The Financial Jigsaw – Issue No. 15

My unpublished (100,000 word) book “The Financial Jigsaw”, is being serialised here weekly in 100 Issues by Peter J Underwood, author

Last week we looked at the commercial banks, see here for last week’s:  Issue 14

In this Issue we look at how investment banks and non-bank institutions like pension funds operate to deal with money outside the normal banking system and engage in investment activities generally using funds collected from wealthy people and insurance contracts. It is not straight forward at all and there are many twists and turns that confound the casual observer. 

COMMERCIAL BANKS 

“Give me control of a nation’s money and I care not who makes its laws”

Mayer Amschel Bauer Rothschild, Banker

Investment banking

Thus far we have been discussing commercial banking which deals mainly with facilitating merchants and international trade; offering their customers easy ways to receive income and pay bills; granting credit facilities to businesses and individuals, credit cards and savings accounts for the general public.  This is only one part of banking services in general; the larger part (by value) is involved with ‘investment banking’.

These types of banks provide investment services to major companies and high net-worth individuals as well as ‘trading’ (speculating) with other people’s money on their own account which is known as proprietary trading. In the eighteenth century these investment/merchant banks provided money to companies in the form of shares (known as equity) as well as arranging large loans against acceptable securities.  These banks also provide advice and investment guidance on corporate matters to the firms to which they would lend.

There is an important distinction between commercial and investment banking which was recognised, following the Great Depression in the 1930s, as being a significant contribution to its cause.  Many economists also suggest that the crisis in 2008 was made much worse because of commercial and investment banks activities having been merged since 1999, allowing excess speculation (gambling) using our money (depositors) which was never the intention of established commercial banking practice. Here is an argument about this confusion:https://www.investopedia.com/ask/answers/032715/should-commercial-and-investment-banks-be-legally-separated.asp

There was a good reason how this came about, which is very important to understand, as it highlights the depth to which bankers have descended recently in taking over lawmakers, mainstream media and government for their own selfish interests. This piece of the jigsaw is crucial to obtain a true picture of the global financial system and which affects each one of us every day.

The Great Depression and the power of bankers

The Great Depression was a severe worldwide economic downturn which began in 1930 and lasted into the late 1930s to the middle 1940s.  It was the longest, most widespread, and deepest depression of the 20th century.

The Glass–Steagall Act was passed in the USA to assist in the prevention of a recurrence of economic depressions among other measures.   It is most often used to refer to four provisions of the U.S.A. Banking Act of 1933 that limited commercial bank operations and affiliations between commercial banks and investment banks and aimed at preventing risky speculation with depositors’ money. Here is a short description of the Glass-Steagall Act: https://www.investopedia.com/articles/03/071603.asp

In the 21st century, the Great Depression is commonly used as an example of how far the world’s economy could decline. The depression originated in the U.S.A. after the fall in stock prices which began in September 1929 and became a crash in October 1929.  International trade plunged by more than 50%.

Unemployment in the U.S.A. rose to 25% and in some countries rose to as high as 33%; not unlike economic conditions today if the true statistics were ever published: (Ref: John Williams of Shadow Government Statistics [SGS]): he publishes alternate data which more realistically reflect the true economic situation in U.S.A.

He shows that unemployment in USA is approaching levels today equivalent to those reported during the Great Depression.  This also shows how governments distort official data to avoid accountability and public outrage.  The mainstream media, which have been reduced to mere unthinking mouthpieces of government policy, mainly report only the government versions: http://www.shadowstats.com

The Glass–Steagall Act held firm until 1999 when the financial elite ‘powers-that-be’, after constant lobbying, managed to have it revoked, freeing investment banks to speculate and gamble with depositors’ money as well as to have the support of the central banks in case of failure.

This demonstrates the sheer, raw power exercised by these so-called ‘masters of the financial universe’ to the detriment of all peoples of the world.  These facts are rarely acknowledged in the popular press and therefore people are left only to wonder at the sorry state to which global economics has become so degraded.  Even leading economists rarely agree as to the remedies to be adopted in order to return economies to a stable and sustainable growth pattern; they are as confused as the politicians and their supporters.

