A Crisis of Financial Capitalism

Postmortems of the global financial crisis, often written by insiders as mea culpas, tend to follow a similar template. Judiciously combine the words “greed,” “excess,” “hubris,” and “opacity” to conjure an image of shadowy financiers toasting their latest trick of complex financial alchemy to provide both bonus-enhancing returns and risk diversification; of regulators either too incompetent or too close to finance to ask hard questions; of a sudden loss of confidence that ends up forging a new breed of central bankers, willing to tackle excesses in exchange for emergency crisis interventions that eventually rescue most if not all financiers.

More sophisticated analyses push the narrative a step further. They zoom in on securitization and repos (repurchase agreements), the two markets that lie at the core of shadow banking. Take Lehman Brothers, the investment bank that went within a single year from record earnings to the largest bankruptcy ever filed in the United States. Lehman aggressively pursed profits with a business model rooted in shadow banking: packaging and securitizing mortgages to issue tradable securities, storing these on its balance sheet as a bet on rising house prices, and then borrowing money in repo markets by using those same illiquid securities as collateral.

Lehman Brothers combined the “moving” and “storing” approaches to securitization. The “moving” business involved pooling illiquid loans (mortgages) to originate tradable securities, sliced into tranches with different credit ratings that were quickly moved to a broad range of investors. Lehman boasted in 2005 that “97 percent of our balance sheet turns within approximately two months” and that its moving business generated 20 percent of the group’s profits, on the back of an outstanding relationship with investors in mortgage-backed securities. By 2006, Lehman had decided to store securitized assets on its balance sheet, a proprietary trading strategy that its managers described as “pedal to the metal in growth mode.” Lehman viewed the downturn in the US housing market as a passing blip that it could exploit to increase market share, applying econometrics rather than common sense to predict ever-rising house prices.

But it was Lehman’s financing strategy that rendered it vulnerable. “It strikes me as borderline insulting to think we would accept Lehman’s self-structured and self-priced CDOs as collateral,” one employee of JPMorgan, Lehman’s clearing bank, noted in early September 2008.

Lehman was repackaging the riskier tranches of its own asset- and mortgage-backed securities into CDOs that it could use as collateral to tap short-term repo financing from cash-rich institutional investors, through intermediaries like Citibank, HSBC, and JPMorgan. Because these intermediaries, in turn, “marked to market” — that is, valued securities collateral at current market prices to protect themselves from risk — the amount Lehman could borrow depended on the market value of those securities. When securities markets moved against Lehman, with price falls or evaporating liquidity, Lehman’s lenders called for additional collateral, until Lehman had none left and had to close down.

This came as a shock to Ben Bernanke, then recently arrived at the helm of the Federal Reserve: “Remarkably, some financial institutions have even experienced pressures in rolling over maturing repurchase agreements (repos). I say ‘remarkably’ because, until recently, short-term repos had always been regarded as virtually risk-free instruments.”

This is where most analyses of the crisis (Adam Tooze’s Crashed being a notable exception) stop. They pay little attention to Bernanke’s surprise. While Bernanke, fresh from academia, may well have been surprised by Lehman, others at the Fed, the ECB, or the Bank of Japan should not have been. The rise of shadow banking was not a post–Bretton Woods accident, but a structural shift towards financial systems increasingly organized around securities, derivatives, and repo markets, underpinned by growing levels of household debt, all in the shadow of the dollar. Authorities in high-income countries actively encouraged this shift.

The Roots of Shadow Banking

Regulators first embraced shadow banking as the necessary infrastructure of the new, anti-Keynesian macroeconomic order of the 1980s and ’90s, in which governments had to finance themselves through securities markets, rather than subservient central banks, while competing with each other for investors. A classic example from the late 1990s was the victorious campaign by Deutsche Bank to persuade German authorities that the key to success in the new central-bank dominated order was to allow global investors to finance or bet against German government securities through liberalized repo markets.

If Germany didn’t drop its tough repo rules, Deutsche Bank warned, foreign investors would shun German securities. The German Bundesbank initially objected (as did the Bank of England), citing the link between repos and aggressive leverage that would bring Lehman down. Yet regulators dropped their concerns with financial instability, viewing the rise of shadow banking as a distant risk worth taking in the race to the bottom for the benefits of financial globalization. Even worker-friendly economies such as Germany carved out spaces for financial capitalism, increasingly allowing its banks to pursue profits through US-based shadow banking.

Furthermore, global shadow banking offered the financial infrastructure for a new neoliberal economy in which both citizens’ ability to collectively provision for future uncertainties through the welfare state, and states’ ability to deal with elite tax revolts, were to be scaled down. In the United States, corporate income taxes fell from 27 percent of federal revenues in 1950 to 10.6 percent in 2015. Shadow banking offered individuals market-based protection via pension funds, insurance companies, or securitizable housing, and it offered elites vehicles to invest their wealth. It also churned out safe assets that global institutional investors — pension funds, insurance companies, money market funds, or multinational corporations — were required to hold, plus the risky assets demanded by European banks hungering for yield, as well as leveraged funds often acting on behalf of institutional investors.

