This is the fairly straightforward message that we receive through our media and its not hard to understand why. The diagram below is a 'toy model' of the banking and 'shadow banking' system. It shows the investment process, of $1 in true capital being 'geared' as it goes through the sausage machine of the fund management industry, with banks pumping in debt at every step. By the time you reach the private equity investors on the sharp end there is a lot of cash to play with. The size of the deals these guys were doing was truly mind-boggling. What is important to understand however, is that no bank, at any point would have had to agree to lending at leverage ratios of 64:1. In fact, in this fairly tame example, no credit committee would have seen ratios above 4:1. What they would call responsible lending!
However, what if the masters of the universe wanted in the private equity business wanted even more cash to play with. One thing you could do is ask the banks to lend more, but there is an even easier way to do it. Introduce another layer of fund Managers. Lets call them 'fund of fund' managers.
Wow! Thats really cool. Now what you've got is leverage of 256:1!!! And still not irresponsible lending by the banks. That's what you call financial engineering.
The really difficult problem with this situation is that its not anybody's fault. These transactions happen all over the world. In different domiciles, and in hundreds of different institutions, and every individual transaction feels like a sensible, and low risk proposal.
The reality is of course much more complex than this, but its possible to see through this simple example how cheap money gets sprayed into the world of business. It was Milton Friedman who said
"... if I spend somebody else’s money on somebody else, I’m not concerned about how much it is, and I’m not concerned about what I get. And that’s government."
Hmmmm. Sounds a lot like fund management too.
The problem now is what do we do about it?
Gordon Browns suggestion is to extend regulation to the fund industries. The regulators have failed to oversee banks though, so its hard to see how that will make the system more robust.
I think a more sustainable long term solution is to restrict and regulate the total supply of debt to the fund management industry, but by controlling banks, not funds.
This would require a much more pro-active, data driven approach from the regulators. This is not the same as having banks fill out more reports however.
With the approach of cloud computing and enhanced grid analytics we do now have the technological capability to do this. But it will require a very far sighted and energetic set of regulators to do this. Not least because the implied deleverage is probably a very difficult political pill to swallow.
Especially for Gordon.....