Last year, I learned how derivatives can be used by banks to manufacture the illusion of profit. Tomorrow, I am introducing a ten-minute rule bill which would bring this casino banking into the light.
My colleage Gordon Kerr, a financial engineer, explains in How To Destroy the British Banking System –- Regulatory Arbitrage via ‘Pig on Pork’ Derivatives:
Nine years ago I worked as a structuring engineer in a three-man team within the investment banking unit of a major British bank. One of us was very bright. He stunned me one day with an idea as to how we could:
- Produce immediate (but illusory) substantial profits for our bank, thus ensuring that we would enjoy generous personal remuneration;
- Generate ‘virtual’ share capital to boost our bank’s capital reserves;
- Leave the actual investment risk exposure and profit expectation of our bank almost exactly the same after the transaction as before it.
Was this idea the kind of rocket science derivative engineering that justifies master of the universe labels for the three of us who designed and implemented it? No: it was extremely simple. Here’s how it worked. We transmuted some loan assets into a derivative transaction for regulatory purposes, whilst leaving the actual loan arrangements unaltered.
The rest of that article sets out the details.
My Financial Services (Regulation of Derivatives) Bill seeks to require banks operating in the UK to prepare accounts which present derivatives and other financial exposures at the lower of historic cost and mark to market values. That simple change would improve accounting transparency and help regulators to protect taxpayers. It would refocus banks on making productive loans instead of operating the derivatives merry-go-round.
In my speech on Tuesday, I will set out in detail how that merry-go-round works. I will indicate how my Bill would begin to correct one of the most damaging and least understood aspects of the banking system by bringing casino banking into the light.