The speech below was delivered on 29th August 2013 at ITAM, Mexico City, in the context on a conference on planned financial sector reforms in Mexico; organised by IMEF (the Mexican Institute of Finance Executives), in collaboration with UNIFIM (a confederation of Mexican owned financial institutions). For an audio of my talk click
“Thou canst not stir a flower, without troubling of a star” remarked famously Francis Thompson. The implied interconnectedness is even more pertinent in our financialised global economy than even in the most non-linear vestiges of Mother Nature.
At least this is my excuse for accepting the kind invitation to address this audience on the subject of banking and in particular in the context of the debates unfolding, currently, here in Mexico over impending financial reforms the purpose of which is, ostensibly, to reverse the dearth of credit to Mexican business. For if the cutting of a flower troubles a star, the failure of the Cypriot banking sector or the problematic re-capitalisation of Spanish banks through the ESM is certainly of grave importance to your deliberations about Mexico’s financial sector.
Before I continue, let me express my gratitude to the organisers, in particular to Adalberto Palma, and of course to this illustrious seat of learning, ITAM, for the great honour and the considerable privilege they afforded me to address you today.
You may have noticed that I am afflicted by a certain condition that, these days, is considered rather serious – especially in the world of public but also private finance: I am… Greek. The kinder souls amongst are now moving their heads up and down in sympathy to my affliction. The less sympathetic are wondering what on Earth a Greek economist is doing lecturing them on finance, banking, the global crisis etc.
Allow me to quip that Greece is in everyone’s mirrors today. And as car mirrors often warn, “objects in mirrors are closer than they appear”. Indeed, I submit to you that Mexico and Greece have too much in common – and I am not referring to our successful wars of independence in the 1810s and 1820s. No, I am referring to violent capital flows, banking troubles, debt restructuring, the inexorable rise of poverty, incorporation into a trade block comprising bigger and more powerful northern surplus neighbours, and, of course, a great deal of political and social unrest caused by all of the above.
In 2009, following the Crash of 2008, Greece effectively became insolvent, falling into the lap of the IMF and our European partners. Meanwhile Mexico was having its own encounter of the third type, securing a gigantic IMF credit line – for reasons not too dissimilar. Allow me to suggest that if you lacked your own Central Bank; if you could not devalue by 25% as you did; if Europe had not spared your banking sector mountains of toxic derivatives (by sucking them into the European banks and thus sparing Mexico’s banks); and if you were banned from defaulting; then Mexico would today be not very unlike the wreckage that is Greece.
My Mexican friends and colleagues tell me that Mexico is today finding it hard to escape the doldrums of the Crisis. That growth is turning negative and credit is scarce. Looking at the data, they seem to be correct. However, the benefit of having a Greek address you is that I can legitimately look at you in the eye and say: Friends, you have plunged to depths that we Greeks, Portuguese, Spaniards, Italians, Irishmen and women are striving to… rise to!
But enough on Greece and Europe, for now at least. Time to look at the broader picture. At the challenges of banking reforms in the post-2008 period globally and then closer at home. In what follows I propose to do the following:
- First, I want to ask the question that Lawrence Olivier, in the role of the hideous White Angel, was asking poor Dustin Hoffman, while torturing him with a dentist’s drill, in that great 1970s flick The Marathon Man: “Is it safe?” Meaning, has the financial sector been rendered safe, or at least significantly safer, than it was prior to 2008?
- Then I want to speak briefly on the ‘Blame the Bankers’ game and argue for a more sophisticated approach to the question of banking ethics and practices.
- Third, I shall put forward my own interpretation of why 2008 happened and how this has changed our reality.
- With this global perspective in place, I shall turn the spotlight on SIFIs (systemically important financial institutions) in a bid not to judge but to comprehend.
- Lastly, I shall ask the inevitable question: What should we do? How should we reform our financial sector? What lessons are there for Mexico?
2. Is it safe?
So, let us begin. “Is it safe”? Is finance safe after the round of supposed reforms that were effected after the 2008 calamity?
