Other People’s Money

“Don’t tell him your name Pike” Capt. Mainwaring.

Capt. Mainwaring is one of the hero’s of this book. John Kay remembers back to a time when bank managers were boring but trustworthy. When they took seriously the duty of care they acquired with other people’s money and spent tiScreen Shot 2015-10-16 at 17.14.40me understanding the needs of their clients and customers. This model of bankers as pillars of the local community, a touch fuddy duddy but completely reliable lasted well beyond the time of Mr Mainwaring.

When I left University and was seeking a mortgage I met a clone of Mr Mainwaring at my bank, the Midland. He asked me all kinds of difficult questions about what I spent my money on, why I had a history of overdrafts, whether he could see the budget he assumed I had produced to demonstrate to myself that I could afford owner occupation, what my prospects were. God he was a pain, and God did he irritate me, and God was he right! This was the early 1980’s.

That bank manager was probably one of the last of the breed, in 1986 we had the big bang which aimed to release all the pent-up creativity of the financial industry. Old-fashioned bankers who wanted to understand exactly how clients were going to repay them were to become a thing of the past.

For those that have not kept up with the changes John Kay’s book is an excellent guide. If, like me, you still thought the role of banks was to take in deposits from lots of people and then lend that money out to businesses that needed help starting up or expanding, think again. If you thought that the bank of England created money by printing notes and pressing coins, think again.

Mr Kay examines how financial services have exploded over the past 30 years and whilst some of that has been positive we are now in the position of having “too much of a good thing”. In fact we have a critical area of the economic system which is generating instability and risk. More than this we have a process where a service, finance, has begun to transform the operation of the wider economy and society. A process of “financialisation” which undermines much which is valuable and creates enormous benefit for the few and enormous risk for the many.

Let us go back to the role of the bank to illustrate the scale of the issue. According to Mr Kay “Lending to firms and individuals engaged in the production of goods and services – which most people would imagine was the principal business of a bank – amounts to 3 percent of the total.” The vast bulk of banks balance sheets nowadays are the claims financial institutions have against each other. But what are these claims?

They are trading positions (or what you and I might call bets) on fixed income securities, currencies and commodities. JP Morgan’s exposure to derivatives of this kind is around $70 trillion. Have in mind that the annual Gross Domestic Product of the world is about $70 trillion. Deutsche Bank has $55 trillion worth of derivatives exposure. Against this it has deposits, the savings of people like you and me, of $577 billion and it lends money to customers of $397 billion. These are big numbers but they mean that what you and I think banks do amounts to 1% of their activities.

Mr Kay identifies 4 key functions of the finance industry: i) a payments system, cheques, ATM’s, bank transfers etc.; ii) “intermediation”, matching borrowers to lenders; iii) enable individuals to manage personal finance across lifetime and generations; iv) help individuals and businesses to manage risk. He then goes on to explore how modern finance does in relation to each of these. In each case we end we conclude that the financialised world is not serving us well.

If we take matching lenders to borrowers banks do provide an important “intermediation” service. Historically they did this by taking in lots of small deposits which people wanted instant access to and converting these into long-term loans. They could manage this trick because a) they had money invested by the owners and b) in practice not all those that deposited money with the bank would want it back at the same time. This meant they only needed to keep a fraction of the money deposited and invested on hand to pay out to those who happened to want it back.

In the mid 19th century it was typical that banks owners would have invested equity equal to 40%/50% of the banks total investments. This meant of course that 40%/50% of the loans that they made could go wrong and the depositors money would still be safe. However, banks decided they could be more efficient and create more profit if they pushed the logic of this along a bit.

By the start of the 20th Century the typical level of equity had dropped to around 25%. (See Admati and Hellwig) Post big bang however they went for it and did two things. First of all took the view that if a banks purpose is to lend money and it wants to expand then it needs more money. If depositors like you and I were not providing enough then they needed to go to the wholesale money markets and borrow big chunks from institutional and large-scale investors. They therefore borrowed a lot more, although still on short terms, but they did not increase the equity reserves.

In the run up to the financial crisis according to Admati and Hellwig the debts (deposits and wholesale borrowing) of many large banks financed 97% of their assets. What this means is, if more than 2% of its loans go bad the bank is insolvent. You might try going to a bank with a start up business and ask to borrow 97% of the costs, putting 2% in yourself. The banks would consider such a prospect as unfundable. So why are they fundable? Because you and I, as taxpayers, have been providing an implicit, and since 2007/08 explicit, guarantee to those that invest in banks.

