Volume 1
Bad Medicine and the Body Economic

It will more than likely only be in the fullness of time that we will know whether the medicine administered to the broken global financial system following its 2008 implosion has worked.

At that time, commentators of the calibre of Martin Wolf were asking whether history would look back at that year as an epochal frontier between something once known as capitalism, and something quite different. The failure of Lehman Brothers, he postulated, might be the 1989 Berlin Wall moment for capitalism.

To his credit, he did not, even at the height of uncertainty during the crisis, blindly sensationalise the facts. In his column published on the 19th of May 2009, titled ‘This crisis is a moment, but is it a defining one?’ he posited that, owing to the “determined” policy response, neither a depression nor the end of capitalism would eventuate. He was right. Neither has occurred. But in the detail his prediction was somewhat off.

The mistake he makes is the mistake we always make, and that is to use the frame of reference we currently inhabit to predict the future. He writes: “Is the current crisis a watershed, with market-led globalisation, financial capitalism and Western domination on the one side and protectionism, regulation and Asian predominance on the other?”

In his 2009 thinking, Wolf has strongly polarised two geopolitical power centres and then established these centres as being defined each by two ubiquitous socio-political concepts. On the one hand we have “western domination”, which is driven by, and drives, “financial capitalism” and “market-led globalisation”. And on the other hand we have “Asian predominance”, which advocates “protectionism” and “regulation”.

As it turns out, as a function of deep declines in oil and commodities prices, fear of ever more visible jihadist terrorism, a war in Syria, and mass migration into Europe from the Middle East and North Africa, the result eight years later is something of a mix between Wolf’s two possible futures. The paucity of leadership, particularly in the UK and the US, and exemplified by the US presidential election, has not helped either.

We have Western domination still – that is true. But this is mostly owing to the slow disappointment of the Asian economies, particularly China, rather than the outright success of Western Europe and the US. Market- led globalisation and financial capitalism have to a large degree been undermined by the medicine itself. When taxpayers were asked to bail out the banks, they did so at a cost. And that cost was the concept of the free market. The argument that the market would self-govern and would cull from its own when necessary was dead in the water the minute Hank Paulson put pen to paper on the TARP (Troubled Asset Relief Program) funding Bill.

Furthermore, the massive injection of money supply through multiple rounds of quantitative easing, radically and forever altered the notion of the national central bank as a passive guide that would, on occasion, nudge its herd in the right direction.

We also have deep-rooted protectionism as the key defining feature now within western democracies rather than within their Asian counterparts. Whereas previously it would have been unimaginable for an advanced western nation such as the United Kingdom to choose isolation from Europe, its fear of immigration, and the ever-widening gap between its politicians and its people, have led to a sharp turn to the right and towards unashamed protectionism.

When history looks back at the decade that followed the 2008 Financial Crisis I think it will judge us harshly. There is no doubt that the determined response of central banks in pumping multiples of money supply into major economies was necessary. That was the swift response that was needed to stop the blood-letting in the banks after Lehman Brothers went down.

And there is no doubt that a Keynesian fiscal response was equally necessary, although it was poorly executed owing to the political fear of selling to a disenfranchised public the notion of deeper government debt to help fund it. Fewer bridges and roads were built than were ought to have been built.

But the real failure that will be studied by future economists will not be in regards to either of these macro-economic tools. It is neither monetary nor fiscal policy that will be deemed the cause of a prolonged period of painful middling growth coupled with rising inequality. It will rather be the macro-prudential response in terms of international, yet oftentimes, conflicting regulatory intervention that will be held accountable.

The conduit to monetary policy, as well as the vehicle that enables and leverages fiscal policy, is the banks. And they have been handcuffed and held in solitary confinement through a plethora of vast, politically- inspired and derelict regulations that have been imposed on a regular and sustained basis against them for the past decade.

Regulations such as FATCA and Automatic Exchange, which aim to rein in tax-evaders, have been imposed at the cost of banks, which are now held responsible for implementation and execution – effectively turning banks into extensions of the tax authorities and the Department of Justice.