Post-2008, there is an understanding urge to believe two things at once. That the banks caused a huge mess from which we have not managed to extricate ourselves yet and, at once, that banking has been fixed and that it is now safe to sail again the vast seas of finance. Both beliefs are profoundly wrong. Banks did not cause the mess, even though they played a gigantic role in bringing it about. And, no, finance has NOT been fixed!
Castigating banks after the Crash of 2008 for their outrageous greed, their propensity to fail shareholders, taxpayers and customers alike, their gross incompetence can be pleasurable and is not at all undeserved. Alas, it throws little light on the deeper causes of the problem or, indeed, on what ought to be done.
One does not need to be a bona fide member of the Occupy movement to think that our banking systems are a clear and present danger for our social economies. On 19th June Mervyn King gave his last speech as Governor of the Bank of England.
“The sheer size and complexity of global banks” he said “have led to failures of governance. Governments, regulators, prosecutors and non-executive directors have all struggled to come to terms with firms that pose a risk to taxpayers, cannot be prosecuted because of their systemic importance, and are difficult to manage because of their size and complexity. It is not in our interest to have banks that are too big to fail, too big to jail, or simply too big.”
Given the highly oligopolistic structure of Mexico’s banking sector, I believe that you need to take note of Mr King’s parting shot. In particular, his conclusion that, and I quote:
“Solving these problems is the work of a generation!”
Andrew Haldane, the Bank of England’s Executive Director for Financial Stability, several years ago, in response to the Crash of 2008, dared say:
“There is a key difference between the situation today and that in the Middle Ages. Then, the biggest risk to the banks was from the sovereign. Today, perhaps the biggest risk to the sovereign comes from the banks. Causality has reversed.”
So, no, it is not safe to think that global finance has been tamed and banks have turned the corner. As Mervyn King put it, it will take at least a generation to get to that. However, we shall fail if we lull ourselves into a blame-the-banks game which obscures the deeper causes of the banks’ collective and individual failures.
3. Beyond the Blame Game: The Minotaur in the room
Why were banks allowed to grow so complex and to increase their rent seeking powers so magnificently since the 1970s? The observation that they grew in power and significance does not contain its own explanation. Greed was never a cause of anything; only a byproduct. Similarly with the bankers’ exorbitant privileges. But a byproduct of what? A byproduct of the rise and rise of what I called, in a recent book, a Global Minotaur – as you can see, this Greek finds it impossible to resist mythological metaphors.
Since the 1970s, the United States began absorbing a large portion of the Rest of the World’s surplus industrial products. In turn, the profits earned by the surplus nations’ entrepreneurs were returned, daily to Wall Street, in search of higher payoff. Wall Street would then use this influx of foreign capital for three purposes: (a) to provide credit to American consumers, (b) as direct investment into US corporations (that helped them globalise further) and, of course, (c) to buy US Treasury Bills (i.e. to fund the American government deficits).
Central to this Global Surplus Recycling Mechanism, which I have likened to a Global Minotaur, were America’s twin deficits. ‘Tribute’ from the Rest of the World was flowing into Wall Street, in the form of net capital flows averaging between $2 and $5 billion dollars net daily (the contemporary equivalent of the tribute that subservient Athens was sending regularly to Minoan Crete, to be devoured by the Minotaur). In exchange, the American trade deficit was generating the demand that Japanese, German, Dutch, S.E. Asian and, later, Chinese factories depended upon. Without America’s twin deficits, the global circular flow of goods and capital could not have ‘closed’, destabilising the global economy. (Just as Minoan Crete, in return of the tribute received, provided peace, tranquillity and the circumstances for healthy commerce over the then known world).
This recycling system broke down because Wall Street took advantage of its central position, of its exorbitant privilege to build colossal pyramids of private money on the back of the net profits flowing into the United States from the Rest of the World. The process of private money minting by Wall Street’s banks, also known as financialisation, added much energy to the recycling scheme, as it oozed oodles of new financial vitality, thus fuelling an ever-accelerating level of demand within the United States, in Europe (whose banks soon jumped onto the private money-minting bandwagon) and Asia. Alas, it also brought about its demise.