One key outcome of the explosion in financial services has been the incredible growth in credit. As Mr Kay makes clear some credit is a good thing. When an economy is growing new businesses require credit to get up and running and to expand their activity. At these times and expansion of credit is a good thing. Indeed in times like this credit may well grow faster than the economy as a whole. It is important to appreciate the causal relationship however. Banks argue that the supply of credit will push growth. It may be of course that in reality growth pulls the supply of credit.

Everything is fine if credit is going into new productive investments creating new products and services that the public want. In the current economy however the demand for investment in new businesses is changing. New high-tech businesses do not have huge capital requirements. Google needs no factories or heavy equipment. Indeed many of the existing large businesses in the world fund their growth needs from internally generated cash.

Investors want good returns and security, a combination that seems contrary to economic theory. One way to square this circle is to invest in existing assets like houses and leverage your investment with borrowed money. So now around 70% of traditional bank lending is to purchase homes. Credit expansion fueling demand can be created by the stroke of a pen or more like the tap of a keyboard. Building houses to create supply is a much more complex and time-consuming business. The result asset price bubbles.

The investor appetite for this kind of business was insatiable in the early part of this century and led to the creation of asset-backed securities. This involves banks bundling mortgages together and “securitising” them. In other words selling the income stream that all the mortgages generated to a third-party, possibly another bank.

This basic asset backed security can then be “structured” and transformed into a collaterals debt obligation (CDO) which pays different rates of return to different investors from different slices of the asset. The purported purpose of all this financial jiggery-pokery was to diversify risk and to place it with those best able to manage it. And then to spread the problem a little further those with CDO’s would take out a Credit Default Swap (CDS) which insured them against defaults on the asset.

Now go back to what all this financial pile of crockery is standing on. A mortgage. Had it been just on my mortgage, taken out after I have been through a third degree interview with Mr Safe who pretty much knew every creaky corner of my finance and prospects then probably 2007/08 may not have happened. However, because there was such demand and so much innovation Mr Safe was long gone. Mortgages were no longer treasured and provided, they were marketed and sold. The third degree was replaced with the mirror test. You placed a mirror in front of the mouth and nose of the applicant and if it went misty they passed.

However high you build the pile and however sophisticated it is, if the underlying asset is worthless everything above it is.

The financialisation of the world since the mid 1980’s has transformed it in many ways, some subtle, some the opposite. Mr Kay’s book guides you through the changes with the insight of someone who really understands what has happened and applies very bright common sense to an area of very murky cleverness. The critique is withering and the implications revolutionary. His prescription for this illness is not ever more detailed regulation. As he puts it “too big to fail is too big.” What is needed is structural change to transform the drivers and incentives of individuals’ actions. The Wolves of Wall Street need to be repelled by the Home Guard of Warmington on Sea. Capt. Mainwaring might not be cool but he is trustworthy.

John Kay. Other People’s Money: Masters of the Universe or Servants of the People? Profile Books 2015


Climate of Change

In December this year, in Paris there will be the meeting of the 21st annual Conference of the Parties (COP21). The parties concerned are those that are signed up to the United Nations Framework Convention on Climate Change (UNFCCC). This is the convention agreed at the Earth Summit in Rio de Janeiro in 1992 aimed at stabilising greenhouse gases in the atmosphere to prevent dangerous interference with the climate system. It was the 16th session of the COP at Cancun that went further and agreed that future global warming should be limited to 2 degrees centigrade above pre industrial levels.

Given this is the 21st Conference you may think it is just another of those climate change conventions that seem to confirm things are getting worse, talk about what progress is being made with renewable energy and what urgent action needs to be taken and end in a diplomatic fudge. Given the track record it is probably right to be sceptical.

There is just a chance however that it might start to gain some traction in the mind of the public as the deadlines for action start to close in. In 1992 when the issue of climate change was still relatively new and the science hotly contested, talking about issues which may have an impact in the middle of the next century was unlikely to generate much public concern.

The situation is different now. The International Energy Authority (IEA), an autonomous agency established in 1974 to promote energy security among its 29 member countries, has written a report in advance of the COP21. It is an interesting read.

In terms of the tone of the document think of Blackadder, yes the Rowan Atkinson one. Imagine the kind of report that Captain Darling might have written to Lord Melchitt about the success to date and prospects of the strategy adopted by the British Generals in World War One. Explaining to an irascible and unwilling superior who might have you shot for dissension why the strategy adopted to date is probably not going to cut it.

As you might expect the report starts with an emphasis on the positive. It talks about the sustained level of investment in renewables at $270bn per annum. It also talks about the fact that 2014 seemed to indicate a decoupling of growth from increases in carbon emissions i.e. whilst the global economy grew by 3% CO2 emissions stayed flat.

