Crises are part of Capitalism’s metabolism

by Mar 12, 2013All Articles

A crisis in the capitalist system is a kind of wake up call: speculative bubbles burst, the price of assets [8] moves back towards their real value; the least profitable corporations go bankrupt, and capital is destroyed [9]. Crises are in a way part of Capitalism’s metabolic system.

However, interventions by public authorities, who cater to demands made by Presidents of large corporations, have made it impossible to “clean up” or purge the Capitalist system. There are millions and millions of victims among the 99%, while those responsible for the crisis have not really put things back in order. Very few major corporations have gone bankrupt, the banks have not cleaned up their accounts, and new speculative bubbles have formed or are forming.

The small number of bank failures can be attributed to the aid provided by the ECB and EU governments. Member states considered that the banks were too big to fail. In the EU, only 7 small or medium-size banks have been liquidated: 4 Danish, 1 Finnish-Luxemburgish, 1 Irish, and 1 British [10]

Unless there is a radical shift towards greater social justice, the crisis is going to continue for many more years due to the following factors: current government policy favours the interests of major private corporations and is attacking the social and economic rights of people everywhere; [11] weak government and market demand; speculative bubbles persist; unprofitable and even insolvent corporations are being kept alive.

It is for these reasons that it is important to better understand how banks function. We need to open their books, and audit the budgets of the public authorities that support them, shed light on their activities, and identify what is behind their actions. This analysis will show that the part of public debt that is the direct or indirect result of the banking crisis and bank bailouts is illegitimate. [12] This debt did not serve the general interest. It simply allowed the banks to have their cake and eat it too, while continuing the same disastrous activities. This public debt is the pretext cited by government leaders around the world for attacking the economic, social, and political rights of people.

However, a different conclusion is in order: given their importance and the devastating effect their bad management can have on the economy, banks must be redefined as public services. The work banks do (as an entity enabling people to save money and take out loans) is far too serious to be entrusted to private bankers, who by definition seek to maximise the profits of a handful of private owners (the 1%, as the Occupy Wall Street movement called them). Given that they use public funds, benefit from government guarantees, and are supposed to provide a basic fundamental service to society, banks should become a public service.

This alternative conclusion leads me to make two radical propositions. First, the cancellation/repudiation of illegitimate public debt and the launch of a new government borrowing policy promoting social justice, better living conditions, and the restoration of the major ecological balances. Second, the banking sector should be socialised, placed under citizen control, and be subjected to public service rules and regulations, [13] and the revenues generated must be used for the common good. Other measures are also necessary, such as putting an end to austerity policies. [14]

The secret mission of banks: maximum Return on Equity (ROE)

If we really want to understand how the major shareholders and Directors believe their banks should operate, where their motivations come from, and their behaviour as capitalist corporations, it is important to take into consideration the scramble for Return on Equity.

The notion of Return on Equity (ROE) is indeed a key to understanding their mindset. From the 1990s to the beginning of the crisis in 2007-2008, there has been a mad race for maximum ROE: 15% was common, but some banks were getting 25 to 30%. In 2007, ROE stood at 15% in the eurozone, 17% in the United Kingdom, and 19% in the USA. [15] Let us take for example two major US banks: Goldman Sachs and Morgan Stanley (the 5th and 6th largest banks in the country). They both posted a 30% ROE in 1999-2000 until the internet bubble burst and Enron went bankrupt in 2001.

From 2001 to 2004, the shareholders of these two banks had to content themselves with an ROE between 12 and 16%. Thanks to the all-out support policy for banks and big business implemented by the Fed and the Bush administration (with Henry Paulson, the former CEO of Goldman Sachs, working as the Secretary of the Treasury), Goldman Sachs’s ROE again reached 30% in 2006-2007, while Morgan Stanley’s shot back up to 25% in 2006, before falling again in 2007. Goldman Sachs advised its clients to purchase structured subprime products (the famous CDOs – Collateral Debt Obligations), while at the same time speculating that they would drop as of 2007. That is why it could post a 30% ROE at the height of the banking crisis, while its chief competitors Bear Stearns, Merrill Lynch, and Lehman Brothers were beginning a descent into hell. The SEC (Securities and Exchange Commission, the authority controlling banks in the United States) ran an investigation into Goldman Sachs activities at that time, and gave the bank a heavy fine. Then in 2008, Goldman Sachs’s ROE fell to 10% and Morgan Stanley’s to 2%. In 2009, Goldman’s ROE went up to 20%, and Morgan Stanley’s was 10% in 2010. Finally, in 2011, the two banks’ ROE dropped back to 5%. [16]

Generally speaking, a bank’s equity is made up of the capital put up by its shareholders [17] 25 years ago, this equity represented 8% of the bank’s assets. For example, for a bank that had assets worth 100 billion euros (broken down into household loans, corporate loans, government bonds, corporate bonds, commissions on corporate mergers, and initial public offerings (IPOs)), its capital equity would have been 8 billion euros.

