Dancing on the Volcano

22 November by Eric Toussaint

Christopher Dombres - The ruling class - flickr cc

The statements of Mario Draghi, Jean-Claude Junker, and Donald Trump remind us of all the past crises. They could very well have participated in the 1825, 1875 and 1929 crises without changing a single word.

Capitalism is not yet on the brink of collapse. Too bad, we would like to see the end of this deathly system. On the other hand, different elements of a new international financial crisis are currently converging.

Often, everything seems to be fine before a financial crisis. For example, some signals are completely misleading. Economic growth seems encouraging, though it is based largely on speculative frenzy in some sectors. Bankruptcies are few and far between, company balance Balance End of year statement of a company’s assets (what the company possesses) and liabilities (what it owes). In other words, the assets provide information about how the funds collected by the company have been used; and the liabilities, about the origins of those funds. sheets seem sound. Let us not forget that the rating agencies Rating agency
Rating agencies
Rating agencies, or credit-rating agencies, evaluate creditworthiness.  This includes the creditworthiness of corporations, nonprofit organizations and governments, as well as ‘securitized assets’ – which are assets that are bundled together and sold, to investors, as security.  Rating agencies assign a letter grade to each bond, which represents an opinion as to the likelihood that the organization will be able to repay both the principal and interest as they become due.  Ratings are made on a descending scale: AAA is the highest, then AA, A, BBB, BB, B, etc.  A rating of BB or below is considered a ‘junk bond’ because it is likely to default.  Many factors go into the assignment of ratings, including the profitability of the organization and its total indebtedness.  The three largest credit rating agencies are Moody’s, Standard & Poor’s and Fitch Ratings (FT).

Moody’s : https://www.fitchratings.com/
assigned triple A ratings to the North American company Enron in 2000 just before it crashed. This signalled the dotcom crisis of 2001-2002. Let us remember the triple A ratings attributed to structured products in the sub-prime market in 2006-2007. Let us remember the reassuring statements of Alan Greenspan, director of the US Federal Reserve FED
Federal Reserve
Officially, Federal Reserve System, is the United States’ central bank created in 1913 by the ’Federal Reserve Act’, also called the ’Owen-Glass Act’, after a series of banking crises, particularly the ’Bank Panic’ of 1907.

FED – decentralized central bank : http://www.federalreserve.gov/
between 1987 and 2006, on the eve of the subprime crisis. He argued that there was nothing to fear since the risks were well-distributed throughout the system and well-covered by CDS CDS
Credit Default Swaps
Credit Default Swaps are an insurance that a financial company may purchase to protect itself against non payments.
(Credit Default Swap, allegedly an insurance against the risk of default). The IMF IMF
International Monetary Fund
Along with the World Bank, the IMF was founded on the day the Bretton Woods Agreements were signed. Its first mission was to support the new system of standard exchange rates.

When the Bretton Wood fixed rates system came to an end in 1971, the main function of the IMF became that of being both policeman and fireman for global capital: it acts as policeman when it enforces its Structural Adjustment Policies and as fireman when it steps in to help out governments in risk of defaulting on debt repayments.

As for the World Bank, a weighted voting system operates: depending on the amount paid as contribution by each member state. 85% of the votes is required to modify the IMF Charter (which means that the USA with 17,68% % of the votes has a de facto veto on any change).

The institution is dominated by five countries: the United States (16,74%), Japan (6,23%), Germany (5,81%), France (4,29%) and the UK (4,29%).
The other 183 member countries are divided into groups led by one country. The most important one (6,57% of the votes) is led by Belgium. The least important group of countries (1,55% of the votes) is led by Gabon and brings together African countries.

, in its 2007 annual report, claimed that all was well and economic growth was solid.

The situation in 2017 is similar to those pre-crisis situations where everything seems to go well while political leaders make reassuring and soothing remarks. The current situation is somewhat akin to what happened in 1987. There was a sharp rise in the stock markets and a significant rise in the corporate bonds Corporate bonds Securities issued by corporations in order to raise funds on the Money Markets. These bonds resemble government bonds but are considered to be more risky than government bonds and other guaranteed securities such as Mortgage Backed Securities, and therefore pay higher interest rates. (corporate bonds are financial securities Financial securities Financial securities include equity securities issued by companies in the form of shares (shares, holdings, investment certificates, etc.), debt securities, excluding commercial instruments and savings certificates (bonds and similar securities), and holdings or shares in Undertakings for Collective Investment in Transferable Securities (UCITS). issued by private companies, they are future guarantees Guarantees Acts that provide a creditor with security in complement to the debtor’s commitment. A distinction is made between real guarantees (lien, pledge, mortgage, prior charge) and personal guarantees (surety, aval, letter of intent, independent guarantee). for repayment in exchange for funds).