It then goes on to say what sterling work nations around the world are doing with things called Intended Nationally Determined Contributions (INDCs). It is worth just pausing to analyse the terms in this concept. “Intended” – we will do our best but we cannot guarantee. “Nationally Determined” – we will decide if we want to participate in saving the world, not some international busy body. “Contributions” – we are not doing this on our own, if you don’t we wont.

Perhaps a bit harsh as there has been genuine progress with e.g. the European Union pledging to cut green house gas (GHG) emissions by 40% by 2030 relative to 1990 levels.

However, we now turn to the bit about walking towards machine guns. The report points out that “With INDCs submitted so far, and the planned energy policies in countries that have yet to submit, the worlds estimated carbon budget consistent with a 50% chance of keeping the rise in temperature below 2 degrees C is consumed by around 2040 – eight months later than is projected in the absence of INDCs.”

In essence if we continue as we are, even with the mitigation strategies in place that we have, in 25 years time we either stop burning fossil fuels all together (one can see the whiskers of the Oil Industry Melchitts starting to twitch at this point) or drop the 2 degrees C target and accept the risks that flow from that.

The IEA propose building on the INDC’s position to create “a “virtuous circle” of rising ambition”. This is Captain Darling speak for “What you are doing is nowhere near working and you have to get real.”

In a rather convoluted fashion they call on “political leaders of the highest level” to make clear their commitment to low carbon development. They identify four pillars to support that achievement. Captain Darling like, they set these proposals out at a level of abstraction which they hope will hide their radical implications.

1) Peak in Emissions – set the conditions that will achieve an early peak in global energy-related emissions.
2) Five Year Revision – review contributions regularly, to test the scope to lift the level of ambition.
3) Lock in the Vision – translate the established climate goal into a collective long-term emissions goal, with shorter-term commitments that are consistent with the long-term vision.
4) Track the transition – establish an effective process of tracking achievements in the energy sector.

Having got this far without being shot Captain Darling gets on a bit of a roll and proposes a “bridging strategy” to deliver a peak in energy related emissions by 2020, 5 years from now. The Bridge Scenario relies upon 5 measures:

1) Increasing energy efficiency in the industry building and transport sectors;
2) Progressive reduction of the least efficient coal-fired power plants and banning construction;
3) Increase investment in renewables from $270bn to $400bn in 2030
4)Phasing out of fossil fuel subsidies by 2030
5) reducing methane emissions in oil and gas production
These measures involve “putting a brake on growth in oil and coal use within the next 5 years…” Oops I think I hear the sound of a firing squad being drawn up.

Whilst the report is written as diplomatically as possible the underlying reality shines through. Burning fossil fuels as we are and expecting to prevent global warming is as rational as marching soldiers towards machine guns to win a war. The reality is we have to stop using fossil fuels, and quickly. Whilst the worst of the consequences are some time off the time we have to take effective action is now.

There are signs that the issue is starting to move up the agenda of politicians and policy makers. In 2014, as recorded in the FT, the then energy secretary Ed Davey “called for tougher rules to be applied to companies holding “risky” fossil fuels assets that could plunge in value because of global action to tackle climate change.” Mr Davey went on to talk about some analysts who were estimating such actions could cost the fossil fuel industry over $28trn in lost revenue over the next two decades.

Earlier this week Mark Carney warned investors that they may face “huge” climate change losses. With almost a 5th of the FTSE 100 industries being natural resources and extraction companies this is a matter of come concern. The carbon budget the world can use if it is to secure its 2 degrees C temperature increase target amounts to between one fifth and one-third of proven reserves of gas and oil.

To be clear, this suggests that somewhere between four fifths and two-thirds of the current reserves, which are giving value to extraction company balance sheets, may be “stranded” in the ground.

Some investors are already alert to this issue. The heirs to the Rockefeller fortune and Stanford University have started to sell out of oil and coal shares. It may of course be there is some ideological driver to those that divest early. However if politicians “at the highest level” start to take actions along the lines set out in the IEA report mentioned above, then serious investors, concerned only with financial returns, may start to move. If this happens it will have implications for everyone. Who’s pension does not have shares in BP? There is no easy option here and the longer the issue is left the worse the options become.

At the moment there are plenty of urgent issues to deal with: ISIS; the Russian intervention in Syria; Austerity; the slowdown of the Chinese economy; and potential crisis in developing economies. Whilst these issues demand attention our leaders cannot ignore the growing crisis that global warming might represent. The science seems to be overwhelming and certainly sufficiently clear to require the adoption of the precautionary principle given the stakes.

Mr Cameron is always telling us about the difficult choices he is willing to make. Is he going to tell the fossil fuel industry that its business model is broken, or gamble with the future of the planet. That may be a particularly difficult choice…for him


Energy and Climate Change World Energy Outlook Special Report; FT 11 December 2014; FT 29 September 2015