In that case, to achieve a 15% ROE, net profit must be €1.2 billion (15% of 8 billion). It seems easy to obtain such net profit with assets that amount to €100 billion, as they represent only 1.2% of that amount.

The exponential inflation of bank assets to increase ROE

The offer of new structured financial products or derivatives developed very rapidly from the middle of the 1990s. The big banks wanted their part of this buoyant and expanding market, knowing that if they were not well placed, they would be overtaken, and eventually taken over by their competitors. The profits on these products are relatively small, usually around 1%. If the shareholders are pushing for a ‘Return on Equity’ between 20% and 30%, the directors are under pressure to greatly inflate their assets. In the previously mentioned example, the assets were tripled in twelve years to €300 billion, while the capital remained stable at €8 billion or 2.66% of the assets. This growth was funded by borrowing.


The bank concerned had used leverage, which consists in increasing its borrowing to increase the profitability of its own resources. [18]The leverage is 36:1 (the debt is equal to 36 times the capital). As the competition between the big banks on the derivatives markets has increased over the years, the profitability of these products has decreased: in some cases it is no more than 0.1%. To maintain the ROE at 30% while the profitability of derivatives is reduced, the banks chose to increase their assets, notably in the derivatives domain, and by creating structured high profit products very much based on sub-prime contracts. In compliance with part 6 of the Basel 2 accord, they are not allowed to have capital inferior to 2.5% of their total assets. To obtain revenues and maintain high ROE, they turn to off-balance sheet methods. They create non banking companies, consequently not subject to banking regulations and controls, specialising in the derivatives markets. In 2007, the sub-prime market crashed. The banks and their specialised offshoots suffered losses, sometimes greater than their capital. If the bank in our example that uses a 36:1 leverage effect has a 3% drop in the value of its gross assets, its net assets are swallowed up. Either it goes bankrupt, gets taken over by another bank, is ‘nationalised’, calls on the State for a bail-out, or tries to cover up the losses by manipulating the accounts until better times arrive and profits return.

These different cases actually occurred. In the US, 400 small and medium-size banks went bankrupt alongside Lehman Bros, which was the 4th largest commercial bank. In Belgium, Fortis, the country’s largest bank was taken over by BNP-Paribas in 2008. Another US bank, Merrill Lynch, was taken over by Bank of America, and Bear Stearns was bought by JP Morgan.

The case of Northern Rock

In the UK, Northern Rock, which was originally a building society [19], changed its legal structure in 1997, and took on an aggressive real estate strategy. Between 1997 and its downfall in 2007, it grew by 23% a year to become the 5th British mortgage bank with 90% of its loans in real estate. In order to finance its growth, Northern Rock isolated its deposits and became dependant on short-term borrowing. Leverage effects were used to the full, going beyond 90:1. On 13 September 2007, Northern appealed to the Bank of England, depositors panicked, and a bank run on Northern Rock took place. Yet, it was not the bank run that caused the bank’s downfall; rather it was the decision by major private lenders, some months before, to cut off the funds from one day to the next that chimed the death knell for Northern Rock. The bank was nationalised in February 2008. [20]

Deutsche Bank charged with deceit by former employees

A much less mediatised case concerns Deutsche Bank (DB), the biggest bank in the world in terms of overall assets (see above). It illustrates a situation in which a bank covers up its losses so as to avoid the government stepping in and investors turning away, which would send share values plummeting. The events occurred in 2009. The three former employees who exposed the facts to the SEC (Security and Exchange Commission) in 2010-2011 claim that Deutsche Bank had concealed a $12 billion loss on the US derivatives market. If Deutsche Bank had acknowledged such losses in its 2009 balance sheet, its capital would have been reduced by 25%, which would have made it compulsory for the German government to bail it out (since it required the equity of German banks to amount to 8% of their assets). Instead of acknowledging any loss, the bank launched a major campaign to boost stock market share value. It announced €1.8 billion profit before tax for the first quarter in 2009. DB share value increased from €16 in January 2009 to €39 at the end of April 2009. Each of the three employees exposed the deception without knowing about the other two. Eric Ben-Artzi, who was risk manager with DB, was fired three days after he had told the SEC about the deceit. He initiated a lawsuit against DB for unfair dismissal. The second complainant, Mattew Simpson, voluntarily left DB with $900,000 in compensation money. The third complainant wishes to remain anonymous. The SEC is most embarrassed by this scandal, because Robert Khuzami, currently Enforcement Director at the SEC, was working as General Counsel for the Americas with Deutsche Bank from 2004 to 2009 when the cover-up occurred. Richard Walker, who is currently general counsel of corporate and investment banking at Deutsche Bank, was Enforcement director at the SEC for ten years. This shows that while Goldman Sachs has indeed a most pernicious influence, other major banks play a crucial role in the decisions made by governments and control authorities both in the US and in Europe.