The current situation and that of 30 years ago are vastly different, no doubt: some central banks (the Bank of Japan, the ECB ECB
European Central Bank
The European Central Bank is a European institution based in Frankfurt, founded in 1998, to which the countries of the Eurozone have transferred their monetary powers. Its official role is to ensure price stability by combating inflation within that Zone. Its three decision-making organs (the Executive Board, the Governing Council and the General Council) are composed of governors of the central banks of the member states and/or recognized specialists. According to its statutes, it is politically ‘independent’ but it is directly influenced by the world of finance.

, the Bank of England etc.) hold corporate bonds. |1| As a result, there is a semblance of stability because the central banks are not likely to sell them should the private bond market Bond market A market where medium-term and long-term capital is lent/borrowed in the form of bonds. Bonds are creditor stakes issued by companies or States. see panics. The Fed, on the other hand, has not bought any yet. Last year, anticipating a likely implosion in the corporate bond Bond A bond is a stake in a debt issued by a company or governmental body. The holder of the bond, the creditor, is entitled to interest and reimbursement of the principal. If the company is listed, the holder can also sell the bond on a stock-exchange. market, its CEO announced that the Fed could eventually start to buy but the decision has not yet been taken. However, it is the American market that is the most developed and the most at risk.

Furthermore, the Fed holds a huge amount of structured products, bought to help banks handle the aftershock of the 2008 crisis. In October 2017, the Fed had $ 1770 billion worth of structured products pertaining to the real estate market (mortgage Mortgage A loan made against property collateral. There are two sorts of mortgages:
1) the most common form where the property that the loan is used to purchase is used as the collateral;
2) a broader use of property to guarantee any loan: it is sufficient that the borrower possesses and engages the property as collateral.
backed securities, MBS MBS
Mortgage Backed Securities
See ABS.
). |2| The Fed knows very well that any attempt at reselling these toxic products in the near future could see the security values go downhill. To top it all, it would have a chain effect leading to bankruptcies.

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Mortgage Backed Securities held by the FED Source: Board of Governors of the Federal Reserve System (US), Federal Reserve Bank of St Louis Economic Data

Crisis factors: private debts are the root cause

In 2017, the significant rise in market capitalization, originating several years ago, continues. This is basically a speculative rise, driven by stock buybacks and the central banks’ quantitative easing policies. The stock market bubble will eventually burst.

There is also a sharp hike in the credit portfolio of large private companies ($ 7,800 billion increase in non-financial corporate debt between 2010 and 2017 in the US). A speculative bubble Speculative bubble An economic, financial or speculative bubble is formed when the level of trading-prices on a market (financial assets market, currency-exchange market, property market, raw materials market, etc.) settles well above the intrinsic (or fundamental) financial value of the goods or assets being exchanged. In such a situation, prices diverge from the usual economic valuation under the influence of buyers’ beliefs. is developing in the corporate bond market. Junk bonds Junk Bonds The nickname in the USA for high-risk bonds, also called High Yield Bonds, issued by a company whose solvency is considered doubtful. This type of bond is considered highly speculative by the rating agencies. (high-risk company bonds) are in great demand because they yield Yield The income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment’s cost, its current market value or its face value. high returns.

Moreover, a private consumer debt bubble in the US automobile industry has resurfaced. Debt in this market exceeds $1200 billion, an increase of 70% since 2010. The number of defaults are on the rise, currently amounting to 7.5% of the sum. Consequently, the major banks controlling 30% of this market are trying to reduce their exposure to this bubble. |3|

In the US, student debt has exceeded $ 1350 billion in 2017 and defaults have reached more than 11%. |4| A housing bubble has formed in Canada. |5| In early 2017, household debt in the US exceeded the level it had reached in 2008 before the Lehman Brothers went to the wall. The total volume of household debt is around $13,000 billion. However, defaults are less than in 2008-2009.

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Student Debt - Evolution of payment defaults (90 Days) Source: Federal Reserve Bank of New York, newyorkfed.org

Although the dominant international narrative claims that the banks are now stable and prepared to deal with a downturn, the past four years have witnessed a spate of major private bank bailouts: especially in Europe (Austria, Portugal, Italy, and Spain etc.). Their balance sheets cannot really be called sound and usually their equity Equity The capital put into an enterprise by the shareholders. Not to be confused with ’hard capital’ or ’unsecured debt’. does not exceed 5%, and again, this ratio is even less in large banks who are able to legally camouflage their actual situation, declare that they have attained a ratio of 10-12% and so pass the stress tests organized by the authorities (see box “How to transform 4% into 10 %"). One of the major problems of the banks is the rise of defaults in their credit portfolio (so-called NPL, non-performing loans). Most Italian banks have gone downhill due to this important factor of the NPLs, which caused the failure of Banco Popular in May 2017, one of the main Spanish banks.

