The Dangerous Opacity of Modern Banking

The inscrutability of financial markets is deliberate, argues a British economist in an important new book.

Eduardo Munoz / Reuters

Even after the reckoning of the 2008 financial crisis, the assets being repackaged and resold by the giant institutions that dominate global finance are still terribly risky. That’s the conclusion of a recent book by the British economist John Kay, Other People’s Money: The Real Business of Finance, which suggests that the overarching arrangement of finance hasn’t changed much in the wake of the crisis.

“The global financial crisis was primarily caused by placing on top of the deposit channel an elaborate and largely impenetrable superstructure of trading activities … impenetrable even by the executives of the institutions themselves,” Kay writes. When that superstructure collapsed, he explains, it threatened the entirety of the banking system. And what was recklessly fragile then is still the core business of banks today, even with the reforms that have taken place and with the addition of capital to the system.

Kay argues that the “real business of finance” mentioned in his subtitle is the project of making the general economy much more opaque. The accounts of major banks are lengthy and impenetrable. No one really knows the profitability, year by year, segment by segment, or in aggregate of the banking system. “The proliferation of poorly understood complexity in the financial sector was intentional,” Kay asserts.

Kay’s assessment is worrying, especially when taken alongside with remarks made by Federal Reserve Board Chair Janet Yellen in 2013, in which she lamented the tremendous shortage of any data that might stave off another crisis. Yellen noted that “highly interconnected firms can transmit shocks widely, impairing the rest of the financial system and the economy.” She added, “Detailed and comprehensive data on the structure of financial markets is needed to understand the systemic risks facing the financial system and to gauge the contribution to systemic risk by individual institutions.” What’s more, Kevin Warsh, a former Fed governor, warned in 2012 that there is still no way to “compare firms’ exposures against one another in a timely and effective manner.” He said that the Securities and Exchange Commission’s rules about financial disclosures and their frequency “[tend] to obfuscate as much as inform.”

The truth is that there are vast stretches of finance that regulators still know very little about. Andrew Haldane, the chief economist of the Bank of England, said earlier this year that major parts of the international banking system are essentially “uncharted territory.” The overlaps between traditional banks and the “shadow banking system”—made up of institutions that behave like banks but aren’t regulated—are so thorough that former Treasury Secretary Larry Summers has suggested that the Fed will never be able to determine when a major bank is approaching insolvency. Huge swaths of the financial system, in other words, might still be outside the Federal Reserve’s jurisdiction.

Or, as Kay puts it in his book, “The complexity of modern finance has been designed, and has operated, principally to benefit financial intermediaries rather than the users of financial services … Interdependencies between financial institutions have increased to a point at which the system as a whole displays fragility born of complexity.” That fragility also stems from the fact that many institutions have a tiny base of equity capital, borrowing and paying interest on roughly 95 percent of the money they use in daily financial activities. A huge portion of this money consists of deposits from consumers and investors who deposit their money for the bank to use in its day-to-day activities. This is the public’s savings, or what has come to be called “other people’s money.”

The author of the original Other People’s Money was Louis Brandeis, whose 1914 book was subtitled “And how the bankers use it.” (Brandeis, of course, went on to become a Supreme Court Justice.) At the time, his book was a widely read diatribe against Wall Street’s use of the public’s savings to finance the assembly of industrial behemoths that benefited bankers above the public good.

One hundred and one years later, it not clear that much has changed. In their disclosures, JPMorgan Chase, Goldman Sachs, Citigroup, and Bank of America make it difficult to determine the extent to which their businesses are dependent on derivatives contracts. These disclosures are often purposely obtuse, masking the real nature of the business for investors and laymen.

Even Warren Buffett has confessed that he does not comprehend JPMorgan Chase’s balance sheet, which indicates its $1.3 trillion worth of derivative positions. He has called derivatives “weapons of mass destruction” and questioned what they contributed to the genuine growth of the economy. Kay tends to agree: “Buffett is smart enough to understand what he doesn’t understand,” he told me recently. The bankers, by comparison, are “smart, but not smart enough to understand what they are doing. They don’t really have a clue.” What they do have a clue about, though, is the value of an industry so complex that the public, the media, and regulators can barely comprehend it.

It is likely too late to recover the “true value of the finance sector to the community” that Kay wants: a simpler, less risky model of banking limited to, in his words, “the goals of making payments, allocating capital, managing personal finances and handling risk.” The fragile and complex network that has formed in the financial industry over the last 30 or 40 years is simply too developed.

That does not mean that changes can’t be made to make global banking safer from another crisis on the scale of 2008’s. First, the shadow-banking system needs a regulator that could act as a lender of last resort, responsible for bailing it out in the event of a failure. Second, there needs to be a better global reporting system so that central banks can find out as early as possible when two firms have reckless liabilities that conflict such that they can’t be resolved. Third, banks are so highly leveraged that they would be healthier if required to keep a higher ratio of capital to debt. Lastly, it would help if the major banks were forced to clearly lay out their trillion-dollar derivative positions in reports legible to regulators and the public, which would reveal what percentage of revenues and profits come from derivatives. Until then, they probably should not be trusted with other people’s money.