Breaking up is hard to do
In 1959 the Canadian sociologist Erving Goffman published "The Presentation of Self in Everyday Life". He shocked polite opinion with his claim that a man can be "sincerely convinced that the impression of reality which he stages is the real reality." That human beings deceive themselves in order to deceive others better is now a staple of evolutionary psychology, but the study of deception among animals has only stamped with the imprimatur of science what was obvious to Robert Burns as long ago as 1786. More than two centuries later, there is still no power that has given us the gift to see ourselves as others see us. Lloyd Blankfein ("Doing God's work"), Bob Diamond ("That period is over"), Barney Frank ("People really hate you") and Poul Nyrup Rasmussen ("When I listen to you it's like you're living in another world") are only vivid editions of the universal fact that it is only by convincing ourselves that we are right and good that we can convince others of our moral and logical rectitude. The result is a collective dishonesty about the origins of the financial crisis, and the remedies for it. Even now there are plenty of people in business and journalism, as well as in politics and banking and central banking, who have convinced themselves that the creation of credit is the source of the generation of wealth. The truth is that in the long run credit adds nothing to the stock of wealth. It is a zero-sum game, which redistributes wealth from those who get their timing right to those who get their timing wrong. Its persistence owes little to its contribution to material progress, and everything to the fact that bankers and politicians use central banks to manufacture money and credit to their mutual advantage. Over the last three decades they have orchestrated one of the longest credit cycles in history. Between 1978 and 2007, the volume of borrowing in the United States to finance purely financial transactions rose four times as fast as borrowing by individuals to buy houses or cars or by companies to build factories or buy goods. That calculation does not even include the leverage added by OTC derivatives, which grew from next-to-nothing in 1978 to a gross market value of $35.3 trillion at the end of 2008. Derivatives feasted on securitizations, especially of commercial and residential mortgages. These became increasingly complex transactions, in which multiple tiers of credit, or "tranches," were created out of the liabilities of a single issuer. They gave rise to structured credit instruments (such as CDOs and CLOs) and credit derivatives (such as the notorious CDSs). By the final stages of the boom, there were synthetic CDOs and even CDO Squareds. Because they ate no regulatory capital, derivatives added yet more leverage to the financial system. By the eve of the financial crisis in 2007, investment banks were creating complicated credit instruments not as a way to earn underwriting fees, but as a liquidity management tool. That is why so much of the MBS and ABS and structured credit ended up not in the hands of end-investors, but on the balance sheets of investment banks and hedge funds, and sometimes off the balance sheet in SIVs and conduits too. Banks and hedge funds were in effect manufacturing their own collateral, to raise the funds to expand their balance sheets. It was not so much a case of "originate to distribute" as "securitize to finance." And financed they were, by short-term borrowing, chiefly in the repo markets. For years, investment banks and others collected an apparently risk-free spread between the cost of borrowing in the repo market and the yield on structured portfolios of bonds that they pledged as collateral. Some called it matched book trading. Others insisted it was nothing of the kind. What matters is that by 2007 the survival of the leading investment banks depended on cash-rich banks continuing to take as collateral pretty much whatever credit instruments they chose to hold. One of those banks was Bear Stearns. By 2007, its balance sheet was leveraged 33 times to 1. In other words, a movement of just over 3% in the value of its assets was enough to obliterate the capital of the firm. It was using the repo market to finance a portfolio of around $150 billion of illiquid credit instruments, including MBS, ABS, corporate bonds and CDOs. In effect, the Bear Stearns repo desk was using short-term funding as longer-term financing through repeated rollovers with the same counterparties, using the same collateral. Its ability to continue to finance the firm depended entirely on the assumption that the collateral would remain liquid, and financeable. That assumption was proved false on Aug. 9, 2007. That day BNP Paribas suspended redemptions in three structured credit funds because, as the bank explained at the time, of a "complete evaporation of liquidity." Repo rates soared. The value of structured credit as collateral collapsed. Margin calls increased. Haircuts, even on AAA-rated ABS, rose from 3% or 4% to 50% to 60%. This was not what was meant to happen. Secured