October 12th, 2011

The large Franco-Belgian bank Dexia went effectively bust last week and had to be bailed out for the second time. Two numbers: the Belgian retail business was nationalised by the Belgian government, with deposits of €60bn. The total balance-sheet of the bank is over €500bn: over eight times the size of the retail bank.

The recent Vickers report on UK banking draws a similar picture of British banks. The Vickers proposal is to ring-fence “£1.1tn-£2.3trn” of retail operations, within total bank balance sheets of £6trn (report, paragraph 3.40, page 52.)

What are the banks doing with the other £4-5 trn? Lending it abroad perhaps? The latest BIS number for the total international claims of British banks is £1.45trn. That leaves £2.5-3.5 trn of domestic non-retail assets to be accounted for.

The FT’s fine pundit Professor John Kay has the explanation :

Most of the £6,000bn total of UK banks’ assets and liabilities represents financial institutions trading with each other.

The UK banking system is an extreme case of hypertrophy, but it’s not alone. The BIS gives the total of international interbank claims (2011 Qtr1) as $8.4 trn.

Most economists are subject to what you might call reality illusion. They think the driving forces of the economy lie in real economic transactions and decisions by households and firms over borrowing, investment, asset allocation and spending. Interbank and other purely financial transactions are unimportant housekeeping.
Really? As Paul Krugman wrote recently on banks in another context:

This is, after all, the 21st century. Things have moved on a bit.

Here’s my wee contribution to postmodern financial theory. Thesis: much of the the financial industry has no connection with the real economy at all, except through its own superprofits, perverse risk creation and huge demands on capital.

A thought experiment. Consider three “investment” banks with no retail operations and no loans to nonfinancial companies. Let then be:

They have access to their central banks. Its CB lets the South Sea Bank have £100m of monetary base. It can now make a loan to Münchhausen Bankgsesellschaft, which in turn lends it on to Banco Ponzisssima, which lends it on the Banque Royale du Mississippi, and finally back to the South Sea Bank. By the magic of fractional reserve banking, the £100m swells to £1bn of loans. But nothing has happened in the real economy. The circuit of such pure banks is a black hole: it sucks in capital, talent, and base money, and produces nothing except its own profits.

Ah, you object, how can the banks make any money on the turn? The answer is that at each stage they lengthen the maturity and add risk in other more advanced ways, with options and swaps and so on. They charge high fees for this negative expertise.

Now of course the thought experiment is unrealistic. It should be widened to nonbank financial corporations, such as hedge funds and financial insurers. This increases the scope for profit and risk generation without necessarily or even probably engaging the real economy in any other way. Eventually, a small proportion does leak out into boring loans to households, businesses and governments – all of which adds the risk, as it’s not just that Greece may default, you have to worry about your loan to Dexia which holds a lot of Greek debt. Still, can you show me that my financial bubble network is impossible?

If the model is even partially true, it has explanatory power over the liquidity trap: it’s not households and non-financial businesses preferring cash to bonds, the cash never reaches them. Monetary expansion in current circumstances is pushing on a cosmic string.

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