Let us not forget that prior to the countless bank failures in 2008-2009, the sector yielded high returns. This is still the case today.

The rise of private indebtedness in China is also a potential crisis factor. The mainstream media that draws public attention to this situation is not entirely wrong, even though it evidently prefers to divert attention from the crisis factors directly affecting western economies.

As for large western private companies, as we have shown in a previous article, |6| debt has a massive impact. They borrow to finance their debt and speculative purchases.

Globally, companies in the steel sector are overproducing while the major oil companies are back to making profits, but the point is that stock speculation and future purchases could have partly triggered the hike of an oil barrel’s price to $60 (as in October-November 2017). The automotive sector is overproducing even though sales are on the rise, mostly due to purchases on credit.

The cost of protection against risk has struck a historic low

We find that the big capitalist companies are so risk-averse that the cost of protecting against a likely payment default is now extremely low. This contravenes the precautionary principle but is quite normal in the capitalist logic. Since many capitalist companies (such as Apple) want to buy high-risk securities (junk bonds), weak companies issuing them might offer lower returns than in a situation where their securities are in little demand. Therefore, junk bonds are now yielding lower returns, which does not at all mean that their risk is less than before. When the price of these coveted securities goes up, the returns plunge, and the “market” decides that the risk has been curbed: this is not the true picture. In the US, in October 2017, a company that wanted to protect itself against a payment default had to pay a credit default swap (CDS) for $ 5.44 to cover a risk of $ 1000 on risky financial securities. In 2008, during the crisis, covering the same risk cost $27,80.

This reminds us of the triple A ratings approved by agencies to structured subprime products just before the financial crisis.

Clearly this points to a risk appetite, eyeing short term returns. The history of capitalism has taught us that apparent stability can change drastically.

How to transform 4% into 10%

If a bank, call it Banxia, has 4 in equities and 100 in assets, this implies a ratio of 4% while it should be 8% according to Basel I and Basel II guidelines (applicable since 2013-2014). How can it be done without changing anything? The bank will risk-weight its assets. Consider the following hypothetical case: out of the 100, the bank holds 30 sovereign assets from countries with a rating between AAA and AA-. It can then subtract 30 from its total assets. Why? Because, as per prevailing laws, capital is not required to amortize any loss, in case of claims on countries rated between AAA and AA-. So it is left with 70 assets, which must be balanced with a sufficient amount of capital. The capital-to-asset Asset Something belonging to an individual or a business that has value or the power to earn money (FT). The opposite of assets are liabilities, that is the part of the balance sheet reflecting a company’s resources (the capital contributed by the partners, provisions for contingencies and charges, as well as the outstanding debts). ratio (4/70) now stands at 5.7%: it is still insufficient.

Let’s proceed further. Of the remaining 70, 30 are receivables |7| from banks or companies rated between AAA and AA-. Since the Basel I (and Basel II) rules stipulate that such claims cannot exceed 20% of risk, the Banxia Bank can show these 30 receivables as only 6 (20% of 30). Therefore Banxia needs to raise equity not for 70 assets, but for (70-24=) 46 assets only. Evidently, the ratio of equity-to-assets has improved, as it is now 8.7% (4 equities for 46 risk-weighted assets).

Let us now assume that out of the 40 other assets, 2 are loans to companies or banks with a bad rating, that is, less than B-. In this case, the risk is 150%. These 2 receivables then count for 3 (150% of 2). Therefore, capital requirement will be calculated on a risk assessment for 3, not 2.

Assuming that out of the remaining 38 assets, 10 are loans to SMEs. In this case, 10 counts for 10, because bank loans to SMEs cannot be reduced: the Basel authorities consider them as high risk, the “risk” being 100%.

The remaining 28 assets consist of personal loans. The risk for loans to individuals is 75%, so these 28 assets weigh 21 (75% of 28).

In this hypothetical case, the risk-weighted assets actually amount to 40 (0 + 6 + 3 + 10 + 21) out of 100 assets. The capital-to-asset ratio is 4/40, i.e. 10%.

Bingo! The bank, whose equity was only 4% of the assets, can now declare that its ratio has actually gone up to 10%. This will fetch a round of applause from the regulatory authorities.

Do you think that it’s only hypothetical? That the pictures painted above do not represent what the banks and regulatory authorities actually do? Think again. We have cited a very real example in the following section and examples like this are numerous. Meanwhile, below is a table summarizing the applicable risk weighting rates stipulated by both Basel I and Basel II.