forms of lending, like repos, were expected to remain liquid while unsecured lenders withdrew. Yet the European repo market shrank from 6.8 trillion in June 2007 to 4.6 trillion in December 2008. The US Treasury repo market shrank from $1.3 trillion in December 2007 to $659 billion in December 2008. The US tri-party market shrank from $2.8 trillion in early 2008 to $1.7 trillion at the beginning of last year. This was more than deleveraging. As a recent report by the BIS Committee on Payment and Settlement Systems notes: "During the recent financial crisis, some repo markets proved to be a less reliable source of funding liquidity than expected." Far from the repo markets taking the place of unsecured financing, central banks ended up using the reserves of banks that would not lend to other banks to lend to banks. It was on Aug. 9, 2007, that the European Central Bank and the Federal Reserve made the first of their many interventions in the money markets. By March 2008, the Federal Reserve was lending directly to US broker-dealers for the first time in its history. There could scarcely be a more dramatic illustration of the loss of confidence, not in counterparties, but in collateral. The banking crisis of 2007-09, like the milder banking crisis of 1998, proved collateral was not the solution, but the problem. In retrospect, the reliance of investment banks on collateralized funding in the wholesale money markets was just one part of a seismic shift within the banking industry as a whole, from long-term and stable sources of finance (such as retail deposits) to short-term and unstable sources of finance (such as repo). The AAA-rated tranches and structured credit instruments being financed in the repo market, like conduits and SIVs and the mania for money market funds, were all symptomatic of that shift. The real vulnerability in the banking systems of the world by 2007 was their reliance on a naturally unstable source of short-term funding: the wholesale money markets. The lenders are well informed, the sums are large, the transaction costs are significant and the terms are shorter and less predictable than a monthly salary deposited in a bank account. They are far from certain to be rolled over. Yet, as the crisis broke in 2007, around half of the $6 trillion US repo market was being refinanced every night. In Europe, 40% of the repo market was being financed on a daily basis, 40% at maturities no greater than a week, and 60% at maturities no greater than a month. There was of course a powerful macroeconomic impetus behind this absurdly risky process. The wholesale money markets are a much more efficient way of recycling global imbalances. They are one of the principal means by which money is recycled from countries that save (such as China, Germany and Norway) to countries that spend and borrow (such as the United States, the United Kingdom, Spain and Greece). The credit-driven world is not one in which rich Americans save the wealth of a mature economy to invest in the lavish opportunities of emerging markets. It is a world in which impoverished Chinese workers earn dollars to recycle to American banks so that they can lend money to rich American consumers to buy Chinese goods. This is where the repo market meets the politico-cultural addiction of Western civilization to credit. In most Western economies, democracy has come to mean the right to refinance a house at a lower rate of interest, pay for everything with a credit card and vote for whoever will give you the most of someone else's money. For decades, Britons and Americans in particular have preferred importing and consuming to producing and exporting. There is nothing intrinsically wrong with that. After all, the purpose of production is consumption. But it is a matter of arithmetic that people cannot continue indefinitely to spend more than they earn, even if they can do it for a surprisingly long time. As P.J. O'Rourke put it in The Wealth of Nations, "imports are Christmas morning; exports are January's MasterCard bill." That bill may be surprisingly large, and not just in financial terms. History suggests that large current account imbalances are not resolved gradually but instead in a series of wrenching political and economic crises - of which what is happening in the euro area today is almost certainly just the first of many. Yet the travails of the euro are merely one malignancy among the many spawned by the nexus between bankers, central bankers and politicians, which makes it impossible to halt the credit cycle. A previous generation would see the current attempts to rescue the euro as a "bankers' ramp." It is not only that, but also a successful attempt by politicians to escape the constraints imposed on credit and money creation by currency competition, and especially by the sound money policy of the Bundesbank. The consequences are now unfolding. The euro has turned out to be a powerful engine for the transfer of wealth to countries that inflate their supplies of money and bank credit faster than others. The sight of the ECB accepting