Market manipulation of interest rates has led to few individual criminal arrests, but rather has led to punitive fines on the institutions that are meant to enable growth through lending. These fines have been of such incredible proportion that they have effectively wiped out large chunks of annual retained earnings from bank balance sheets, making it even more difficult for these banks to increase their capital levels.

Then there are the adjustments under Basel III of these same capital levels – effectively doubling the Tier-1 capital requirement. This means that banks must, in order to achieve the required capital levels, either increase retained earnings or decrease lending. And it means that banks are now, counter-intuitively, more likely to fail rather than less likely. It seems clear and logical that the harder you make it for banks to meet capital requirements, the greater the likelihood that they will not meet them.

To really add salt to the wound, bank regulators introduced annual stress tests that impose hypothetical stresses on bank balance sheets that are already suffering from real-world stresses. The absurdity of this was made clear recently during European bank stress test season. Several banks fell short on stressed capital tests primarily owing to the combination of real- world and hypothetical scenarios taking effect simultaneously. The stress tests in their conception never considered the Brexit effect, but that effect was embedded in bank balance sheets before the hypothetical tests were even applied.

Making matters even worse, once the results were released, the credit rating agencies then took their turn. Based on the results, the rating agencies then got to decide whether to downgrade these miscreant banks for ‘failing’ the tests. When downgrades do occur they usually lead to widening credit spreads for these banks’ own funding, and thereby to an increase in the cost of funding, a depression in margins and earnings, less retained earnings and further pressure on capital levels.

Recall that these are the same credit rating agencies that various US and European government-led investigators found seriously wanting in the run-up to the crisis. These agencies had issued triple-A ratings for CDOs which were vastly more dangerous than the one in ten thousand chance of default that this rating implies. And they did a lot of this – tens of thousands of ratings on tens of thousands of CDOs.

Their business model – which is to have the issuer pay for the rating – inspires at the very least some question of conflict of interest. And it is a business model that remains largely unchanged, nearly a decade after the Financial Crisis.

Banks have responded to these sustained attacks on their balance sheets by doing one of two things that they can easily control and that speaks well to investors – cutting costs or selling assets. In some cases they have cut costs, and this has meant job losses. And where assets have been sold it has generally meant a reduction in geographic diversification, such as the sale of Asian subsidiaries, or a reduction in asset class diversification, for example a focus on investment banking at the cost of retail banking.

In both cases this translates into an increase in risk profile for these banks, who have sold assets at fire-sale prices, under pressure from regulators and rating agencies.

There have been litanies of other regulations that have each had their own effect on the business of banking. We have not touched on the new liquidity rules for banks, for example, nor on the protection of personal information laws. Nor have we covered the treatment of trusts and shell companies, nor the innocent-sounding, but very onerous law called ‘Know Your Customer’.

In each and every case the rule has been conceived symptomatically – it has been made to address a particular failing observed at the time of crisis in 2008. In some cases the intention of the law has been clearly politically motivated, such as rules governing executive pay. But in many cases the rule has been made from a good place – its intentions were sound – it just never took cognisance of the entire body economic.

I suspect economic history will judge the macro-prudential medicine that was administered to the critical function of money supply and credit extension, to banking, to be bad medicine.

Like all of the symptomatic drugs that we use to smooth over the challenges of everyday life – the cortisones and the pain medication and the muscle relaxants and the anxiolytics – they work well to reduce our discomfort. But this is not a case of the flu, it is something far more enduring. By addressing only the symptoms, by never attacking the source of the infection itself, we only delay the inevitable.

And that inevitable outcome will be structural reform. It will not be long before banking faces an existential question. Can banking serve both its macro-economic duties as well as its duties to shareholders? And if so how can it do so profitably? At the point at which banks find themselves today, it is becoming increasingly difficult to cross even the double-digit boundary for return on equity. Investors may just do what investors always do, and migrate to better performing and less challenged asset classes.