Mexico suffered the collapse that the Eurozone now experiences much earlier, in fact it did so in two doses; one in the 1980s, with the debt crisis that followed the disastrous experiment with the pesos-dollar peg (an experiment of the same ilk as the Eurozone’s basic logic) and, then, with the banking collapse that followed on the coattails of NAFTA’s inauguration. Having chosen to attach itself fully to the US economy, de-coupling from the rest of Latin America, Mexico experienced large capital inflows as a result of both (a) leakages of capital flowing into the US due to the aforementioned Minotaur dynamics, and (b) outflows of toxic money minted by Wall Street as part of the financialisation drive that began in the 1980s. When the asset bubbles that these flows occasioned looked like they were about to burst, the savage capital flight that followed not only burst these bubbles but almost tore the Mexican social economy asunder, with debt overhangs, banking failures, severe recession, hefty rises in absolute poverty and much political instability the evident results.
Mexico in 1994/5 was, in this sense, a prelude to the Eurozone’s Periphery trials and tribulations after our own capital inflows put our banks and governments in jeopardy. In a sense, 1994 shielded you from a catastrophe in 2009 much, much worse than the one you experienced. It is the reason that we Europeans are now aspiring to achieve your… lows.
4. Understanding the systemically important financial instittuions (SIFIs henceforth)
This circular flow of surpluses, with the American deficits at its heart, was the environment in which banks grew into SIFIs – into the banks that, according to Andrew Haldane, continue to pose a clear and present threat to civilisation as we know it.
The major problem with these banks is simple: They are not that keen to lend! The reason they grew to the extent that they did, thus becoming SIFIs, was that they used a combination of, on the one hand, options or derivatives and, on the other, leverage so as to borrow on the liabilities side of their books and bet on the assets side. The greater the leverage they employed the larger the profits from such activities, the result being an exponential growth in their assets, profits and, of course, bonuses.
As a result, most SIFI’s loans to customers came to represent a small portion of their business – of their total assets. From the SIFIs’ perspective, where all that matters is to make as much money ASAP, we, the customers, are a nuisance to them; a group of self-important people that they must pretend to take seriously when, in reality, they would rather they wasted no time on us.
During the good times we, the customers, benefitted to from the banks’ largesse, in a global environment of the credit-fuelled growth rates which were the reflection of the capital flight into the United States, which financed the US deficits that, in turn, created the requisite Aggregate Demand world-wide for the net exports of the net exporters. Alas, in the meantime, the world of finance was de-coupling from the world of real stuff produced by people for consumers.
When the pyramid of derivative paper, a form of private money that Freidrich von Hayek had never imagined (and would certainly never have approved if he had recognised its existence), burst into flames and turned into ashes, the whole edifice came tumbling down. At that point, with regulators too timid to challenge the bankers, who (it must be said) were their former colleagues and golf partners, SIFIs experienced a dream-come-true: As they could rely on exponential profit making on the cycle’s upside, they could now rely on similarly exponential taxpayer-funded bailouts on the cycle’s downside.
Why should they, all of a sudden, become excited by the prospect of bread and butter lending to people like you and me? One party was ending but another, aided and abetted too by various waves of Quantitative Easing, was beginning. The only danger on the horizon was greater regulation. To see it off they employed terror tactics against the hand that had just fed them.
To see in vivid Technicolor how little SIFIs care about lending to little people, it is interesting to look into a scheme that the British government tried out in order to elicit greater credit from the large banks – even from banks that it… owned. One may, reasonably, ask: If the government owned the banks, after their 2008 meltdown, why could the Chancellor of the Exchequer not just order their managers to get cracking; to loosen the purse strings and start lending to small and medium sized businesses more liberally? Why did the government have to concoct a set of incentives to get them to do that which they could order them to do? Had the taxpayer not paid enough to rescue them?
However pertinent these questions may be, they are not at the centre of my argument here. What is at its centre is the outcome of the scheme that the British government introduced, known as ‘Funding for Lending’, in order to increase the supply of credit from the banks to the private sector. In essence, the said scheme made it possible for the banks to borrow at rock bottom rates as long as they lent the monies to firms or households. Indeed, almost 17 billion pounds were given to the banks for that purpose.