as collateral against loans to European banks Greek government bonds reduced to junk status is an illustration of how the credit cycle aligns perfectly the interests of politicians and bankers. Investment bankers were content to rely on overnight forms of finance secured on illiquid and even synthetic collateral because they knew the risks they took were underwritten in the first place by the central banks, and in the second place by the taxpayers. The only permanent way of breaking this nexus is to put out of commission the tails-I-win-heads-you-lose money creation machine, fueled by central banks under pressure from politicians to maintain a permanent boom, and operated by private banks under pressure from shareholders to increase revenues and profits by growing the balance sheet. To believe that it can be tamed by slightly higher levels of capitalization (as proposed under Basel III) and slightly improved systems of regulation (as proposed by everything else) is Goffmanism of the purest kind. Yet there is enough at stake for politicians and central bankers to deceive themselves into thinking that it is possible not only to grasp the behavior of financial markets, but to regulate it. The modish device of choice is the CCP. It is being applied, or applied more widely, in markets as various as equities, OTC derivatives, repo and reverse repo. The fact CCPs are being embraced so enthusiastically by banks ought to worry more people than it does. Banks have spent the last 30 years inventing ways to take on more risk for less capital, and capital relief for CCP-intermediated trades offers them a new tool for doing exactly that. Investment banks broking centrally cleared OTC derivatives are already advertising to hedge fund clients that CCPs will reduce the collateral they are obliged to post. But whatever their merits and demerits, CCPs do not address directly the central issue raised by the financial crisis of 2007-09: Collateral liquidity risk is less stable than counterparty credit risk. After all, not many of the MBS and ABS and structured credit from which the market fled in 2007 and 2008 proved delinquent. Much has already redeemed at par. Yet investment banks continue to maintain modest trading limits, not because they distrust counterparties, but because they are not confident they can liquidate collateral in difficult market conditions. Far from solving that problem - and despite repeated claims they have proved they can liquidate collateral in an orderly fashion - CCPs might actually make the problem worse, by appropriating liquid collateral, and concentrating some risks while excluding others. With or without a CCP, collateralized lending is vulnerable to the fear of illiquid collateral prompting destabilizing margin calls and haircut increases and rollover withdrawals, in which markdowns of illiquid collateral drive further margin calls, haircut increases and rollover withdrawals. That is exactly what happened in 2007-09. Central bank intervention never broke that damaging positive feedback mechanism, because it could not. Central banking was, and is, part of the system, not separate from it. Even now, nearly 2 years on from the nadir of the crisis in March 2009, and despite the expiry of many of the special measures taken at the height of the crisis, central banks are still densely involved in financing the private banking industry through auctions against eligible collateral. Higher liquidity requirements are likely to ensure at least part of this inflation of central bank balance sheets becomes permanent. Weaning the banking industry off central bank money and returning banks to financing themselves in private markets, like reversing the effects of quantitative easing, will be far from easy. Indeed, the continuing reliance on central bank funding is the most obvious measure of how the financial crisis has tightened the nexus that binds politicians, bankers and central bankers. It is not excessive to say that the crisis has exposed the true nature of the relationship between commercial banks, central banks and high spending governments. Deficits are funded in large part by the sale of government bonds to the banking system. Banks are happy to buy them because they are eligible collateral at the central bank. The decision of the ECB to buy Greek government bonds, despite their junk status, is the reductio ad absurdum of this ugly coincidence of interests. The consolidation prompted by the crisis is another perverse consequence, because it has concentrated power in the banking industry to an extent that makes a major bank failure unthinkable. In the US tri-party repo market, for example, the top ten broker-dealers account for 85% of the securities being financed, and the top ten cash providers for 65% of the money advanced. The largest individual cash providers are putting $100 billion a day into tri-party, as a matter of routine. The 52 banks that took part in the latest ERC survey account for EUR6.9 trillion in outstandings or, without adjusting for double counting, EUR134 billion per bank. "Moral hazard" is