by Felix Martin
The shift was most pronounced in the U.S., where securities-based finance had always held a stronger position than in Europe. In the early 1980s, around half of debt capital to U.S. companies was still provided by banks.23 From the middle of that decade, however, the share of finance arranged instead on the credit markets began to rise. The Savings and Loan crisis of the late 1980s and early 1990s gave this shift a major boost. With a large part of the commercial banking sector in repair mode, the credit markets took up the slack. By the end of 1993, they accounted for more than 60 per cent of U.S. corporate debt finance. A decade later, their share reached 70 per cent. And not only the scale, but the scope, of the credit markets was being transformed. When Michael Milken was almost single-handedly creating the market for bonds issued by small or risky companies from his famous Beverly Hills office in the early 1980s, few would have predicted that two decades later issuance of what were then derisively called “junk” bonds would grow to U.S. $150 billion a year, and displace a substantial part of the banking sector’s financing of Main Street U.S.A.24 An even bigger revolution was taking place in the provision of debt finance to individuals. The development of techniques for pooling and securitising large numbers of mortgage, car, and credit-card loans to individuals generated a near-total shift in the organisation of these types of debt from banks to credit markets. It was a dramatic and fundamental change in one of the most basic functions of the capitalist economy. The days when mainstream finance was the business of banks and the debt capital markets were an obscure specialisation were gone for ever. In 1968, Sidney Homer had been able to lay out in three pages of The Bond-Buyer’s Primer, his celebrated insider’s guide to the debt markets, all the important U.S. corporate bond issuers in existence.25 There were so few that they all had their own nicknames, speaking quaintly to the simplicity of the corporate landscape of the day: “Rubbers” for the bonds of U.S. Rubber; “Steels” for the bonds of U.S. Steel; and so on. By the late 1990s, such familiarity was unthinkable. There were now tens of thousands of bonds issued by many thousands of issuers—and when the legal structuring was peeled away, most were no longer U.S. household names but just plain U.S. households.
This was just the beginning. In the 2000s, the business of securitisation—the bundling together of many smaller debt securities to make new, larger debt securities—took off. Mortgages, car loans, corporate loans, credit-card debt—any kind of credit could be packaged up, sliced into tranches, assessed by a ratings agency, and then sold on to a new set of investors. The borrowing of money via the credit markets had once been a simple transaction: a bond issued by a company with assistance from a bank was bought by an individual or an institution. Now it could be much more elaborate. A company could still issue a bond. But rather than being bought by the end-investor, it could instead be acquired and “warehoused” by another company specifically established for the purpose. That company could then issue asset-back commercial paper (another type of debt security) to a special-purpose vehicle (another type of company) whose liabilities would in turn be “warehoused” by a fourth company, whose own debt securities could be bought by another special-purpose vehicle which would use it to back collateralised debt obligations (yet another type of debt security) that would be purchased by a hedge fund and finally used as security for a loan from a money market mutual fund. Only then would the end-investor rematerialise, just in time to buy shares in the money market mutual fund and thereby provide the cash which would in the end wend its way back up the chain to the original issuing company—less fees, of course.26
This enormous increase in complexity left those weaned on Sidney Homer’s Bond-Buyer’s Primer perplexed. What was the point of it all? They were summarily dismissed as quaint, old fuddy-duddies. Under the powerful spell of the orthodox, modern theories of finance and macroeconomics, the prevailing wisdom was that these innovations represented the royal road to everything from lower mortgage rates for homeowners to greater macroeconomic stability. The International Monetary Fund delivered one particularly memorable verdict in 2006. “There is growing recognition,” it said, “that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped to make banking and the overall financial system more resilient.”27 The new arrangements would moreover “help to mitigate and absorb shocks to the financial system” and amongst their manifold benefits would be “fewer bank failures and more consistent credit provision.”28 But the real shortcoming of such confident predictions was not their over-optimistic appraisal of what they thought the new arrangements in the credit markets were doing. It was the fact that what they thought the new arrangements were doing was not the main story at all.29
The conventional wisdom assumed that the innovations of the late 1990s and early 2000s were transferring the role of banks in the creation of credit, but not in the creation of money, to the credit markets. It was an easy enough assumption to make. The global mutual fund industry had, after all, existed for decades to collect savings and select creditworthy borrowers for them. The new arrangements had just increased its size and scope. The business of maintaining synchronisation between payments on long-term assets and short-term liabilities—the management of liquidity risk, the thing that allows bank liabilities to be money—that, it was assumed, remained the unique preserve of banking. After all, only banks have charters from the sovereign, and only sovereigns can make credit into money. Right?