What happened? In the 4th quarter of 2012, lending fell by 2.4 billion pounds. The Royal Bank of Scotland borrowed 750 million pounds from the ‘Funding for Lending’ scheme and managed to reduce loans by 4 billion overall. HBOS borrowed 3 billion and culled loans by… 6 billion.
Recapping, SIFIs are a problem for a variety of reasons. Let me stick to two for now: First, like all oligopolies, they maximize profit by restricting quantities to push up prices (that is, to increase spreads in their favour). Secondly, because the bigger they are the more they profit by borrowing on the liabilities’ side and betting on the assets side; a dangerous ploy rendered safe for the banks and unsafe for the rest of society by means of lobbying and by ensuring that no politician will dare move against them.
Now, don’t get me wrong. This is not an ethical critique of bank CEOs or indeed of the traders and middle managers below them. I have no doubt that each one of them is doing their best while working within a complex organisation that will spew them out if they do otherwise. It is not at all a matter of ethics. It is more important than that. If you want, the situation resembles more a form of ancient Greek tragedy, e.g. Oedipus Rex, in which every character is doing his or her best, under circumstances that they have not chosen, but each, unwittingly, is adding his or her small brick to the collective disaster that is looming on the horizon.
What we must come to grips with is that large, global banks that have grown beyond a certain level of complexity are not capitalist enterprises. They are feudal entities. Or as Manchester University anthropologist Karel Williams put it, SIFIs have become loose confederacies of profit seeking rent seeking franchises. Williams, quoted by John Lanchester in a recent London Review of Books article on these issues, tells us that one risk analyst talks about his bank as a “nation engaged in perpetual civil war” while a trader said “You have to understand, it’s us against the back”.
Regulatory devices and hurdles are to them nothing more than irritants to be circumnavigated and whose teeth need to be taken out. If traders and analysts fail to do this, their bosses will be compelled to get rid of them as they themselves fear replacement if they fail in doing so. It is a grave error to imagine SIFIs are well-defined business entities run by smart bankers who know what they do and do what they know how to. Smart they may be. But they do not have a clear view of what is happening in their realm and, more significantly, they can control very small parts of the feudal confederacy that they are supposedly watching over. That confederacy, the SIFI, runs its own show, as if by a will of its own; an unending quest for economic rents that are increasingly decoupled from the mundane task of providing credit to business.
From a macro perspective, SIFIs are trouble because they profit through volatile lending: Too much when restraint is crucial and too little when a credit boost is necessary. In short, SIFIs are a type of volatility boosting machine joined at the heap with a magnetic field that spreads credit aridity around them.
5. Why Mexico’s banking reality today is a source of concern
From what I read and hear, and I stand to be corrected as a non-expert on Mexican banking, it seems that Mexico’s banks are a source of good and of bad news. The good news is that they appear to have a healthy capital structure and a low portion of bad assets. The speedy implementation of Basle III is also a source of pride and a reflection, perhaps, of the Mexican regulators’ urgency to avoid the pitfalls of the past. 1994 still concentrates their minds. However, the bad news is that credit seems too scarce at a time when the economy is starved of credit fuel and repossessions are on the rise.
There is more bad news I am afraid. Basle III compliance may sound like an excellent thing but, in reality, it means little. Lehman Brothers, Wachovia, and Citigroup in the US, Bankia, Dexia as well as the Greek and Cypriot banks in Europe were rated as well capitalized, according to Basle III criteria, on the very day they failed. Do you realise that they would all have passed the Basle III test with flying colours moments before they went belly up?
What happened, of course, was a systemic collapse of the sort that the Mexican oligopolistic, highly concentrated, banking sector is highly susceptible to. In the case of Lehman Brothers, it was the luck of the draw that determined which domino fell thus triggering a vicious domino effect within a sector containing so much combustible fuel that the explosion was irrepressible. In the case of the European banks that I mentioned a moment ago, while none of them were SIFIs, in aggregate they were as systemically dangerous as Deutsche Bank.