When the United States failed to keep up with the demand for safe US government debt, the Federal Reserve reacted quickly. It spearheaded initiatives to make it easier for investment banks like Lehman to raise finance using mortgage-backed securities, as an alternative to US Treasuries, in repo markets. If the Treasury would not provide “safe” assets, then Lehman would produce them, with a little help from the Fed.

Central banks’ support for financial capitalism had been unscathed by the earlier collapse, in 1998, of the hedge fund Long-Term Capital Management (LTCM). In a sequence eerily similar to Lehman, LTCM came under pressure when its “aggressive risk, aggressive leverage” strategy of pursuing profit from short-term changes in securities and derivative prices came under pressure from its repo lenders. As collateral requirements increased, its largest lenders agreed to finance the firm’s orderly unwinding, worried that a disordered collapse of LTCM would trigger fire-sales of collateral securities that would, in turn, affect their own repo financing.

This private bailout created a false sense of confidence for both financiers and central banks. Financiers viewed LTCM as an outlier that had arrogantly believed it could beat the laws of risk and return. Central banks had a more structural analysis of the LTCM collapse as a crisis of the emerging regime of market-based global finance. But the correct diagnosis was not accompanied by proper regulation. Rather, central banks agreed that self-imposed market discipline and more sovereign bonds to act as safe collateral assets would be enough. It is one of the paradoxes of financial capitalism that central banks call for less public debt when talking about monetary policy, and for more public debt when considering financial stability.

Regulators reacted differently immediately after Lehman. Andy Haldane, from the Bank of England, decried global banks’ role as “super-spreaders of systemic risk.” The new, postcrisis Basel III rules on liquidity and leverage targeted global banks’ systemic footprints in shadow markets. The newly created, international Financial Stability Board focused on shadow banks and shadow markets (securitization and repo markets). The European Commission, prompted by Germany and France, proposed a financial transaction tax (FTT), that is, a “Tobin tax” for financial capitalism that directly targeted intra-financial securities trading and financing via repos and derivative markets.

“About 80–90 percent of all transactions for which an ftt would be due are transactions where financial institutions trade in their own name and own account,” noted Manfred Bergmann, the Commission official credited with the ftt’s intellectual parenthood, reminding reluctant politicians that the ftt would encourage European banks to return to traditional lending to businesses, as would the European version of the Glass-Steagall Act (known as the European Banking Structural Reform directive). The IMF recognized that its erstwhile opposition to capital controls had been misguided, and that middle- and low-income countries should be allowed to carefully manage their engagement with global finance.

Global finance decried the regulatory tsunami heading its way. Despite such lamentations and “ferocious industry pushback,” as IMF head Christine Lagarde put it in 2014, global regulators promised to stay put. That same year, Mark Carney, the powerful head of the Bank of England and the Financial Stability Board, declared that it was time to end the “heads I win, tails you lose” model of global finance that was undermining the social contract that bound citizens to states (and to capitalism).

This commitment would last another six months.

Austerity and Shadow Banking

There is a powerful contradiction at the core of the macroeconomic architecture underpinning financial capitalism: neither central banks nor elected politicians have institutional incentives to pursue the structural change that would reverse the rise of shadow banking.

This is clear if one examines how the regulatory tsunami became a trickle by 2015, the year that began with Syriza’s victory in the Greek elections. Europeans dropped the FTT and the Glass-Steagall reforms. Despite its claims to independence, the ECB that year worked hard to oppose collective taxation initiatives from EU countries (the FTT); co-designed and enforced Troika conditionality in Greece; and worked with the Bank of England to revive the European securitization market.

That same year, China announced that it would reign in the rapid growth of its own shadow banking, which had been powered by the country’s postcrisis fiscal stimulus, implemented via shadow instruments like Local Government Financing Vehicles (LGFVs). China instructed local governments to transform LGFVs into municipal bonds, and began opening up local repo and derivative markets to foreign investors.

In doing so, China took its cues from the Financial Stability Board (FSB). Indeed, Mark Carney announced in 2015 that it was time for the FSB to switch the focus from regulating shadow banking to encouraging a transition toward resilient securities-markets-based finance. What that meant quickly became clear. “After ferocious lobbying,” the Financial Times reported, BlackRock managed to persuade the FSB that it shouldn’t treat shadow banks that operate in the guise of global asset managers as systemically important, despite compelling evidence from the US-based Office for Financial Research, as well as common sense. At that point, BlackRock alone was managing around $5 trillion of client assets. By 2018, that figure had increased to $7 trillion.

