1bn in savers’ deposits lends it to people who want to purchase houses (this is known as a loan book). Some of these mortgates are risky, others less so. The mortgage bank then sells half of this loan book to a merchant bank at a discount of 10% – to take account of the risk. The bank now has £450 in cash to make further loans, while the merchant bank has £500m in mortgages for which is has paid £450m.
In order to improve the value of its new asset, the investment bank manipulates the risk profile of the asset by taking chunks of the loan book and reassembling it with other loan books purchased elsewhere in a new way to make them look more credit worthy. Once this has been done, a ratings agency will give it a AAA rating, meaning that the merchant bank can now sell is £450m asset for £490m, making a profit of £40m.
The effect on the overall economy is that there is now £450m more to lend which is unsupported by savers deposits, and the investment bank has made £40m – leading to bonuses all round! All that has changed is the risk level. The main reason Lehman Brothers went bust is because they insured a lot of these so-called ‘toxic debts’. When the loans defaulted, Lehman’s had to pay out twice: to the investment bank and to the purchaser of the loan.
As we all know, the Government lent the banks £50bn of taxpayers’ cash to try and put an end to the matter. But, because of the scale of the problem, this is drop in the ocean. All it will do is cover the banks’ outstanding loans and sure up their balance sheet. Banks can’t extend credit because they need any cash they get to cover their existing loan commitments, which have disappeared into the system.
There are realistically only three ways the Government can get the banks to start lending again (and thus end the recession).
First, by lending them the value of the capital assets of the banks PLUS the value of existing loans. This is around £700bn – considerably more than our annual GDP.
Second, by restoring confidence in the banking system and getting them to start lending to each other – which can only happen if banks start attracting deposits (something that won’t happen while interest rates remain at 1% and consumer confidence is at a low ebb).
Third, by nationalising the banks which are at most risk and providing them with capital that does not cost them an arm and a leg. They can then be directed to lend appropriately, to small businesses so desperately short of working capital. There are currently two banks in this position: Lloyds-HBOS and the Royal Bank of Scotland.
* Joe Taylor is Liberal Democrat Organiser for Camborne and Redruth.
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5 Comments
Nice article.
But have we all got a bit dim? Why is the font in such a huge format? Did it all get put in bold because people are struggling to read things on this site? DO I NEED TO START TYPING LIKE THIS?
I agree with almost all of the article – Clinton and Greenspan were financially reckless, Brown dutifully followed on their coat tails. The one error though is the one near the end, where it says “There are realistically only three ways the Government can get the banks to start lending again (and thus end the recession).”
The problem was that the mortgage banks and investment banks used the apparently cheap sources of finance to lend ever increasing amounts to people (including each other) who were uncreditworthy and so couldn’t pay back he loans. This created unsustainable growth, and this growth is now being reversed, as the increased demand brought about by the loans has now gone. Lending to new people who can’t afford to repay is not an option. Demand has fallen; hence manufacturers are reducing production to deal with excessive stock levels.
There is no ‘if the banks start lending again the recession will end’. All we can do is ensure good businesses are not driven out of business by loans being withdrawn or not renewed. We, as a society, have binged; now we have a big hangover.
Kind of agree – it’s pretty clear Lloyds TSB is currently a going concern – making £1.7 bn profit last year. Its less clear, but probable, that the Bank of Scotland part of HBOS is also a going concern.
I’d be tempted to do three way demerger – hive off the profit making bits (and give Scotland back one of its oldest institutions) and take the toxic bit off to deal with in the same way as Northern Rock.
I’d suspect it might cost the tax payer less than nationalisation of a part profit making/part basket case bank
Hmmm!
It is correct that Clinton abolished the Glass-Steagall Acts at the instigation of Alan Greenspan and others but even that only makes him a bit part actor in the drama.
There were many, many milestones on the road to perdition of which probably the most important single one was the decision by the Securities and Exchange Commission (the US regulator) to allow the big banks to set their own reserve ratios on the basis that, as big and sophisticated institutions, they would be sensible and prudent in doing so.
If only! In reality they were about as imprudent as they could possibly be. Moreover, many commentators consider that there were epic amounts of outright fraud going on at the same time. Following Lehman’s bankruptcy there was found to be a $100 billion black hole in its accounts.
But, more important than all these has to be the intellectual climate in which the whole thing was allowed to spiral out of control. This comprised an incendiary mix of crony capitalism that flowered under Bush (although already well established before him) and a naive and deluded faith in the godlike wisdom of ‘free’ markets. The failure of rival political voices to develop, articulate and promote a coherent alternative narrative left the field by default to the power-elite behind Bush. They were able to go on making up the rules to suit themselves (and yes, manoevering Clinton into abolishing Glass-Steagall). Incidentally, it is precisely because rules were being made primarily to suit the power-elite’s agenda that income and wealth inequality grew so much in these years.
But what really worries me is that liberals in the UK do not, by and large, seem to me to have learnt the really important lesson, namely that liberal circles generally, and Lib Dems ones in particular should be the ‘Silicon Valley’ of progressive thinking; a focus for developing a tough-minded, coherent narrative that can stand as a clear and electable alternative to the self-serving nonsense being dished up by the power-elite. Absent a coherent liberal narrative we too will leave the field open by default to the election of Cameron and Co which would amount to little real change.
That the Lib Dems still have so poor a narrative and so little debate around it (other than a few trusty themes) represents a quite remarkable failure of succesive Lib Dem leaderships.
Interesting stuff! As I suspected, bad regulation is at the heart of the problem. And we know where the blame for that lies!