What we should never forget is that when a Crisis hits, especially when it hits a peripheral economy, global banks walk away. Even if they own subsidiaries in the hit nation, they take their leave. The fact that the SIFIs in this country, in Mexico, happen to coincide with the global SIFIs deserves to be a great worry.
The moment a financial shock happens, as it is bound to periodically, the greater the concentration ratio of the baking sector, and the more global the local banking sector is, the greater the proportion of bank assets that stand to wither. As a result, the greater the tendency of capital, and of the global banks, becomes to flee the hapless peripheral nation, like a vicious tide leaving behind nothing but a few weedy posts and a great deal of mud.
Now, if the exposure of global banks to the Periphery threatens them, then the ‘Metropolis’ inevitably intervenes. The cavalry will never fail to appear but only in order to save the Metropolis’ own global banks at whatever cost to the local economy. This was your experience with Brady Bonds, later with James Rubin’s $50 billion bailout following the 1994 banking sector crash. And it certainly was the experience with our Euro so-called bailouts: cynical attempts to shuffle off bad losses from the books of Deutsche Bank and BNP-Paribas onto the shoulders of the Greek, German and French taxpayers.
Let us make no costly mistake here: The Metropolis will stop at nothing to avoid bankruptcies that are, ironically, prescribed not by the Left but by the Hayekian New Right; bankruptcies that would have been less costly to the economy as a whole – and certainly to the innocent unsuspecting citizen.
Whenever we study the robustness of some banking sector, it is imperative that we go beyond banking and think in macro terms. Mexico’s 1994 problems were partly systemic but largely due to a drop in aggregate demand following the earlier downturn in the US, Canada and Europe. As were the problems of the Greek banks in 2010. No banking reform can shield a banking sector from a serious macroeconomic downturn.
And there is the rub. If my analysis of the deeper causes behind the 2008 crash, my Minotaur tale, is correct, we have much to worry about: The US trade deficit has returned and the Rest of the World keeps buying US Treasury Bills. However, and this is a big ‘however’, America’s capacity to generate aggregate demand for the Rest of the World is 30% down on trend compared to the pre-2008 era while the Rest of the World’s capital flow to the US no longer provide essential finance to US corporations. In short, the conditions for low and volatile aggregate demand in our countries, here in Mexico, are becoming more and more entrenched.
6. So, what should Mexico do?
Looking back to the 1990s, it is worthwhile recognising that deregulation in finance, especially when it comes on the coattails of other forms of deregulation/liberalisation, engenders an oligopolistic credit boom. Large, global players emerge that operate as a conduit of huge capital inflows, leading with mathematical precision to a future shock. At the same time it removes the shock absorbers so that, when the shock comes, its impact proves gigantic. Neither the money markets nor the macroeconomy more generally has defence mechanisms capable of responding to such an eventuality.
It was a distinguished alumnus of this fine institution, Mr Augustin Carstens, then at the Bank of Mexico, who told our University of Texas colleague Sidney Weintraub, now retired: “We took a calculated gamble and lost”. Guillermo Ortiz, along the same lines, added: “In 1994 we bet that the shocks would be temporary”. Alas, those were not gambles or bets. Just like in 2010 the IMF’s and Europe’s bailout strategies in the Eurozone were not mere gambles or wagers. They were shots in the dark. A little like gambling that a light will appear at the end of a tunnel when you are digging vertically, toward the Earth’s core.
Clearly, something must be done to reduce systemic risks to economies like Mexico’s; economies whose sustainable growth is not important for trivial reasons but because we have no other weapon for fighting abject poverty and social exclusion.
- Will Basle III not do the trick? No, it won’t. I already mentioned failed banks that passed its tests. Basle III does constitute an improvement over Basle II over the definition/measurement of capital; of the numerator of the capitalization ratios. But the devil lies in the mark-to-model shenanigans in the denominator (i.e. the arbitrary model-based risk-weighing of the assets).
- Ring fencing, Vickers style, as the UK is experimenting with? No, this is a joke and my British colleagues are beginning to recognize this. Ring fencing will simply annoy the SIFIs’ functionaries for a few days before they find a way under, over, around it.