Less visible, but arguably more important, is the entanglement between monetary, fiscal, and financial stability policies that shadow banking creates. With a few notable exceptions, this is seldom recognized by central banks. Public debt is “vital to the functioning of the financial system, analogous to the function of money in the real economy,” stressed the ECB’s Benoît Cœuré in a 2016 speech on safe assets. But if sovereign debt represents money for the (securities) market-based financial system, that means the safe assets issued by treasuries (government bonds) are as important for financial capitalism as the safe assets issued by central banks.

If the central bank is mandated to defend financial stability, then the rise of shadow banking structurally requires that mandate to include defending the safe-asset status of government debt — that is, protecting governments from volatility in sovereign bond markets, even if it means printing money to do so. This is an unpalatable conclusion. It questions the theoretical basis for central-bank independence, as well as the entire edifice of modern macroeconomics, which views fiscal policy as an obstacle to optimal monetary policy and economic stability in general.

The only public institution that has benefited from this entanglement is the central bank. Wolfgang Streeck once remarked that central banks are outposts of private finance in the state. As outposts of shadow banking in the state, central banks can now discretionarily inject liquidity into private securities markets to arrest their fall in price, thus protecting (shadow) banks’ profits and access to secured financing. Arguably more important, central banks have instituted a discretionary regime for intervening in sovereign bond markets (qe, the ECB’s Outright Monetary Transactions, and market-maker-of-last-resort operations) that tacitly recognizes the fundamental role these markets play as safe havens for fragile finance. By burying these measures in a sea of acronyms removed from public debate, central banks effectively protected the powerful position that financial capitalism has conferred on them through the discourse of central-bank independence.

Central banks had to step into such uncharted territory, the argument goes, because austerity-inclined politicians left them no choice. Monetary policy overcompensated for feeble fiscal policies. Yet the austerity that financial capitalism can coax out of politicians, even well-intended social democrats, is itself the consequence of the gamble political elites made with shadow banking in the 1990s. Shadow banking had initially hardwired an illusion of liquidity into the minds of elected politicians. Stripped to its core, it promised liquidity and low interest rates, especially if states issued a lot of debt. The central banks’ response to the collapse of LTCM in 1998 further entrenched that illusion. Yet, as it turned out, they did not mean it.

Once Lehman collapsed and financing needs increased, politicians outside the US realized that (shadow) banks could still make daily profits when market prices of sovereign debt go down (and interest rates go up), as long as they have one sovereign debt issuer left to run to — namely, the US Treasury. And the US Fed generously provides US dollar swap lines to its central-bank counterparts in high-income countries.

Confronted with the specter of illiquid markets and increased financing costs as central banks discretionally rationed their interventions, politicians dropped ambitions for deep reforms and embraced austerity, even though some financiers protested the ensuing shortage of safe assets. The turn to austerity reinforced the structural drivers of financial capitalism: hesitant taxation of big capital, reduced state spending on public goods, asset-based welfare and passive index investment for middle-class citizens, debt and stagnating real wages for poor households.

In abandoning efforts to reverse shadow banking, states took the global finance space from a handful of global banks and handed it to a handful of global asset managers. This new systemic breed of shadow banks has grown rapidly, from $60 trillion in 2007 to $85 trillion in 2016, with around 80 percent held on the accounts of institutional and retail investors in Europe and North America. China’s rapidly growing asset-management sector will accelerate this trend, without challenging the dominance of the Big Three (BlackRock, Vanguard, and State Street), which own corporate America on behalf of retail and institutional investors. Their next target: poor and middle-income countries.

From Billions to Trillions

The year 2015 marked another important moment in the life of globalized finance. The international financial institutions, led by the World Bank, declared that a paradigm shift was necessary to achieve the UN-mandated Sustainable Development Goals (SGDs). The “Billions to Trillions” agenda, they argued, “is shorthand for the realization that achieving the SDGs will require more than money. It needs a global change of mindsets, approaches and accountabilities to reflect and transform the new reality of a developing world.”

The institutions were transparent that the new mindset meant embracing the idea that poor countries should aim for the trillions institutional investors and asset managers have available for “impact investment.” They were less transparent about the overall strategy. For poor countries to access global institutional investors, they would need to reengineer their financial systems around securities markets on the terms of those investors, a Trojan horse for shadow banking and financial globalization.

