The City by Tony Norfield

Author:Tony Norfield
Language: eng
Format: epub
Publisher: Verso Books

Source: Bank of England, Financial Stability Report, June 2011, Excel file 3: ‘Resilience in the financial system’, Tab Box 3, Chart A

The financial system can develop a destructive dynamic in the search for extra profit. This is one consequence of the fact that banks can expand their assets by credit creation. Banks also have a clear incentive to boost the volume of their financial transactions. While the financial system grows alongside and is intertwined with the accumulation of capital, weak economic growth and lower profitability prompts the accelerated growth of different types of financial business, especially if there is also a decline in returns on financial investments in an environment of low interest rates.

It was these lower returns that prompted the extra leverage and the explosive growth of derivatives markets in the 2000s. Financial institutions could not maintain the returns they needed from their loans or from bond and equity investments. For example, many pension funds needed annual yields on their investments of around 7 per cent if they were to meet their promises to pensioners of an attractive income in retirement. But government bond yields were only around 4 to 6 per cent in the early 2000s, and returns from investing in equity markets were also relatively weak. So pension funds switched some of their investments into commodity derivatives – betting on the price of oil, wheat, copper, etc. – and other ‘alternative assets’, like property or forests, and some even put their money into hedge fund investments.8

The relationship of financial returns to the underlying rate of profit of productive capital investment is a complex one. However, the lower the rate of profit, the more likely it is that returns will also fall, and that what ends up taking the form of a ‘financial’ crisis has its roots in weak profitability. In turn, the lower the capitalist system’s underlying rate of profit, the greater the economic damage wreaked by what appears to be ‘only’ a financial crisis.

The ability to expand assets is a key driver of profitability for the banking system, and the search for acceptable yields on financial investments helps spur financial market ‘innovation’ and all kinds of madcap speculation that, sooner or later, turns investment geniuses into morons. A famous example from 2012 was that of the ‘London Whale’. The big mammal in question was a trader for US bank JP Morgan Chase in London named Bruno Iksil.9 After successfully betting on credit derivatives in 2011 and making hundreds of millions of dollars, things started to go wrong for him the following year. In time-honoured fashion, he began doubling up on his positions to recover his losses. This was much worse than betting $200 on red in roulette after losing the previous $100 bet. A roulette wheel will continue to give you the same odds of just less than half that red will come up next time. But the credit derivatives market is very small, and other traders had an idea of who was doing what because a gigantic whale-like position could not be hidden in such a small pond.

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