I promise this will be my last one no really!
By Melvin J. Howard
How do the risks of the big gamblers of the financial system like Wall Street firms and the currency speculators, get transferred to the public who have no say or gain in these gambling adventures? How does this risk transfer work to increase income and wealth gaps globally, which then further increase financial risk, which in turn exacerbate global income inequality, and the cycle starts over again and again. Presently the big financial players are merrily increasing the financial risk to be transferred to the public and the public is now finally noticing. Rather, what many are noticing are the consequences of risk transfers that have happened in the past and materialized through such things as the IMF bailouts. Not too many concerned citizens were noticing the risk transfers that were being set up right in our own backyards now for the public to digest. The financial instruments through which these speculators were to gamble got more and more complex, and layer upon layer of instruments. Things like options, swaps, naked calls, floors, caps and collars. Then they mated and had offspring like - swaptions, captions, knock-out options and roller coaster swaps. I don’t think even the players themselves really knew what going on they were just saying what everybody else was saying. They were there for a quick profit, and have bedazzled the best mathematical minds money can buy to help them do this. Lets not go into the details of how these multiplying and magical instruments work. Rather we note that their growing use in the past that made the economies wobblier everyday, and that the financial markets were becoming too complex to regulate. On top of this, for every regulation curtailing speculator activity a new instrument materializes to circumvent it. Speculator’s instruments multiply like new strains of bacteria, gaining resistance to the old treatments. Now lets take a look at the Basel Capital Accord, this is sponsored by the Bank for International Settlements in Switzerland, to address the issue of bank and speculator risk. The Bank for International Settlements (BIS) might be considered the third arm of the major global financial institutions, the other two being the World Bank and the International Monetary Fund, which have been in the news lately. In comparison the BIS seems to get very little public attention. The BIS is owned by the central banks of the richer countries. Central banks in other countries are like the Federal Reserve in the U.S. That is, they are responsible for monetary policy or, the real activities of the BIS are extremely well guarded in secrecy. I could not find out what they really do and I could not find anyone who knows what they do either. But one thing I do know is that they host the discussions and rule-making about how countries should supervise their banks to make sure they are not getting into too much trouble, which might in turn upset the global financial system. While they host the international bank supervision meetings (closed to the public) the BIS says they are not responsible for the Basel Accords, which set international bank supervision standards. Banks don’t like to be supervised they rather just supervise themselves.
How much money can banks create through the lending process?
For every amount of money there is a corresponding amount of debt owed to the banking system. But how much money can a bank create through the lending process? A lot of that depends on how risky its loans are. Banks can create new loans (or bank money) up to a certain maximum multiple of their shareholder capital that is; the amount shareholders have invested in the bank, which is also the excess of the banks assets over its liabilities. Remember banks assets are its loans to the public, and its liabilities are deposits of the public. Capital for a bank can be thought of as a safety net the more capital a bank has, the safer it is. That multiple of shareholder capital that banks can create, as money will depend on how risky the loans are they choose to make. If they are very risky the multiple will be lower. Put another way, a bank that makes risky loans will have to hold more capital (i.e. more of a safety net) as a percentage of total loans than a bank that makes less risky loans.
Do you like to gamble, if you do when you go to the casino, you don’t bet all of your life savings. You leave some of your money at home or in your bank account so that if you lose all your bets that day, you will be able to tap into your untouched savings the next day to buy food, pay rent i.e. conduct business as usual. This is exactly what banks must do to make sure they can remain viable entities in the long run. The more risks you take with your money the higher a capital buffer you need because more risks mean a higher probability of loss. For many banks these "risk based" capital levels were set under the Basel Capital Accord years back. These capital accords were just revised, the banks complained that they have to hold too much of a capital buffer. You see banks want to hold as little capital as possible, so that they can create a maximum amount of loans (or money) that can bring in higher profits. From their perspective a safety net has an "opportunity cost" which limits the profits they can make. "But aren’t they worried about not having enough of a safety net if their bets go bad?", you might ask. Well, not if they are "too big to fail" and the public will be called upon to bail them out if their bets go bad i.e. look up Moral Hazard. This is what has been happening since the beginning of banking. From a public interest perspective conservative (higher) capital levels are a good thing. They help to prevent banks from taking excessive risks which often lead to publicly funded bailouts to rescue them from insolvency.
Banks took excessive risks, of course, because higher risk investments bring in higher returns. This means more profits for shareholders and higher bonuses for the executive staff and others. The disincentive for higher risks is that a risky investment is more likely to fail and you could lose some or all the money you put in. High risk investing is exactly like gambling in fact it is gambling. Such speculation is of concern to the public because the gamblers are playing with the financial system and currencies upon which all real economies are dependent, and because the public is often called upon to bail out speculators to avert financial and economic crises. As income inequality grows, fewer people have more and more money to play with and so financial activity becomes increasingly about speculation in the markets, speculative financial instruments alluded to earlier, rather than purchase of real goods and services. Hence financial risk increases as income inequality grows. As we have seen, this risk taking then often leads to devaluation of foreign currencies against the US dollar, and publicly funded bailouts, whose costs fall disproportionately on the poor (or those who are not major players in the global financial system). This widens the income and wealth gaps even more, and further increases speculative activity and financial risks that will later trigger another bailout. And so the cycle continues a dangerous path for everyone. Let me ask you something if you knew you would get a free pass or bail out no matter what how much would you risk?
This problem is compounded further because the big players are getting even bigger through global mergers and acquisitions in the wake of global financial deregulation. It is ironic that these beneficiaries were the very same players who instigated so much of the excessive risk taking that caused this past crisis. This shows you just how much the moral hazard of bailouts can distort what is supposed to be a "free market". The public should understand how banks and other gamblers increase the risks in the financial system, since the public always pays the price for excessively risky bets that go wrong through various bailout mechanisms.