On its 2017 launch, the World Bank euphemistically termed this strategy “Maximizing Finance for Development” (MFD). Its promotional video starts with simple arithmetic: ending extreme poverty and meeting the SDGs will cost $4 trillion a year; development aid is only $380 million a year, while remittances and philanthropy can generate another $1 trillion annually, leaving the world about $2.6 trillion short. Cue sad music and a bright solution outlined by an enthusiastic millennial voice: developing countries can offer $12 trillion in market opportunities to global institutional investors. These market opportunities include “transportation, infrastructure, health, welfare, education — everything actually.” Everything can become an asset class, as development is recast as an exercise in the privatization of public services to generate returns for global finance, and a “changed mindset” means abandoning any future hope for developmental states.

The World Bank video explains the process — formally termed the Cascade Approach — for turning everything into an asset class. The Cascade Approach offers a sequence of steps to diagnose why global investors are reluctant to finance development projects: first, identify reforms (regulatory or other policies) that improve the risk-return profile; if reforms are insufficient, then identify subsidies and guarantees to de-risk the project; if reforms, subsidies, and guarantees are still not enough, then opt for a fully public solution. This is a blueprint for promoting shadow markets in which bankable projects can be transformed into liquid securities ready for global institutional investors.

To achieve this, the mfd agenda envisages creating three new markets where they are currently missing: derivative, repo, and securitization markets. Foreign investors will need derivative markets where they can hedge currency risk if they are to hold local currency bonds, and repo markets where they can finance those securities in local currency. Furthermore, the World Bank will promote the development of securitization markets that can transform loans into tradable securities, thus leveraging its own limited resources.

The MFD agenda thus reimagines international development interventions as opportunities for global finance. Through multilateral development banks, global (shadow) banks will be able to influence, if not altogether shape, the terms on which poor countries join the global supply of securities.

Poor countries will have less room to define what is a “bankable” project and will have to accept large infrastructure projects at the expense of smaller projects with more developmental potential. The World Bank will lead the efforts to design the “de-risking”/subsidies measures that will seek to protect global investors from political risk, or the demand risk associated with privatized public services.

As Jim Yong Kim, the World Bank’s president put it in 2018: “We have to start by asking routinely whether private capital, rather than government funding or donor aid, can finance a project. If the conditions are not right for private investment, we need to work with our partners to de-risk projects, sectors, and entire countries.” But the World Bank should also be asking who pays for de-risking.

The answer is uncomfortable. Poor countries will bear the costs of de-risking, guaranteeing private financial profits. Middle-income countries with a rising middle class will be pressured into adopting the US model of private pensions in order to create local institutional investors. The tendency toward concentration in the asset-management sector (to exploit economies of scale and scope) may result in US-based asset managers absorbing the funds of poor countries’ institutional investors, and making allocative decisions on a global level.

This celebration of the opportunities that financial globalization creates for poor countries is strangely quiet on its downsides. This is not for lack of research. Elsewhere, the IMF recognizes that financial globalization has generated a global financial cycle: securities and equity markets across the world, capital flows and credit cycles increasingly move together, all in the shadow of the US dollar. The global financial cycle confronts poor countries with a dilemma, named after the French economist Hélène Rey: there can be either free institutional flows into securities markets or monetary policy independence.

The MFD agenda — development aid is dead, long live private finance! — will make it more difficult for poor countries to choose monetary-policy autonomy and actively manage capital flows. In choosing to surrender to the rhythms of the global financial cycle, poor countries surrender their ability to influence domestic credit conditions, and therefore, autonomous growth strategies.

In this reengineering of financial systems in the Global South, the space for alternative development strategies shrinks further. Public resources have to be dedicated to de-risking “developmental” assets, to identifying “bankable” developmental projects that can easily be transformed into tradable assets, to mopping up the costs of the financial crisis inevitable with this more fragile model, all the while dismantling the financial infrastructure that might support a developmental state (including developmental banking by state-owned banks).

A Less Bleak Future

So, what can left-of-center governments do to change the economic conditions underpinning the rise of global finance? The answer from recent historical experience, surveyed above, seems to be: depressingly little.

Poignant critiques of financialization are welcome, but they need to be translated into effective political strategies that can grapple with the forces connecting central banks to global shadow banking on the terrain of sovereign bond markets. Progressives may have quietly applauded the “bond vigilantes” on hearing Matteo Salvini, the de-facto head of Italy’s right-wing government, confess that “every morning, before I call my kids, I check the spread” (of Italian government bonds to German bunds), but the spread was equally unforgiving of Spain’s social democrats in 2010, and pushed them to embrace austerity.

Optimists point to Corbynomics as the way forward, an example of a new politics committed to resuscitating the social contract with its citizens. But can Corbynomics be successful without curtailing the United Kingdom’s relationship to global finance, without repressing local shadow banks and their funders (by nationalizing pension funds, for example), without exercising nationalism in the one arena where it is warranted, finance, and without bypassing the constraints, and the political power, of central-bank independence? These are the questions that should guide the Left in the struggle to reclaim the terrain lost since the global financial crisis to far-right parties.