- Would a Glass-Steagall Act work? Not really. Think of Northern Rock. Of HBOS. Indeed of our Greek banks. They contained no substantial investment arms, no casino banking. And yet they were the ones that failed.
So, what do we do? Give up? No, of course not.
Here is my two-pronged suggestion: We need very high equity minima for SIFIs and policies that actively encourage, nurture, motivate and assist small, local, non-SIFIs that make use of new methods of mobilising idle savings locally and turning them into productive investment in SMEs.
- High equity minima, as suggested by my colleague Anat Admati and her co-author Martin Hellwig, for the large banks, so that they are forced to replace much of the risky derivative trades on their assets side into boring loans to business and to households. And,
- Introduce policies that defeat the SIFI monoculture, helping a rich ecology of home grown credit institutions develop in the SIFIs’ shadows, thus providing much needed competition to them. For instance, phase in Basle III provisions much more slowly for local, Mexican, small, non-SIFIs but make sure that they know that they will never be bailed out if they fail.
What we need, in other words, is simple rules that:
- remove not so much the size of the banks but the complexity of their regulatory devices and their reliance on mark-to-model accounting practices, and
- allow a thousand flowers to bloom in credit provision by Lilliputian institutions which, collectively, can fill the funding gap left gaping by the SIFIs and add the missing shock absorbers to the macro-economy.
Let’s, in simpler terms, make life difficult for the SIFIs and nurture TFBs (i.e. thousand flower banks)!
Time to take stock.
If my analysis is right, and I do hope it is not, the global economy is, and will remain, in a fairly depressed state until some newfangled surplus recycling mechanism comes into being. Until then, economic life will be stressful and volatile.
In this global context, an economy like Mexico’s requires courageous financial reform that is not at the mercy of SIFIs that have every incentive in the world to subvert the process of reforming the financial sector so as to extract larger rents at the expense of the social economy while starving it of credit.
The good news is that many people the world over, producers of real ‘stuff’ in particular, are getting tired of SIFIS, their lobbyists and the dearth of credit that they spread wherever they go. There is indeed a global move toward smaller, local banks, with high equity and immobile capital base that is tuned directly into the community’s SMEs.
Mexico seems to be blessed with a flourishing sector of that ilk. An array of small credit providers, banks and non-banks, whose credit supply has been growing even during the worst quarters of the post-2008 period. Let’s find an acronym for them, TFBs (thousand flower banks), and let the Mexican authorities protect and nurture them. And the easiest way of doing this is to refrain from imposing identical regulations on global SIFIs and non-SIFI-local-financial-service-providers; not to treat unequals equally.
TFBs, i.e. smaller, local banks and non-bank financial institutions, differ from SIFIs in one respect: they lack the capacity to bend the spirit of Basle III by tampering with the capitalisation ratio’s denominator. In this sense, they are the regulator’s friend. But they suffer from an incapacity to use the SIFIs instruments of circumventing Basle III; e.g. their capacity to issue instruments like CoCos is circumscribed.
The rush to Basle III is thus ill advised: It does not make the SIFIs safer and it impairs the smaller banks that are serving Mexico’s social economy well. The solution: As Anat Admati suggests, go for a minimum equity ratio of between 10% and 15% for banks with assets more than a certain limit. And allow smaller, Mexican owned banks substantial more leeway, on the understanding that, if they go under, they will be allowed to go to the wall.
Naturally, this suggestion will cause a cacophony of protestation from SIFIs. They will accuse me of failing to grasp the complexity of the modern banks; their contributions to financial innovation.
Paul Volcker’s rejoinder to the accusation of not having grasped the importance of the SIFIs’ financial innovations was to suggest that the only innovation he has ever seen is the… ATM.
Inspired by the formidable Volcker, my rejoinder to the argument that a bank is too complicated for me to understand in terms of equity ratios, let alone for mere citizens to understand, is that if their risk weighted models are too intricate for common sense to grasp, then they are too intricate to be allowed a crushing share of an economy’s (like Mexico’s) credit market and, most certainly, too ‘complicated’ to bailout out when their bets turn awry.