Evolution in bank assets and activities since the 1990s

In the theoretical case presented above, it is claimed that the balance sheet values of banks, both their liabilities (debts) and their assets (property and bank products generating revenues), increased significantly between the 1990s and the outbreak of the crisis in 2007-2008. The IMF reports that global bank assets increased by about 140% from 2002 to 2007, rising from $40to $97 trillion. They further increased from 2007 to 2011, reaching $105 trillion. While bankers and governments keep repeating that banks have cleaned up their assets and gone on a strict diet, this is not at all true. Only very recently has the volume of assets started to decrease, and in a marginal way. The IMF reports that from the 3rd quarter of 2011 and the 2nd quarter of 2012, the reduction of assets in European banks (outside derivatives) amounted to only 2%.

The Liikanen report, named after the chairman of the group of experts appointed by the EU Commissioner for Internal Market and Services Michel Barnier to make propositions concerning structural reforms to the EU banking sector, provides extremely interesting information on EU banks.

It shows that in France the assets of Société Générale (8th largest European bank, 3rd biggest French bank) increased from €410 billion in 1999 (when the euro was launched) to nearly €1.2 trillion in 2008 (an increase of close to 300% over a decade). In 2010, assets were still close to €1.2 trillion. In Germany, the assets of Commerzbank (15th largest European bank, 2nd biggest German bank) went from €380 to €850 billion between 1999 and 2009.

If we consider the whole European banking sector, assets went from €25 trillion in 2001 to €43 trillion in 2008 (3.5 times the EU’s GDP)! Banks debt followed the same trend.

The increase in bank assets has relied on more borrowing, in some cases in a steep rise in mortgages and for most major banks on a dramatic increase in trading activities that include derivatives and structured securities. The issue of Asset Backed Securities was massively monopolized by US banks, but European banks were also keen to participate. They bought those ABS thanks to short-term loans, while the products bought had much later maturity, thus using the leverage effect. To cover the risks, banks would buy credit derivatives and other kinds of derivatives meant to protect them against risks related to currency exchange, interest rates, and so on. In September 2008, the bankruptcy of Lehman Brothers and the bailout of AIG (the biggest insurance company in the world) showed that those who issued derivatives could not cope with the risks they were meant to cover. The total volume of derivatives literally exploded, from $100 trillion in 1998 to $750 trillion in 2007.

The growth of European banks did not rely on their clients’ deposits (which increased only modestly), but on their debts on the interbank market, with the ECB, or with Money Market Funds (MMFs).

What are Money Market Funds?

MMFs are financial corporations in the United States and Europe, rarely controlled and subject to few rules. The specialized press considers them to be closely akin to shadow banking. [21]

The Obama administration is considering creating regulations, because if an MMF goes bankrupt, it may be necessary to bail it out with public money. A worrying situation given the vast quantities of money they handle, and the sharp drop in their profitability since 2008. In the United States, they held $2.7 trillion in 2012, a significant drop from the $3.8 trillion in 2008. MMFs lend on a very short-term day to day basis. Created by JP Morgan, the biggest bank in the United States, Prime Money Market Fund is among the largest, worth $115 billion. Wells Fargo the 4th largest bank in the United States has an MMF managing $24 billion. Goldman Sachs the 5th biggest bank controls an MMF worth $25 billion. US banks also operate MMFs in Europe; JP Morgan (€18 billion euros), Black Rock (€11.5 billion), Goldman Sachs (€10 billion), alongside European banks such as BNP Paribas (€7.4 billion), and Deutsche Bank (€11.3 billion). Some MMFs also operate in British pounds. Michel Barnier (European Commissioner for the Internal Market and Services) has also announced that he would like regulations to be imposed on this activity, but this is most likely to remain nothing more than a statement of good intentions. [22]

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