Regular NC readers have seen us repeatedly invoke the work of Andrew Haldane, the executive director of stability of the Bank of England. His thoughtful and original work on the risks and costs of our financial system have provided serious ammunition for reform advocates.
At the recent INET conference in Berlin, Haldane recapped some of his recent observations under the rubric of an arms race, in which efforts of individual players to improve their own position wind up leaving everyone worse off.
I have one quibble with his presentation. Haldane depicts the increase in returns to global banks post 1990 as due to leverage. That isn’t entirely true. The early 1990s saw the rise of the over-the-counter derivatives business, and big banks had an advantage over securities firms, since it took a big balance sheet and a decent position in the related cash market to be successful. The rise of derivatives gave the behemoth banks a new business they could enter on the ground floor. And while derivatives are leveraged, the real attraction to banks was the opacity, in that dealers could load a lot of margin into the various risk attributes without the customers being able to see what a bad deal they were getting. The exceptional profitability of OTC derivatives provide a big boost to bank bottom lines, and attributing all the increase to leverage misses an important shift in the mix of business at these players.