Having been brought to the edge of ruin by what can best be described as deregulated capitalism, you would have thought that our political masters would have seen the error of their ways and demanded tighter regulations and greater transparency. They have …sort of, but it’s not worked. In America, fierce lobbying has totally emasculated proposed reforms to the financial regulatory system. With one or two notable exceptions, it’s back to the status quo.
In Britain the Independent Commission on Banking, headed by Sir John Vickers, is due to report in September. We already know that his proposals are not going to be earth shattering and that he’s bottled out when it comes to recommending retail banking be split from investment banking. So, what’s been achieved? Frankly, not a lot: all we appear to have done is to put the gravy train back on the rails and given it a new timetable – which will be ignored.
We are none the wiser today about what banks are up to as we were before the banking crisis. In 2008 we had no idea about toxic Mortgage Backed Securities (MBS) – neither, it would appear, did our politicians or the Treasury. Since then, no regulator or politician has alerted us to any undiscovered toxic instrument lurking in the balance sheets of our major banks. Should we feel reassured by their silence? Absolutely not: the activities of the banks are as opaque as ever.
To illustrate the point, did you know that there are $600 trillion (yes, trillion) – that’s 10 x the total value of world output – worth of outstanding notional derivative contracts, and that many, of these contracts are held by banks? (a derivative contract is a perfectly acceptable means of allowing people / companies and investors to minimise risk. A problem arises when those who use these contracts try to gear their risks by allowing institutions and funds to invest more of the underlying commodity or currency than they can afford to buy or to go short – with the potential for substantial losses if they bet the wrong way)
What we need to be worried about is that if world markets are spooked – potentially by a Greek default or some other catastrophic happening – these derivative contracts could unravel. Potentially, the consequences of this could be a global melt down.
Now, surprise, surprise, the derivatives market is very lightly regulated, which is a polite way of saying it is hardly regulated at all. There is absolutely no limit on how much banks can get involved in this activity. We think we have bailed out the banks and that they have exorcised all the toxic elements from their balance sheets. That is not the case. We have no idea what they have hidden away.
There are three things that need to happen as a matter of urgency. Firstly, we need to know what exposure major British banks have, and secondly there needs to be a limit on how much capital banks can devote to derivatives. Thirdly, and most importantly, the G8 need to agree to a global regulation of the derivatives market.
If we fail to act, the immortal words of Private Fraser could well come true.