no longer a theoretical possibility, but a fact of daily working life in the banking industry. A choice between letting the entire financial, economic and commercial system collapse, and funding banks when the wholesale money markets will not, is not a choice at all. But if the funding of banks in the wholesale money markets is now on such a scale that only the full faith and credit of taxpayers can underwrite it, because only governments can commandeer taxes and confiscate property of commensurate value, it is time to ask not whether the risk should be concentrated at CCPs but whether it should be concentrated at all. As even Alan Greenspan has now conceded, if banks "are too big to fail, they are too big." Yet the basic premise of current policy, whether by accident or design, is that a smaller number of large but systemically important banks is easier to regulate successfully. It is not surprising that the big banks themselves have endorsed this view, since it raises the barriers to entry, and gives them a distinct funding advantage over their competitors. The head of the investment banking arm of one of the largest banks explained recently that his clients needed his bank to be "this big." In fact, they need the opposite. After all, the American economy rose to greatness in the 19th Century with a completely fragmented and decentralized banking system, characterized by a high rate of failure. It did not even have a lender of last resort until 1913. Though it is customary to argue that the creation of the Federal Reserve marked the coming of age of American finance, it is was really an early instance of the state being placed at the service of the banks. They gained a backstop that could bail them out with public funds, and which they could direct because they occupied two-thirds of the seats on the board. The Fed was still there, and the bankers were still on the board, on Aug. 9, 2007. As a result of that and subsequent episodes - indeed, because and not in spite of the failure of Lehman Brothers - the threat that a central bank will ever allow a mismanaged bank to fail now lacks all credibility. It is time to go back to an industry that does not loom so large that the failure of even one institution is a catastrophe for every other institution. Failure is a normal part of business. It ought to be a normal part of the banking business too. But that degree of normality is impossible without a more fragmented, more decentralized and more specialized system of finance, in which the role of the authorities is reduced to the maintenance of competition. It would not be failsafe, but safe enough to fail. This is not a fantastical proposal. The Volcker Rule is actually a step toward it, because its shifts proprietary trading and hedge fund activities out of the major investment banks, and into a marketplace where the risks can still be taken, but are much less concentrated. Big Banks play the role in economies that Big Men play in societies. They crowd out alternative sources of power, and reduce the level of experimentation. Ask any broker-dealer how easy it is to compete with a major investment bank. Ask a hedge fund manager what scope he has to negotiate his margin terms with a prime broker, or a domestic custodian how easy it is to keep abreast of the global custodians. Ask sub-custodians what luck they have had in resisting the squeeze on prices from network managers. Look at how the incumbent depositories and clearing houses have used prices and processes to hobble their competitors. Everywhere, oligopolists are slowing down the natural evolution of the banking industry, and perverting its course. Evolution is a system of trial and error, which progresses by doing more of what works, and less of what does not. In a system where error cannot be penalized, progress is impossible. It is a paradox - restoring faith in commercial bank money by withdrawing the central bank safety net - but, where the courage to go all the way and return to a system of 100% reserving is demonstrably lacking, the only way to take excessive levels of risk out of the system is to increase the cost of taking it on. There are those who say that this will reduce the rate of innovation. There are those who welcome that prospect, because they never welcomed CDS and CDO Squareds in the first place. Both are wrong. A more fragmented, more diverse, less frightening (and less frightened) banking industry will actually be more innovative, not less. In the market for banking services, as in any market, it is not the market participants that are the source of innovation. It is the market itself. In a properly functioning market, everything belongs to someone, and ownership confers responsibility. In a system where bankers own the profits, but taxpayers own the losses, nobody has responsibility. Where nobody has responsibility, we cannot have a market. Only by breaking up the oligopolies can the nexus be severed, the amplitude of the credit cycle be suppressed, and the market, in all of its fullness and variety, disclose its infinite possibilities.