Attempting to control the bankers

In an effort to apply corrective measures the Dodd–Frank Wall Street Reform and Consumer Protection Act was introduced in America by President Obama in July 2010.  As with other major financial reforms a variety of critics have attacked this law, some arguing it was not enough to prevent another financial crisis others, mainly the private bankers, arguing it went too far and unduly restricted the free operation of financial institutions and particularly that of investment banks.  Here are details of the Act: https://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp

The global debate about regulating banks centres on stabilising financial systems and encouraging growth in economies around the world.  Banks are at the core of these initiatives as without them international trade, and therefore growth, cannot recover.

It may well be that the rise in debt during this decade is a consequence, rather than a cause, of the growth slowdown.  However, the reason for the crisis nonetheless lies in too great accumulation of debt during the boom years.  Economies follow a natural cycle of growth and contractions during periods of approximately 8-12 years.

Economic theory requires that during periods of growth debt levels should reduce allowing governments to apply increased borrowings (government debt) during periods of contraction to support their economies in lean times.  Since we are all supposed to be drawing our economic lessons from the remedies that the Americans applied in the 1930s it is no surprise that we in the UK have also managed to prolong our misery and extend our recessions.

In a proposed 2013 supplement to the Dodd-Frank solution, the ‘Brown-Vitter Bill’ offers a different and possibly more elegant solution by extending the Dodd–Frank Wall Street Reform provisions. Rather than impose arbitrary size limits, it simply insists that banks with over $500 billion in ‘assets’ maintain higher capital reserves than are currently required. Giant investment banks such as J.P. Morgan Chase, Wells Fargo, Morgan Stanley, Goldman Sachs, Citigroup and Bank of America will have to have capital reserves of about 15 percent which is about twice normal reserve limits. Here is comment on this legislation: https://dealbook.nytimes.com/2013/05/01/in-brown-vitter-bill-a-banking-overhaul-with-possible-teeth/

The bill has tough limitations but for only the largest twenty ‘mega banks’ which control 95% of the market. The aim is to reduce the risk these banks are taking and to improve overall stability in the markets. The biggest U.S. banks enjoy a massive inherent market advantage; they are able to borrow money much cheaper than other banks because everybody knows the government will never let them fail and are otherwise known as ‘Too Big To Fail’ (TBTF).

A precedent was set in 2008 whereby the TBTF banks will always be bailed out in a crisis which makes their debt essentially U.S. government guaranteed.  Studies have shown that these banks borrow money at about 1% less than other banks and that this implicit government subsidy is worth about USD 85Bn a year for just the top ten mega banks in America.

This bill would essentially wipe out that hidden subsidy and make these banks ‘bailout-proof’, at least in theory.  After the many recent banking scandals, for example: J.P. Morgan’s $6Bn sudden trading loss in 2012, the LIBOR scandal, the outrageous HSBC money laundering settlement and nearly five years of rapacious market-dominating behaviour by these state-backed banks, the general community of banks have finally come together to support more effective regulation.

Attempts to improve banking regulation

The Financial Crisis Inquiry Commission (FCIC) was set up to discover the root causes of the 2008 financial crisis.  In its final report it placed blame for the crisis squarely on the investment banks and the credit rating agencies.  The FCIC said: “The three credit rating agencies were key enablers of the financial crisis of 2008. Here is the Senate report on Credit Rating Agencies: https://www.housingwire.com/articles/credit-ratings-agencies-key-cause-financial-crisis-senate-report

This Issue ends the Chapter on commercial banking and next week we move on to the intricacies of credit and debt and how the global financial system manages these important items

To be continued next Saturday

Author: Austrian Peter

Peter J. Underwood is a retired international accountant and qualified humanistic counsellor living in Bruton, UK, with his wife, Yvonne. He pursued a career as an entrepreneur and business consultant, having founded several successful businesses in the UK and South Africa His latest Substack blog describes the African concept of Ubuntu - a system of localised community support using a gift economy model. View all posts by Austrian Peter