has been a declining part of banks’ activities for decades. Between 1996 and 2008,
for example, lending to businesses in the productive parts of the UK economy fell
from 30 per cent to 10 per cent of the total, while lending to property and other
financial institutions rose sharply (CRESC, 2009). Lending has become increasingly
short term.
This is not just a matter of banks preferring to lend short term. The ‘financial
instability hypothesis’ describes how the maturity structure of finance in the
economy becomes increasingly short term during periods of stability. Short-term
loans are cheap. Assuming the ‘good times’ will continue, borrowers have an
incentive to increasingly rely on (cheap) short-term borrowing, which they can ‘rollover’ to mimic a longer term loan. This works fine until loans can no longer be
rolled over, defaults multiply and crises engulf unstable financial systems (Minsky,
1992).
22 Banks are borrowers too, of course. A striking feature of the 2007–2008
crisis was the extent to which banks came to fund their activities through shortterm borrowing in the wholesale market. When a ‘Minsky moment’ caused credit
to freeze in the interbank market, the whole edifice came crashing down.
23
Banks’ have also become more leveraged: between 2003 and 2007, average
leverage ratios of the major US investment banks doubled from 15 to 30. UK banks
were no different. By 2006, the Royal Bank of Scotland had assets of £848 billion,
equivalent to 64 per cent of UK gross domestic product (GDP). Its capital (equity)
was only £38 billion, or 4.5 per cent of these assets. The attraction is straight -
forward: a 10 per cent return on these assets yields a profit of £85 billion, more
than 200 per cent of total equity. The higher the leverage ratio, the greater the
return on equity, but the more vulnerable the bank (MacKensie, 2013).
As banks became larger, more short term and leveraged, trading in financial
markets exploded, fuelled by the creation of ever-more complex derivative
products. The notional value of outstanding over-the-counter (OTC) derivatives
rose from around US$50 trillion in 1998 to more than US$600 trillion by 2013
(BIS, 2013), or from roughly equal to almost six times global GDP.
Similar to increased leverage in the banking system, the purpose of much financial
innovation is to increase the profits of financial institutions. As we saw all too clearly
in 2007–2008, however, and is true even in the absence of financial crises, ‘what’s
good for Wall Street’ is not necessarily ‘good for Main Street’. This begs the question
as to how financiers have been able to influence events such that the financial system
serves their interests rather than those of wider society.
One explanation comes from the economics of regulation. The theory of
regulatory capture describes how regulators come to serve the interests of those
they regulate. To a greater or lesser extent, the history of financial regulation since
the 1970s has been one of steady liberalization, as restrictions on financial actors
– or ‘financial repression’ (Stigler, 1971) – were removed. Some of these restrictions
– such as the Glass–Steagall Act
24 that separated investment from commercial banking
in the US – had been in place since the 1930s. Others were implemented soon
after the Second World War.
Financing green transformations 163
for example, lending to businesses in the productive parts of the UK economy fell
from 30 per cent to 10 per cent of the total, while lending to property and other
financial institutions rose sharply (CRESC, 2009). Lending has become increasingly
short term.
This is not just a matter of banks preferring to lend short term. The ‘financial
instability hypothesis’ describes how the maturity structure of finance in the
economy becomes increasingly short term during periods of stability. Short-term
loans are cheap. Assuming the ‘good times’ will continue, borrowers have an
incentive to increasingly rely on (cheap) short-term borrowing, which they can ‘rollover’ to mimic a longer term loan. This works fine until loans can no longer be
rolled over, defaults multiply and crises engulf unstable financial systems (Minsky,
1992).
22 Banks are borrowers too, of course. A striking feature of the 2007–2008
crisis was the extent to which banks came to fund their activities through shortterm borrowing in the wholesale market. When a ‘Minsky moment’ caused credit
to freeze in the interbank market, the whole edifice came crashing down.
23
Banks’ have also become more leveraged: between 2003 and 2007, average
leverage ratios of the major US investment banks doubled from 15 to 30. UK banks
were no different. By 2006, the Royal Bank of Scotland had assets of £848 billion,
equivalent to 64 per cent of UK gross domestic product (GDP). Its capital (equity)
was only £38 billion, or 4.5 per cent of these assets. The attraction is straight -
forward: a 10 per cent return on these assets yields a profit of £85 billion, more
than 200 per cent of total equity. The higher the leverage ratio, the greater the
return on equity, but the more vulnerable the bank (MacKensie, 2013).
As banks became larger, more short term and leveraged, trading in financial
markets exploded, fuelled by the creation of ever-more complex derivative
products. The notional value of outstanding over-the-counter (OTC) derivatives
rose from around US$50 trillion in 1998 to more than US$600 trillion by 2013
(BIS, 2013), or from roughly equal to almost six times global GDP.
Similar to increased leverage in the banking system, the purpose of much financial
innovation is to increase the profits of financial institutions. As we saw all too clearly
in 2007–2008, however, and is true even in the absence of financial crises, ‘what’s
good for Wall Street’ is not necessarily ‘good for Main Street’. This begs the question
as to how financiers have been able to influence events such that the financial system
serves their interests rather than those of wider society.
One explanation comes from the economics of regulation. The theory of
regulatory capture describes how regulators come to serve the interests of those
they regulate. To a greater or lesser extent, the history of financial regulation since
the 1970s has been one of steady liberalization, as restrictions on financial actors
– or ‘financial repression’ (Stigler, 1971) – were removed. Some of these restrictions
– such as the Glass–Steagall Act
24 that separated investment from commercial banking
in the US – had been in place since the 1930s. Others were implemented soon
after the Second World War.
Financing green transformations 163