“…the oldest and simplest reason of bankruptcy in finance: lending money to people who can’t pay it back.”
Banking has a long, colorful history – in fact, it’s probably the world’s second oldest profession and created as much controversy as the first. Banking in modern times was largely a sedate affair, characterized by what is known as the 3-6-3 rule: pay 3% on savings deposits, lend at 6%, and be on the golf course for a 3 pm tee time. But more recently banking has undergone a radical transformation, one that viciously came to light during the 2008 global financial crisis.
This transformation can be noted in the explosive growth of two asset markets: foreign currency exchange (FOREX) and the markets for financial derivatives. Let us consider first some of the changing metrics of the foreign currency exchange market (source: Wikipedia):
The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world’s major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.
The FOREX market is the most liquid financial market in the world. Traders include large banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail investors. The average daily turnover in the global FOREX and related markets is continuously growing. According to the Bank for International Settlements, the preliminary global results from the 2013 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity show that trading in FOREX markets averaged $5.3 trillion per day in April 2013.
Compare this to the total value of global trade in real goods and services for the entire year of 2013, which was only $37.7 trillion. Obviously, there’s a lot of action in foreign currency trading. Why? Because of the volatility of floating currency rates. The original idea of moving from fixed exchange rates to floating rates was that policy differences between countries would be forced to converge on efficient fiscal and monetary policies because of the discipline imposed by currency fluctuations. In other words, bad policies would harm the domestic economy and the markets would sell off the domestic currency, forcing politicians to correct those policies.
Unfortunately, the opposite happened. Bad economic policies caused currency values to fluctuate widely, creating price volatility that attracted the attention of traders into the game, creating the exponential increase in trading volumes (with the economic consequences). And guess who are the major traders of foreign currencies, otherwise called speculators? You guessed it: the major global banks that today are Too Big To Fail.
The volatility of FOREX markets then created the opportunity for financial innovation to create numerous new markets for those wonderful financial derivatives we’ve all heard so much about. To give an idea of the size of the derivatives market, The Economist magazine has reported that as of June 2011, the over-the-counter (OTC) derivatives market amounted to approximately $700 trillion, and the size of the market traded on exchanges totaled an additional $83 trillion.
Don’t misunderstand this – financial derivatives have been around for a long time to hedge the uncertainty of price changes over time. In other words, they can provide insurance against the risk of loss associated with those price changes. This is what commodity futures are about, where farmers can lock in a price for their products, be it corn or pork bellies, before they invest in new production. There is a productive financial role for derivatives, which is why they exist. However, newly created volatility in asset markets can be highly leveraged in derivatives markets (think 100 to 1), to offer gambles with incredible pay-offs. Often this just becomes a highly leveraged play on risk with OPM (Other Peoples’ Money) yielding little economic benefit. In other words, a casino.
The problem is that gambles don’t always pay-off and somebody gets saddled with the losses. As these markets have grown, national governments have had to become heavily involved in assuring the integrity of these markets. Consequently they have been forced into the breach to backstop the losses with bailouts that eventually fall on taxpayers – either in the form of accumulated debt and increased taxes, but also through the slow devaluation of the currency. This helps reduce the value of debts incurred by speculators in the FOREX and derivative casinos.
The upshot is that banking is no longer a boring but secure backwater for the country club crowd. It’s become a hot-bed of furious trading and living on the edge, with incredible pay-offs to the winners and taxpayer bailouts for the losers. We’ve essentially turned finance, which is supposed to fund the real economy with prudent capital investment, into a trading casino where winners and losers result from the throw of the dice.
How do we sober up? That’s a good question that we’re going to have to ponder at some point. It certainly would be nice to send the bankers back out on the golf course. Hopefully before the next global financial crisis wipes us out.