Above: Adair Turner's interview in the September issue of Prospect hit the headlines and caused a furore in the City
The City takes too big a share of our economy and is bloated by doubtful profits from dubious activities. Not the allegations of placard-wielding demonstrators but of Adair Turner, chairman of the Financial Services Authority (Prospect, September), and of Lloyd Blankfein, chief executive of Goldman Sachs (to a German banking conference in September), respectively. Suspicion inevitably accrues both to an embattled regulator talking tough and an emollient investment banker. And neither Turner nor Blankfein seems comfortable in their role as Jeremiah. But is either right? Is the City too big?
Britain faces an estimated bill of £130bn for shoring up its banking system, a higher proportion of GDP than any other country. This alone should put the issue of the “right” size of the finance sector on the agenda. Unfortunately, the question yields no easy answer. There is no consensus on a relevant measurement, or even on whether the statistics—especially those in Britain’s national accounts—are reliable. Britain has a historic comparative advantage in finance, so one would expect it to have a relatively larger finance sector than some other countries. No one thinks it odd that Germany has a big car industry.
The problem arises (if it is indeed a problem) because of the profitability of finance. Analysis of the published earnings of the largest quoted British banks shows an across-the-board increase from the beginning of the 2000s until the recent debacle. Barclays, HSBC and Standard Chartered all more than doubled profits between 2001 and 2006. In the US, banking, broking and insurance mushroomed from around 10 per cent of total corporate profits in the 1960s to a staggering 41 per cent, its apogee, in the early 2000s, before collapsing in 2007-08. Corporate profits are calculated slightly differently in Britain, but the trend is the same: finance grew both absolutely, and as a percentage of total private sector earnings.
We now know that the rising tide of earnings was not sustainable. Some question whether the profits were ever even “real.”In particular they question whether it is wise for banks to count among today’sprofits income to be collected years into the future, a process known as “mark-to-market” accounting that leads to wild swings in earnings, and which can have dramatic consequences for the economy.
Financial sector income does not necessarily depend on what a bank’s assets (such as a bond) are worth when they are sold; merely on estimates of what they would be worth, if they were sold. Put simply, a bond bought for £100 on Monday, but quoted at £102 on Tuesday will generate a profit of £2 in Tuesday’s accounts. True, these estimates are based on credible quotes from independent brokers. And this ability to turn instant profits or losses applies only to trading assets (which can be bought and sold with relative ease) rather than to longer-term loans (where earnings are realised more gradually).
This process of marking to market is the key to understanding both the boom and the bust. Writing in the Financial Times, the economist John Kay recently argued that profits from trading assets alone cannot explain banks’ earnings growth during the boom, because while some banks win on their trades, others lose. The results cancel each other out. However, in an asset boom like the early 2000s all banks can (and did) make money just by owning similar assets, such as property. Rather in the way that we all felt richer as our houses rose in value at the same time, banks all became more profitable as their asset holdings did likewise.
A great deal of this soaring profitability was, of course, based on wild optimism regarding the value of bank’s loans and bonds. These rose in value on the back of a variety of fantastical assumptions—including that property prices would continue to rise across the board, virtually forever. Likewise, a good portion (though by no means all) of the losses banks took in 2007 and 2008 reflected a spiral of pessimism regarding guesses about the financial predicament of home owners, and other borrowers. Bonds backed by US subprime mortgages, for example, were briefly valued on the assumption that almost 80 per cent of all borrowers would default on their loans. Subprime mortgage losses will indeed be high, but not that high. This also partially explains the return of euphoria to the City. Not only are market conditions helping banks make money again—with low interest rates and less competition—but assets that were marked down last year are beginning to recover their value.
Such swings from boom, to bust, to mini-boom again are the product both of exceptional circumstance and poor judgement. But they are also the natural order: earnings are volatile because of the way banks rate their assets, swinging on small changes in the economic outlook. Ironing out these excesses to produce more predictable earnings is an appealing but impractical idea. No other plausible accounting mechanism exists to calculate the value of what a bank owns, except simple guesswork. An uncertain future means the “true” value of a bank’s assets must remain uncertain too.
Understanding this helps to undermine wilder theories about excessive profits. Some financial institutions might, from time to time, have overcharged for their services. But the idea that the financial sector was routinely ripping off its customers, and extracting excessive profits from regular businesses, is a fiction. And while the current spate of City profits are being helped along by government interventions designed to stabilise the system (in particular a virtual guarantee of low interest rates), this was not true prior to the bubble bursting, and so can’t explain earlier rises in profitability.
Must we just accept an unstable finance sector? Not entirely. Proposals by the G20 finance ministers to force banks to hold more capital will lessen the gyrations of their earnings, as will plans to levy new charges on certain types of trading. But even vigorous attempts at reform along such lines will not turn banking into a predictable utility-style business—however consoling the analogy. In practice, of course, Britain cannot easily reduce its national bet on finance. And neither would we want to: the next government is hardly likely to turn away the more than one-quarter of corporation tax revenues generated by the City. Financial analyst Manus Costello, of Autonomous Research, suggests that a new Tory government might instead even consider a windfall levy on the City, to claw back the roughly £31bn in extraordinary profits banks could earn in 2009-10 on the back of unusually low interest rates. If not that, a new government would do well just to recognise the inherent volatility of finance, and manage accordingly. Act as any good finance director would: keep risks to a minimum, hedge against a downturn and cultivate alternative, more stable sources of national income.
