Global Investment Banking Busted by Bank of England

Written by John Lounsbury

The Bank of England has published a research report that documents the parasitic activities of large investment banks with surgical precision.  Reporting real numbers removes subjectivity from the picture.  And the real numbers show that a substantial majority of banking business is “incestuous” –  involved in transactions with other financial institutions and only a small amount of banking interacts with the real economy which produces goods and services.

Here is an overview from GEI News:

It was about one year ago that the Bank of England published a research report that documented the well known (but often obscured from view of the broad public) fact that banks create deposits by writing loans with money “created out of thin air” based upon the security of assets lent against. That paper, “Money creation in the modern economy” now has a companion of comparable importance: “Investment banking: linkages to the real economy and the financial system” by Kushal Balluck of the Bank’s Banking and Insurance Analysis Division. This is a clear and complete summary of banking sector activities and an empirical assessment of the money volumes of various banking functions.

The study finds that the revenue of the largest global investment banks is 75% derived from interbank activities and only 25% from activities in the “real economy”. In other words, investment banking is much more about “making money” and much less about “making goods and services” than some may have heretofor thought. Certainly those who proclaim that their bank is “doing God’s work” would want to portray that just the opposite were true, unless, of course, money is their god.

So there is a reason that financial system assets are much larger than global GDP. It’s because many of those assets are unrelated to GDP, which is a measure of the production of goods and services. The relationship of banking to the real economy has been a matter of discussion for some time, especially since the Great Financial Crisis (GFC) of 2008.

Balluck has clearly diagrammed the business activities of the large investment banks with an emphasis of showing how the financial institutions interact with the real economy which produces godds and services. See Figure 1 and Figure 2.

Click for larger image.

Balluck compares the balance sheets of the global investment banks 2008 and 2013. He says:

The amount of debt securities – corporate bonds, government bonds and securitised assets – held by the major global investment banks fell by over 40% during this period.

When the total of all estimated “real” assets held was determined, he says:

Taken together, investment banks also had smaller lending portfolios through securities financing transactions in aggregate in 2013 than they did in 2008.

But the story in derivatives assets, those assets that are strictly financial system related without direct real economy asset backing, is different:

In contrast, activity in derivative markets has continued to grow since the crisis, albeit at a slower pace than it did prior to the crisis.

The notional values of banks’ open derivatives contracts has risen by nearly 16% between 2008 and 2013 to a value equaling almost $500 trillion. This 6.6x the global GDP for 2013, according to the World Bank. The same ratio in 2008 was nearly the same: 6.9x.

So while the banks have reduced “real” debt securities by 40% from 2008 to 2013 they have increased derivative assets (let’s call them “phantom” assets) by 18%. If normalized to global GDP, these percentages become real debt securities reduced by 50% and phantom securities reduced by only 4%.

Another revealing ratio is presented in the Balluck paper: The ratio of notional value of derivatives ($500 trillion) to real bank assets held for trading and securities financing operations ($3 trillion) is 167:1.

Balluck speaks to the uncertainty about this and mentions a factor (compression) which has kept the total value of derivatives from increasing even more:

It is impossible to know with certainty what has driven this increase, but it may be due to the long-term growth in the use of derivatives as they have become more popular for hedging risks. The rise could also reflect greater use of derivatives for speculative purposes. The notional values of derivatives have increased despite a recent increase in the use of compression services, which cancel offsetting derivative trades, by investment banks.

Note: Financiers may argue that the notional value of derivatives are an incorrect measure for assessing risk because the derivative positions are largely offset with counterparties within the system and only a very small fraction, say 1% or less should be netted out after all counterparties settle, represent the amount at risk. This can be accepted only if there is a very naive assumption: All counterparties will be there to settle. We have the proof of what happens when even one small counterparty cannot fulfill its contracts in the Lehman Brothers bankruptcy of 2008. Lehman Brothers had a miniscule position in derivatives (less than 0.01% of the global nominal total). But the financial system collapsed because no one knew which Lehman counterparties would be affected and how that would impact their ability to honor their other contracts. Within a day AIG was determined to have been swimming naked and became a ward of the government. The important risk factor is the total nominal value of derivatives because the structure is like an array of dominoes stood on end – when one falls, depending on where it is in the array a few more will fall or most could fall. Without a map of the contract dependencies the systemic risk is not known. And there is no map, no transparency in this morass.

Balluck devotes four pages of his paper to a detailed discussion of the risks involved and another page and a half about measures that have been attempted to deal with and contain these risks. These two sections should be read -they are as good a detailed summary as I have seen.

These large global investment banks have gotten themselves in a too big to fail (TBTF) position because of the banking services they provide to the real economy, both public and private. They are getting government support for their financial engineering adventuring activities because they do a small amount of their activity in the real economy.

When will this nonsense stop?