It was a story that would have seemed horribly naïve to anyone familiar with the history of the Monetary Maquis. Small-scale curiosities like community currencies show that private money can exist without any help from the sovereign. The episode of the Irish bank dispute and the precocious success of the sixteenth-century merchant bankers in manufacturing private money demonstrate that scale is not necessarily an obstacle. History proves that the power to issue money is an irresistable lure. If sovereigns allow it, whether by commission or omission, private issuers will take full advantage. The decade before the crisis was no exception to this general rule. To the student of the Monetary Maquis, the only real question would have been how the new arrangements on the credit markets could be pulling it off. The key to issuing money is the ability to make the magic promise of both stability and freedom. The sovereign can do it because it has authority. Community currency clubs are able to do it because they share an ideology. Under the Great Monetary Settlement, banks were able to do it because they combined creditworthiness with the endorsement of the sovereign. But how could it be done outside the regulated banking system in the wide world of the modern credit markets? How could the ability to create and manage private bilateral credit outside the regulated banking sector be transformed into what had been the Holy Grail of private bankers since at least the time of Nicolas Oresme: the ability to create private transferable credit—private money—without the annoying constraints imposed by the policies of sovereigns and their assorted central banks and regulators?
The answer turned out to be surprisingly simple. It was to make everything surprisingly complicated. With a chain between borrower and end-investor involving seven legal entities in several jurisdictions issuing seven different securities rather than one issuer in one jurisdiction issuing one bond, a sleight of hand could be achieved. Somewhere along the long line of intermediaries, the critical issue of the synchronisation of payments could be conveniently fudged. The traditional credit market transaction, between end-investor and borrower via the medium of a bond, had been stolidly transparent on the matter of liquidity. Buy a three-year bond, and one’s money was tied up for three years; buy a ten-year bond, and see it tied up for ten. Of course, if one wanted one’s money back sooner, one could try to sell one’s bond before it matured—and in normal market conditions, one would be able to. But there was nothing in the prospectus to guarantee this surrogate source of liquidity. There was a clear and simple link between the liquidity terms bought by the end-investor and the liq
uidity terms promised by the borrower. Like a manual transmission gearbox in a car, there was a simple, mechanical connection between what you chose and what you got.
The new style of credit market transaction was different. The end-investor could buy a share in a money market mutual fund that promised conversion to cash on demand—the credit market equivalent of a bank’s demand deposit. The borrower, meanwhile, could promise a bond that repaid in ten years. The awkward liquidity mismatch between the two could then be systematically obfuscated somewhere along the long chain of counterparties. Like a car with automatic transmission, few were equipped to understand exactly what was going on inside the box, even if the ability to shift gears without any actual effort from the driver is, when one thinks about it, rather remarkable. As for consulting the owner’s manual, that would have done no good at all. The theory behind the new arrangements didn’t concern itself with anything so trivial as money. And in any case: since it all seemed to work, who cared?
As with the demise of the Great Monetary Settlement, it was only when it was too late that the truth of the matter was discovered. The decades of specialisation and the division of labour had led in the financial sector to something much more revolutionary—and less innocent—than they had in other industries. The displacement of traditional banks by a disaggregated network of specialist firms linked together by complex supply chains, had not just been about greater efficiency, more choice, and better value, as it had in the car or mobile-phone industries. It had been about the reanimation of the Monetary Maquis: the discovery of a miraculous new means of creating private money outside the control of government. The result, by 2008, was nothing less than a parallel monetary universe: a vast, unregulated, “shadow” banking system organised internationally within the credit markets, alongside the regulated banking systems of nation states. In the U.S. alone, the balance sheet of the shadow banking system stood at around U.S.$25 trillion on the eve of the crash—more than twice the size of the traditional banking system.30 In Europe, where securities markets, like automatic gearboxes, have always been less popular, the new “Army of Shadows” was less numerous—accounting for a mere EUR 9.5 trillion.31
It was only in the teeth of the crisis that these magnitudes began to be grasped and the true size of the challenge facing the world’s central banks and sovereigns became clear. Not only was the Great Monetary Settlement in tatters, and the traditional, regulated banking sector rapidly swallowing up billions of dollars in credit support, but there was a gigantic and previously unaccounted for shadow banking sector as well. The failure of this monstrous parasite would kill its host: it could no more be allowed than the collapse of the traditional banks themselves. Liquidity and credit support would have to be extended to it as well.32 The result was the bizarre sight of the U.S. Treasury providing credit support to an insurance company, and an expansion of central-bank balance sheets on an unimagined scale, as they absorbed the liquidity risk that banks and shadow banks had proved unable to manage alone. In the six weeks between 10 September and 22 October 2008, the balance sheet of the Federal Reserve doubled and the Bank of England’s more than tripled.33 The European Central Bank was initially a more reluctant saviour—but in time it too found itself having to backstop the broken promise of liquidity transformation made by both the traditional and the shadow banking sectors.34 Analysts expressed horror at this expansion of the money supply, warning of the imminent approach of hyperinflation, the collapse of the U.S. dollar, and the eruption of currency wars. But these lurid fantasies started from a mistaken premise. The news of what had really been happening was only beginning to leak out. The money had been there all along—it had just been hiding in the shadows.
With this coup d’état exposed, attention turned to the sovereigns’ response. The U.S.$25 trillion question, it seemed, was whether the regulators have the firepower to bring the system back under control. In the next chapter we will discover the answer.
