Bill Totten's Weblog

Friday, February 05, 2010

Bank rules miss their target

by Richard A Werner

Special to The Daily Yomiuri (February 04 2010)

US President Barack Obama's proposed government restrictions on bank speculation are a step in the right direction. But they are like opening an umbrella, when the roof needs fixing. Banning proprietary trading and bank ownership of hedge funds improves financial markets, because the vast game of insider trading that has been going on for decades in the world's major financial centres may be discouraged, whereby large banks and securities firms abused client confidentiality and their privileged position as counterparty to large transactions in order to take bets on their own books ahead of or against their own clients. This is the sort of conflict of interest that former New York District Attorney Eliot Spitzer rightly and somewhat heroically campaigned against. And that's why President Obama's rules to ban proprietary trading and bank-owned speculative vehicles, such as hedge funds and private equity funds, are a good thing.

But something happened when these long overdue restrictions were announced. Some of President Obama's advisers must have mixed up their notes or got confused. For poor Mr Obama ended up giving the impression that he actually believed these sort of restrictions would prevent, or perhaps even end, banking crises and the intermittent transfer of vast tax funds to the banking sector (every ten to twenty years).

These restrictions have little if anything to do with the causes of banking crises. They do nothing about banks' dangerous involvement in speculative finance. With such new rules, there will be just as many banking crises in the future as in the recent past (over 100 in the past thirty years). At the World Economic Forum in Davos, bankers argued (in vain) against Mr Obama's restrictions, by correctly pointing out that proprietary trading was not the main cause of the banking crisis. Such trading should be banned, but not because it causes banking crises (but because insider trading is illegal and taking bets against your clients on the basis of your knowledge of their positions is unethical). If we also want to prevent banking crises, something else will need to get banned, namely the activity that was the main cause of the banking crisis.

Proprietary trading can be defined as banks "taking risky bets with their own capital to make money on the financial markets". Whether it is a hedge fund's investment programs, private equity funds' business techniques, the operation of structured investment vehicles (SIVs) investing in subprime mortgages or merger & acquisitions (M&As) - almost all such apparently sophisticated financial "innovations" of the past decades rely on something rather simple and old-fashioned (about 5,000 years old - the age of our banking system, which started in Babylon): plain vanilla bank credit. All the above, including bank credit to hedge funds or credit for mergers and acquisitions constitutes, just as much as proprietary trading, banks "taking risky bets with their own capital to make money".

Banning banks' direct investment in or ownership of such ventures won't prevent them from extending credit to these speculators. Worse, their credit extension is only backed by a fraction of their own capital, hence it is more dangerous than proprietary trading (which technically might be said to be "fully" backed by capital, though in fact it is fully backed by the tax-payer). Thus banning banks' speculative investment for their own books must be done together with a ban on banks' lending to speculators.

The full extent of the problem and hence the need for such a measure will only be understood what makes banks special: they enjoy the public privilege of being authorised to manufacture and allocate about 98 percent of the money supply. That's why there is in fact no such thing as a "bank loan": When banks "lend" money, they actually create credit and hence "coin" new money. Whenever their newly created money is used for transactions that are not part of the real economy (such as all the above financial transactions), asset price inflation is created and an unsustainable bubble comes about that, if large enough, will threaten the banking system and lead to calls for tax payer-funded bailouts.

If US conglomerate Kraft wants to buy British confectionery firm Cadbury, let them do it, but why should this US firm be allowed to fund its takeover by being given newly created British pounds, with the money proudly produced and handed over to Kraft by a British government-owned bank? RBS provided more than 600 million euro for Kraft's purchase of Cadbury - an example of unproductive credit creation. Why not instead create credit and lend it to the many productive and innovative British small and medium-sized firms? (You know the answer: it's more work and generates smaller bonuses per bank staff; and the government and central bank do nothing about changing these wrong incentives). The millions provided by RBS will be handed to all those shareholders who sell their shares to Kraft, and hence will be injected into financial markets, fueling asset inflation, while the small firm credit crunch continues.

Since under the guidance of the government banks have been given the go-ahead to reengage in speculative credit creation on a grand scale over the past year, we should not be surprised that asset prices have been driven up again. Intriguingly, the German government, when hesitantly claiming to welcome President Obama's restrictions on banks' proprietary trading, said that the financial sector should be "made to pay for future financial crises" (Finance Minister Schaeuble). It seems they are wise enough to start talking about the next banking crisis.

That, indeed, is also the view taken by the IMF. On February 1, its managing director, Mr Dominique Strauss-Kahn, argued that the best way to respond to the American and British banking crisis was to impose new taxes on international financial transactions, which the IMF wishes to receive. This would serve two purposes, Mr Strauss-Kahn says: It would encourage the financial sector to take fewer risks, and secondly, it would raise money for the future banking crises - that seem to be on the horizon. This statement makes obvious that, like me, Mr Strauss-Kahn does not believe that such a tax (often called "Tobin tax") would prevent future banking crises.

So why is that major regulators and decision-makers wish to engage in "reforms" of the banking system, which might achieve various things, but will ensure that the cycle of recurring banking crises will continue? Eliot Spitzer and his fine nose for conflict of interest have not yet identified the problem that the IMF and the World Bank thrive on crises. Why else would countries allow the young IMF staff to boss around their governments and dictate structural adjustment programmes that have now been proven to make people worse off? (A 2008 report in a medical journal by Cambridge and Yale scientists demonstrated that where the IMF treads, public health spending goes down, and tuberculosis goes up).

Meanwhile, World Bank economists have said on record that they do not mind financial crises that much, because they are "a window of opportunity" - for what? For "structural reform" (of the free market type imposed by the IMF that allows greater access to large international corporations) and for a "transfer of ownership" (you guessed right; not a transfer from the few to the many).

If one was serious about preventing bubbles, banking crises and indebting tax payers further, one would not stop at banning banks' proprietary speculative investments, but simply ban all bank credit creation for unproductive use, which includes all bank credit for financial transactions. Let the speculators speculate, and ideally without charging a tax that will fund unhealthy bureaucracies, but prevent them from gaining access to the public privilege to create money, and let them try to raise the money in the oh-so-efficient capital markets. With this simple rule to ban banks' credit for financial transactions, there won't be asset boom/bust cycles, speculators and bankers would have lower bonuses, risk in financial markets would be reduced, and, most importantly, there won't be any more banking crises. For it is the creation of credit for use in transactions that are unproductive and do not contribute to GDP (financial transactions) that creates asset bubbles and banking crises.


Werner, DPhil (Oxon), is professor of international banking at the School of Management, University of Southampton, author of Princes of the Yen (M E Sharpe, 2003), and in 2003 was selected as "Global Leader for Tomorrow" by the World Economic Forum in Davos.

Bill Totten


  • President Obama and Ben Bernanke are in a MOVIE about hedge funds called "Stock Shock." Even though the movie mostly focuses on Sirius XM stock being naked-short-sold to near bankruptcy (5 cents/share), I liked it because it exposes the dark side of Wall Street and reveals some of their secrets. DVD is everywhere but cheaper at

    By Anonymous Anonymous, at 2:56 AM, February 06, 2010  

Post a Comment

<< Home