In a previous post we argued that little of any significance has been accomplished effectively to regulate investment banking. There is no doubt whatsoever that global investment banking, which had been dominated by US companies, had been responsible for the Global Financial Crisis. As a result of government actions, risk is now concentrated in that sector more than ever before. If institutions then were too big to fail, there are bigger now investment banks. Moreover there are less of them. Risk is therefore exacerbated and arguably more acute than 2008.
Why do size and number of investment banks matter?
Since an investment bank normally uses other investment banks to lay off risk, the fewer the number of institutions, the less effectively risk can be laid off. It works this way: a core business component of investment banks these days is the manufacture, sale, and purchase of derivatives. These are financial contracts between two parties involving the future sale or purchase of something--usually commodities like oil or pork bellies or coffee, or financial assets like stocks or currencies or bonds. Derivatives are so called because their raison d'etre is derived from some other asset. Sometimes they are called synthetics, because they are manufactured to represent some other hard, real commodity or asset.
Derivative instruments have existed for centuries and are extremely helpful in facilitating trade and reducing risk. That's right. Derivatives properly deployed are very effective in reducing risk for producers and traders.
Derivatives, however, have now become a very nasty piece of business in the hands of the huge global investment banks. Nowadays, in pursuit of ever expanding profits, investment banks not only manufacture derivatives and sell them, they also trade them on their own account trying to make gains from purchasing someone else's derivative contracts and either exercising them or on-selling them at a profit.
Since derivatives are contracts to buy or sell something in the future they require capital. Without adequate capital backing and resources, derivatives are fraudulent by nature. Consider an insurance company which sells lots of insurance contracts, but has no capital. When your house burns down your fire insurance is useless because the insurance company has no money to pay out. The insurance company has defrauded you. It has sold you a service on false pretences. That's why insurance companies are regulated. That's why they have to maintain adequate capital if they are to maintain their license to trade. They have to prove to the government that they are trading in good faith, not fraudulently.
It is a criminal act in company law to trade whilst the company is insolvent. To trade under such conditions would mean that the company cannot pay its creditors and suppliers, thus purchasing goods and services without fraudulently. It is a crime. If an insurance company sold insurance contracts without having sufficient capital to meet claims it would likewise be acting criminally. If an investment bank, however, manufactures and sells derivatives it cannot possibly honour--given the extent of its pre-existing liabilities--it is called smart business.
Investment banks, to be sure, have a suite of methods that allegedly and purportedly obviate the need to have vast capital reserves to back their derivatives if called due. The regulators and politicians have by-and-large accepted these as off-setting the need for prudent amounts of financial reserves. More fools them (and all of us).
One popular method is to create and sell counter-derivatives. Let's assume an investment bank has been busy creating and selling (or buying) derivatives that will make an awful lot of money if interest rates in Europe were to rise. What this would mean, however, is that the investment bank would lose a lot of money if interest rates did not rise, or actually fell. In that case instead of taking money off the counterparties who were betting that interest rates would not rise, they would be paying it out to them. Remember derivatives are legal contracts. If and when the derivative matures or is exercised, real money or real assets have to change hands.
One way of reducing risk is to hedge one's bets. Let's say you are pretty sure that interest rates will rise, but not infallibly certain. To reduce the risk an investment bank buys or manufactures derivatives that will make money if interest rates do not rise. This is called insurance. It means that if interest rates were not to rise, the investment bank will exercise these derivatives and call upon someone else's balance sheet or capital to help offset its own losses.
Investment banks can by these methods hold huge derivative exposure but senior managers can sleep soundly at night. If things were not to turn out as they planned they can call upon other institutions who hold opposite derivative contracts and take some of their capital off them to ameliorate their losses.