Alex Crossman was formerly head of strategy for a global investment bank
The City takes too big a share of our economy and is bloated by doubtful profits from dubious activities. Not the allegations of placard-wielding demonstrators but of Adair Turner, chairman of the Financial Services Authority (Prospect, September), and of Lloyd Blankfein, chief executive of Goldman Sachs (to a German banking conference in September), respectively. Suspicion inevitably accrues both to an embattled regulator talking tough and an emollient investment banker. And neither Turner nor Blankfein seems comfortable in their role as Jeremiah. But is either right? Is the City too big?
Britain faces an estimated bill of £130bn for shoring up its banking system, a higher proportion of GDP than any other country. This alone should put the issue of the “right” size of the finance sector on the agenda. Unfortunately, the question yields no easy answer. There is no consensus on a relevant measurement, or even on whether the statistics—especially those in Britain’s national accounts—are reliable. Britain has a historic comparative advantage in finance, so one would expect it to have a relatively larger finance sector than some other countries. No one thinks it odd that Germany has a big car industry.
The problem arises (if it is indeed a problem) because of the profitability of finance. Analysis of the published earnings of the largest quoted British banks shows an across-the-board increase from the beginning of the 2000s until the recent debacle. Barclays, HSBC and Standard Chartered all more than doubled profits between 2001 and 2006. In the US, banking, broking and insurance mushroomed from around 10 per cent of total corporate profits in the 1960s to a staggering 41 per cent, its apogee, in the early 2000s, before collapsing in 2007-08. Corporate profits are calculated slightly differently in Britain, but the trend is the same: finance grew both absolutely, and as a percentage of total private sector earnings.
We now know that the rising tide of earnings was not sustainable. Some question whether the profits were ever even “real.”In particular they question whether it is wise for banks to count among today’sprofits income to be collected years into the future, a process known as “mark-to-market” accounting that leads to wild swings in earnings, and which can have dramatic consequences for the economy.
Financial sector income does not necessarily depend on what a bank’s assets (such as a bond) are worth when they are sold; merely on estimates of what they would be worth, if they were sold. Put simply, a bond bought for £100 on Monday, but quoted at £102 on Tuesday will generate a profit of £2 in Tuesday’s accounts. True, these estimates are based on credible quotes from independent brokers. And this ability to turn instant profits or losses applies only to trading assets (which can be bought and sold with relative ease) rather than to longer-term loans (where earnings are realised more gradually).
This process of marking to market is the key to understanding both the boom and the bust. Writing in the Financial Times, the economist John Kay recently argued that profits from trading assets alone cannot explain banks’ earnings growth during the boom, because while some banks win on their trades, others lose. The results cancel each other out. However, in an asset boom like the early 2000s all banks can (and did) make money just by owning similar assets, such as property. Rather in the way that we all felt richer as our houses rose in value at the same time, banks all became more profitable as their asset holdings did likewise.
A great deal of this soaring profitability was, of course, based on wild optimism regarding the value of bank’s loans and bonds. These rose in value on the back of a variety of fantastical assumptions—including that property prices would continue to rise across the board, virtually forever. Likewise, a good portion (though by no means all) of the losses banks took in 2007 and 2008 reflected a spiral of pessimism regarding guesses about the financial predicament of home owners, and other borrowers. Bonds backed by US subprime mortgages, for example, were briefly valued on the assumption that almost 80 per cent of all borrowers would default on their loans. Subprime mortgage losses will indeed be high, but not that high. This also partially explains the return of euphoria to the City. Not only are market conditions helping banks make money again—with low interest rates and less competition—but assets that were marked down last year are beginning to recover their value.
Such swings from boom, to bust, to mini-boom again are the product both of exceptional circumstance and poor judgement. But they are also the natural order: earnings are volatile because of the way banks rate their assets, swinging on small changes in the economic outlook. Ironing out these excesses to produce more predictable earnings is an appealing but impractical idea. No other plausible accounting mechanism exists to calculate the value of what a bank owns, except simple guesswork. An uncertain future means the “true” value of a bank’s assets must remain uncertain too.
Understanding this helps to undermine wilder theories about excessive profits. Some financial institutions might, from time to time, have overcharged for their services. But the idea that the financial sector was routinely ripping off its customers, and extracting excessive profits from regular businesses, is a fiction. And while the current spate of City profits are being helped along by government interventions designed to stabilise the system (in particular a virtual guarantee of low interest rates), this was not true prior to the bubble bursting, and so can’t explain earlier rises in profitability.
Must we just accept an unstable finance sector? Not entirely. Proposals by the G20 finance ministers to force banks to hold more capital will lessen the gyrations of their earnings, as will plans to levy new charges on certain types of trading. But even vigorous attempts at reform along such lines will not turn banking into a predictable utility-style business—however consoling the analogy. In practice, of course, Britain cannot easily reduce its national bet on finance. And neither would we want to: the next government is hardly likely to turn away the more than one-quarter of corporation tax revenues generated by the City. Financial analyst Manus Costello, of Autonomous Research, suggests that a new Tory government might instead even consider a windfall levy on the City, to claw back the roughly £31bn in extraordinary profits banks could earn in 2009-10 on the back of unusually low interest rates. If not that, a new government would do well just to recognise the inherent volatility of finance, and manage accordingly. Act as any good finance director would: keep risks to a minimum, hedge against a downturn and cultivate alternative, more stable sources of national income.
Alex Crossman was formerly head of strategy for a global investment bank