15 The Boldest Measures Are the Safest
MONETARY COUNTER-INSURGENCY
The Great Monetary Settlement has become a one-way bet for banks, and the Monetary Maquis has been busy on a scale unparalleled in history. The last four decades, it seems, have seen monetary society burst its political bonds as never before. It is therefore no surprise that counter-insurgency is the order of the day. What might seem a little more improbable is that the global headquarters of the regulatory rapid-reaction force should be a provincial town in north-west Switzerland. The primary international forum for the co-ordination of financial regulation is the Basel Committee on Banking Supervision, based at the Bank for International Settlements—the so-called central bankers’ bank. When the crisis struck, Basel was therefore the first port of call for defining a new regulatory response. It was in Basel, after all, that the most important conventional regulatory weapons to mitigate moral hazard had been designed: rules requiring banks to keep a specified quantity of cash or highly liquid securities in their portfolios to reduce the chance of needing to borrow from the central bank, and others requiring banks to maintain a buffer of equity capital sufficiently large that they would not fail in the first place.1 But over the course of the twentieth century, the size of the protective capital buffers maintained by U.S. and U.K. banks had been allowed to fall by a factor of five.2 The proportion of cash and highly liquid securities in their portfolios has fallen by the same amount in only the last fifty years.3 Basel’s diagnosis was that there was nothing wrong with these tried-and-tested weapons per se, but that more firepower was needed. In December 2010, a new directive requiring banks to hold more capital and more liquid assets in their portfolios was therefore agreed.4
The picturesque Swiss town of Basel: the unlikely headquarters of the world’s monetary counter-insurgency operations.
(illustration credit 15.1)
Requiring increased holdings of equity capital and liquid assets acts as a tax on risky activities. Make it more costly for banks to gamble and limit the tables at which they can play, the basic argument runs, and a healthy equilibrium can be restored. On this view, the regulatory challenge is a schematic one, familiar from any industry which generates private benefits but also social costs. A chemical manufacturing plant, for example, might generate profits for its shareholders and salaries for its employees, but also waste products detrimental to the local environment. If the factory isn’t made to bear the costs of this pollution, it will enjoy a free ride, and therefore produce more than is economically justified. The solution is to impose a tax that ensures the polluter pays the full economic cost of its production.5
Many in the regulatory establishment are, however, sceptical that the deep problems revealed by the crisis can really be met successfully by conventional warfare of this sort. The pollution caused by the banking sector, they warn, is not like the pollution caused by a chemical factory, for two reasons. The first is simply the scale of the problem: the potential social costs of operating the monetary system as currently configured are simply too large to be discouraged through the tax system. Recovering the direct fiscal costs of liquidity and credit support might just about be plausible via a levy on the banks—albeit one that would wipe out most of their profits.6 But the full bill for the financial instability that came home to roost after 2007 includes the costs of lost GDP, of mass unemployment, and lost capacity. These run into the tens of trillions of dollars: they are, practically speaking, uninsurably large.7 If we stick to conventional warfare, in other words, victory would require an atom bomb so large it would destroy the Earth.
The second reason that taxation will not work, its critics argue, is that the networked nature of the banking system means that the activities of individual banks also generate emergent risks at the level of the system as a whole. So unlike in the case of the polluting chemical factory, an extra tax to discourage activities that generate systemic risks is in theory required. But the system is international—and there exists no multilateral political authority with the legitimacy to le
vy it.8 Victory, if we stick to conventional warfare, would require a well-resourced and capable United Nations Army.
The main case against persisting with the Basel strategy of conventional warfare rests on nothing more complicated than its existing track record, however. The innovations of the late 1990s and 2000s proved that the financial sector is infinitely inventive at devising ways to circumvent such tax-based regulation. Even worse, the aftermath of the crisis demonstrated that the effects of these conventional weapons may even be perverse: requiring banks to raise capital ratios following the crash exacerbated the credit crunch, restricting banks’ ability to make loans at precisely the time when companies facing falling demand have a need for credit lines. John Kay, one of the U.K.’s most respected regulatory economists, has put it bluntly: “[t]he belief that more complex versions of the Basel rules would be more effective in future represents the triumph of hope over experience.”9 To continue with the conventional approach would be to risk a regulatory Verdun, with more and more resources committed to the battle, for less and less return.
The regulators have therefore embarked on a fundamental reassessment of strategy; one which recognises that the root problem lies not with the bankers themselves, but with the structure of institutions in which they operate. “Financial stability,” warned Daniel Tarullo—the leading authority on bank regulation on the Board of Governors of the Federal Reserve—in June 2012, “is, in important ways, endogenous to the financial system, or at least the kind of financial system that has developed in recent decades.”10 Moral hazard is hard-wired into the system. This is why attempting to mitigate it by tinkering with capital ratios or liquidity requirements would be a Sisyphean task. So long as the nature of banking is to lend long-term by borrowing short-term, and take credit risk whilst promising none, the boulder of moral hazard would forever be tumbling back to the bottom of the hill just as the regulators think they have it fixed. What is needed is reform targeted at the fundamental structure of the banking system, rather than at the behaviour of the bankers within it. The war on financial instability requires not conventional tactics, but a counter-insurgency strategy.