All of this sounds fine, until . . . . Until the positions become so huge that there is not enough capital if called upon. Or until some unforeseen catastrophic event breaks out that makes your vast derivative position worthless overnight. Or until one of your key counter-parties to whom you have off-laid risk has a cash flow crisis to meet your calls upon their capital and they have to go out into the market and sell some of their assets. Emergency selling means fire sale prices. But if they force sell some of their capital at lower prices, suddenly their whole capital base shrinks because they have to revalue all of their remaining assets according to the latest market price. And by the same stroke, the capital base of all investment banks and financial institutions shrinks, because they too now have to revalue their capital downwards valuing them at the lower forced sale prices of the one cash starved bank. Another credit crunch that hits every business in the land begins.
Derivative risk offsetting, which allegedly meant no need for adequate capital reserves, disappears like a vapour. Within a matter of days, if not hours, an investment bank can become insolvent to the tune of billions upon billions of dollars. Within days, other investment banks are likewise cash strapped and technically insolvent. Banks no longer lend to one another because they don't know about the solvency of their competitors and other financial institutions. Banks no longer fund overdrafts and working capital of main street businesses, hoarding as much cash as they can because in a credit crisis every dollar counts. Recession leading to world-wide depression beckons.
The only sustainable and honourable way to deal with this situation is to require the investment banks to have sufficient hard, real, tangible capital on call and in hand to meet all their obligations in an "extreme event". But here's the rub. If regulators were driven by the ethical requirement to ensure that investment banks did not trade to insolvency, if they began to insist that investment banks held sufficient capital to meet all their contractual obligations, real and implied, then the dominant investment banks would never have grown to the size and influence and dominance that they have. And that would affect some "very important people's" careers, income, and prestige. So politicians get wined and dined to ensure that such prudent regulations never come to pass.
Keith Fitz-Gerald, writing in October 2011, gives us a measure on the size of the exposure now before us:
The notional value of the world's derivatives actually is estimated at more than $600 trillion. Notional value, of course, is the total value of a leveraged position's assets. This distinction is necessary because when you're talking about leveraged assets like options and derivatives, a little bit of money can control a disproportionately large position that may be as much as 5, 10, 30, or, in extreme cases, 100 times greater than investments that could be funded only in cash instruments.All this, of course, at a time when governments in Europe are risking default. Mega-catastrophes are no longer without portent it would seem. As we argued previously, the situation is in some ways more precarious after the GFC than before.
The world's gross domestic product (GDP) is only about $65 trillion, or roughly 10.83% of the worldwide value of the global derivatives market, according to The Economist. So there is literally not enough money on the planet to backstop the banks trading these things if they run into trouble.
The appropriate regulations to correct this are easy, both conceptually and instrumentally. A simple advance would be to increase the size of capital deposits and reserves required when trading derivatives. At present hardly any money needs to be put down to buy a derivative. It requires a small deposit only (usually between five and ten percent of the face value). This should be increased substantially, by government regulation, to force traders, investors and speculations to put more prudent levels of capital into the derivatives in the first place. If they end up losing money on the derivative, their counterparty has a greater assurance of being paid, because more capital has been put up initially.
Moreover, the "netting off" used by major investment banks should be scaled back by force (that is, regulation). As we have argued above, when one house goes down or is forced to sell assets to raise capital to meet obligations, the capital base of all competitor institutions shrinks immediately. The claims you thought you had upon your derivative counter-parties suddenly becomes vulnerable. Prudent ratios need to be established, such that investment banks cannot allow offsets for more than, say, twenty-five percent of their total derivative exposure.
Were these two simple measures deployed, the risks of a global financial crash ahead would be reduced substantially. The major investment banks would be forced to scale back their derivatives business to more prudent levels. Other institutions would enter the market place. Concentration risk would be eased.
Whilst these are very helpful outcomes the fundamental driver of such regulation lies elsewhere--in the realm of ethics and commercial morality. Contract law requires that we do not steal: we are all required to meet the obligations of our contracts, whatever happens. Granted, this ethical precept has been eroded over the years. Without it, however, markets and trade, commerce and production cannot survive.
Capitalism, much derided, is fundamentally the application to the world of commerce of an eternal ethical truth: do not steal. When capitalism is separated from that fundamental ethical precept it will eventually collapse. The Global Financial Crisis is a warning flag. To date, Western government have not heeded.