The short and long of a Big Society

One of the immediate causes of the banking industry collapse was its long-established practice of borrowing short to lend long – agreeing a 25-year mortgage with a customer but financing it by borrowing money from wholesale markets which would have to be repaid every few months and then borrowing again.
What are wholesale money markets? They don’t exist in a physical sense, but they are well-developed financial arrangements where major businesses, organisations and institutions who routinely hold large amounts of money can lend some of it out to earn interest. Banks, pension funds, multinationals, national and local government all put money through wholesale markets, sometimes on terms lasting a few years, sometimes for as little as a few days.
Wholesale cash can be used to smooth out gaps in capital outflows and inflows and for conventional borrowing products like mortgages and bank loans. Banks routinely use significant proportions of wholesale cash to fund loans, and it’s standard practice to refinance every 30, 60 or 90 days.
‘Rotating’ the money underneath a loan has been the norm for a long time. It’s one of the ways modern-day finance has allowed economies to expand faster, using and reusing capital on short-term inter-bank deals to help generate an increased level of economic activity. Granted, there’s a lot of plate-spinning in there, but financial and accounting software packages can keep this show on the road quite comfortably…as long as the money is available.
The crunch showed that the short-long principle has one potentially fatal flaw: if wholesale funding markets closed, banks would be left holding ‘rotating’ loans which their own reserves were far too small to refinance.
This is why Northern Rock, whose entire business was built on borrowing short to lend long, had to go running to the Bank of England. It had a book full of loans it could not refinance and cash in its own reserves which wouldn’t have come within a country mile of covering them. Arguably, it was insolvent.
Northern Rock was also a major player in the securitisation market – agreeing mortgages with homebuyers but selling the mortgages on in packages to investors. Again, fine in theory but a huge problem if the market for buying securities dried up – which, of course, it did, leaving Northern Rock with a book full of assets whose loan-to-value ratios were crumbling by the day.
Wouldn’t it be safer to abandon these practices altogether? While banker-bashing has become a popular political sport, few people fully understand the consequences of stopping financial institutions engaging in what seems like complex and risky behaviour with our money.
Put simply, our economy would be far smaller, with fewer businesses, fewer jobs, fewer luxuries and far slower growth if we banned practices like short-for-long lending. So let’s put the issue another way: would you still agree with banning complex financial instruments if it meant you couldn’t move house, buy a better car or take out a loan to buy new equipment for your business?
Not if you wanted the economy to grow again.
So, what regulators have been focusing on instead is forcing banks to hold more cash in reserve and to build more stress-tests and warning signs into the relationships between complex financial instruments and the markets which fund them. Banks themselves have already started pricing risk into their loans and avoiding some of the riskier lending altogether.
That in itself has already slowed the global economy.
In the end, there is only so far a set of rules can go. On a very basic level it makes no sense whatsoever to borrow more than you can afford to pay back. But huge numbers of people did just that during an era when there seemed to be an expectation that if the State didn’t provide then your credit card would.
We’ve just lived through what some commentators have already dubbed the Age of Entitlement, when conspicuous wealth and consumption almost encouraged people to think they were only a credit card swipe away from that celebrity lifestyle.
It’s been popular to scoff at David Cameron’s Big Society initiative because it coincides with a period when some charities are seeing government funding dwindle (and because the slogan seems all-too reminiscent of some of the wearying initiativitis beloved of governments past).
It’s not for me to make a judgement on the politics of it (other than to say that the current government sometimes seems as cack-handed as its predecessor). But after 10 years of easy money at least one of part of the implications behind Big Society – that charity begins at home – may take a while to sink in.
But it’s an important implication, and begs a question about a different kind of short-for-long: whether short-term volunteering can make up for a long-term hole in the economy. If few people knew what a rotating loan was, I bet even fewer could imagine the credit crunch coming back round as do-it-yourself society.