The Crazy, Dangerous World of Modern Banking

by ukcivilservant

  • Lending to firms and individuals engaged in the production of goods and services amounts to only 10% of British banks’ total assets.
  • The annual volume of foreign exchange payments processed in Britain is £75 trillion, about forty times Britain’s national income
  • The value of derivative contracts (whose values are dependent on the values of other derivative securities) is three times the value of all the physical assets in the world

How It Began

[Most of the following text is taken from John Kay’s paper Robust and Resilient Finance.]

When the Piper Alpha oil rig went on fire in 1987, killing 200 people and triggering what was then the world’s largest marine insurance claim, underwriting names who had never heard of Piper Alpha discovered they had reinsured it over and over again.  The total value of claims at Lloyds turned out to be ten times the value of the underlying loss.

A Lloyd’s underwriter denounced in extravagant language the ignorance and incompetence of the agents who had promoted these structures and brought Lloyd’s close to collapse.  When asked why he had not blown the whistle on the individuals concerned he simply said: it was because they were willing to buy risks at a price at which he was delighted to sell them.  This would be a forerunner for the development of modern financial markets more generally.

Modern banks trade in securities, and the growth of such trade is the main explanation of the growth of the finance sector.   Lending to firms and individuals engaged in the production of goods and services – which most people would imagine was the principal business of a bank – is literally an insignificant part of their balance sheets. For British banks today, it amounts to about 10% of their total assets.

World trade has grown rapidly, but trading in foreign exchange has grown much faster.  The value of daily foreign exchange transactions is almost a hundred times the value of daily international trade in goods and services.[4]  The annual volume of payments processed in Britain is £75 trillion, about forty times Britain’s national income.

Once you have created derivative securities, you can create further layers of derivative securities whose values are dependent on the values of other derivative securities – and so on.  The value of such derivative contracts outstanding is three times the value of all the physical assets in the world.

These developments are so obviously crazy that it seems remarkable that no-one appears to be worried.  But …

The Danger has long been Obvious to Some

In 2005 the Federal Reserve Bank of Kansas held a symposium at the agreeable Wyoming resort of Jackson Hole.  The purpose was to honour Alan Greenspan, who would soon retire from his position as chairman of the Federal Reserve Board.  Raghuram Rajan, then chief economist at the International Monetary Fund, queried the value of recent innovation in financial markets and warned of troubles ahead.

Rajan’s paper was not well received.  …  Don Kohn treated the speech as an attack on what he called ‘the Greenspan doctrine’, which proclaimed the virtues of the financial innovations which Rajan had queried.  … Larry Summers described Rajan’s views as ‘Luddite’, and likened his thinking to those who would substitute runners and horses for cars and aeroplanes. … The keynote address at Jackson Hole was delivered by Robert Rubin [who was an] enthusiastic supporter of financialisation and had groomed Larry Summers to be his successor.  Timothy Geithner subsequently told his audience:  ‘Financial institutions [risk managers] are able to measure and manage risk much more effectively’.

The breathtaking scale of these misapprehensions proved no obstacle to the subsequent advancement of those who embraced them.  Rajan left the International Monetary Fund at the end of 2006 and returned to India where he became Governor of the Reserve Bank.  But talking truth to power proved no more welcome in India than in Wyoming and Rajan’s contract was not renewed.

The Result

Three years after Wyoming, Lehman’s failure turned the instability of 2008 into a crisis that jeopardised the functioning of the global financial system. But Lehman was not, in any ordinary sense of the phrase, a business of economic importance.  If it was a systemically important financial institution, it was not an important financial institution.  The business provided no services to the real economy which were not available elsewhere, and few services to the real economy at all.  The company was badly run and operated primarily for the benefit of its own staff, especially its most senior executives.  But Lehman was massively interconnected.  At the time of its bankruptcy, the company had over 200 subsidiaries around the world and approaching one million outstanding transactions, almost entirely with other financial institutions.  

Here in the UK, Alistair Darling, Chancellor of the Exchequer during the 2008 financial crisis, was taken aside by the chairman of one of Britain’s biggest banks and offered the reassurance that ‘they had had a meeting last night and decided that, from now on, we will only take on risks that we understand‘.

But Nothing Much has Changed since 2008

Philip Stephens appears to have been pretty well spot-on when he wrote the following in the FT in January 2014:  ‘The organising purpose of banking – to provide essential lubrication for the real economy – remains entangled with dangerous and socially useless speculation.’

A similar conclusion was reached by Joris Luyendijk writing in The Guardian in September 2015. He quotes a City veteran:  “Seven years after the collapse of Lehman Brothers, it is often said that nothing was learned from the crash. This is too optimistic. The big banks have surely drawn a lesson from the crash and its aftermath: that in the end there is very little they will not get away with.

And Paul Volcker, former Federal Reserve chairman, saw the 2008 financial crisis as a missed opportunity to “put a spear through the heart of all these guys in Wall Street”

Indeed, it is striking that many aspects of the modern financial system are designed to give an impression of overwhelming urgency – the endless ‘news’ feeds, the constantly changing screens of traders, the office lights blazing late into the night, the young analysts who find themselves required to work 30 hours at a stretch.  But very little that happens in the finance sector has genuine need for this constant appearance of excitement and activity.  Only its most boring part – the payments system – is an essential utility on whose continuous functioning the modern economy depends.  

No terrible consequence would follow if the stock market closed for a week (as it did in the wake of 9/11) – or longer; if a merger were delayed, or large investment project postponed for a few weeks; if an initial public offering happened next month rather than this.  A millisecond improvement in data transmission between New York and Chicago has no significance whatever outside the absurd world of computers trading with each other.

The tight coupling is simply unnecessary, the perpetual flow of ‘information’ part of a game traders play that has no wider relevance, the excessive hours worked by many employees a tournament in which individuals compete to display their alpha qualities in return for large prizes.  The traditional bank manager’s culture of long lunches and afternoons on the golf course may have yielded more useful information about business than the Bloomberg terminal.

Analysis & Conclusions

Lehman – an ill-managed purveyor of unneeded products – represented exactly the kind of business that should fail in a well-functioning market economy.  The view that it was a mistake for the US government to permit Lehman to collapse is expressed, not by people who miss the services that Lehman provided, but by people who regret the consequences of its failure.  

The lesson is – on the one hand – to eschew unnecessary complexity, and – on the other – to give close attention to the management of such complexity as is unavoidable.  None of these features – simplification, modularity, redundancy – were characteristic of the financial system as it had developed in 2008.  On the contrary.  Financialisation had greatly increased complexity, interaction and interdependence.  Redundancy – as, for example, in holding capital above the regulatory minimum – was everywhere regarded as an indicator of inefficiency, not of strength.  

The lesson is not that policymakers should try to prevent such failures but that public processes should ensure that similar failures are more easily contained.  This requires reintroducing to the financial sector the modularity and redundancy which characterise robust and resilient engineering systems and which recent decades have foolishly sought to characterise as inefficiency.

Don’t hold your breath!


This blog is essentially a precis of John Kay’s paper Robust and Resilient Finance, first published in July 2021.  I strongly recommend that you read the whole paper, and apologise to Professor Kay if I have not done it justice.

Readers with long memories will recall that Lord (Adair) Turner, chairman of the Financial Services Authority, in 2009 described much of the City’s activities as “socially useless” and questioned whether it had grown too large.

Martin Stanley
Editor – Understanding Regulation