Summary table of risk weighting |8|

The Basel Committee: banks can determine the value of their own assets

The Basel Committee fully trusts the bankers: each bank can choose its own risk assessment model. This is, with a few exceptions, what all major banks do.

More specifically, Basel recommends two options: either the banks adopt the risk-weighted assets calculation method proposed by the Basel II Committee, or they develop their own risk measurement system for capital requirement calculation. To adopt this system, they must get approval from the supervisory authorities, which is easy enough for a big bank with substantial resources.

Dexia: a telling example of the sloppiness of the Basel Committee and the national supervisory authorities

The example of Dexia serves well to highlight the hazards of the risk weighting system, be it the standardized approach or the internal rating approach.

In June 2011, Dexia easily passed the stress test imposed by the European Supervisory Authority on 90 major European banks. |9| Four months later, it had to be bailed out for the second time in three years. The document which Dexia submitted in order to pass the test with flying colours is enlightening.

While the assets (not risk-weighted) totalled € 567 billion, the risk-weighted assets amounted to only € 141 billion. In the hypothetical example of part 8, the risk weighting method allowed the imaginary bank Banxia to change the number of its assets from 100 to 40. Dexia did much better in June 2011: its assets went from 100 to 25. The sorcerers of Dexia, take a bow! “Reality” has outranked fiction.

In the document submitted to the European Authorities, Dexia claimed that its core-capital to risk-weighted-assets ratio was 12.01%. How mesmerizing for the regulatory authorities! Had the unweighted assets been considered, this ratio would have been 3%: a more factual version. The supervisory authorities asked the banks, including Dexia, to add strictly financial products to their capital. Otherwise, the ratio would have been even more disturbing. Point to note: if the Basel III rules (which are expected to be fully operative in 2018-2019) were applied to the ratio of equity to unweighted assets and the ratio of equity to weighted assets, Dexia would also have passed the test. This shows that Basel III does not provide any solution.

The Banks are immensely misleading

Dexia’s story is not at all isolated. According to the Liikanen Report, in 2011, equity accounted for only 2- 6% of the unweighted assets of major banks. For Deutsche Bank, just over 2% (which implies a leverage Leverage This is the ratio between funds borrowed for investment and the personal funds or equity that backs them up. A company may have borrowed much more than its capitalized value, in which case it is said to be ’highly leveraged’. The more highly a company is leveraged, the higher the risk associated with lending to the company; but higher also are the possible profits that it may realise as compared with its own value. effect of 50). For ING and Nordea (Sweden): just under 4%. For BNP Paribas, Crédit Agricole, BPCE, Société Générale and Barclays: around 4% (leverage of 25). For Spain’s Santander and BBVA, Italy’s Intesa Sanpaolo and Unicredit, and Belgium’s KBC: about 6% (leverage of around 16). |10|

However, all these banks passed the June 2011 stress test and have an equity-to-weighted assets ratio>10%.

Based on their 2012 annual report published in 2013, we calculated the ratios of equity-to-risk weighted assets and equity-to- unweighted assets for two major European banks with a sound foothold: BNP Paribas and Deutsche Bank. As the following illustration shows, the result is alarming enough, even for the most diehard optimist.

Since 2014, the ratio of equity to unweighted assets have slightly increased in the topmost banks, still they remain extremely fragile.
Basel III cannot impose a proper financial constraint either. Basel III, adopted for general principles in 2010 and scheduled for a global launch in 2018 or 2019, proposes only one significant change: instead of the 2% hard capital Hard capital The capital provided by shareholders plus the undistributed profits (retained earnings). requirement stipulated by Basel II, banks will have to raise it to 4.5%. If funds are calculated in easier ways and added to the 4.5%, the 8% requirement set by Basel I and II can be achieved. Who do they think they are kidding?

However, the basic thing to remember is that the assets will continue to be calculated on risk weighting. This invalidates Basel III’s rhetorical solution to the banking crisis, since 4.5% of hard capital proportionate to risk-weighted assets is a joke. The books can be cooked in various ways.

The contents of this text box have been taken from Eric Toussaint, “Banks bluff in a completely legal way”, http://www.cadtm.org/Banks-bluff-in-a-completely-legal , published on July 4, 2013. Also see: “Banks: fudged health report”, http://www.cadtm.org/Banks-Fudged-health-report

Translated by Suchandra de Sarkar in collaboration with Christine Pagnoulle and Mike Krolikowski


|1| In October 2017, the ECB held €357 billion of corporate bonds, including €236 billion covered bonds, that is to say the least dependable securities. Information retrieved on November 9, 2017. The ECB holds 1/3rd of the European market for covered bonds (see Financial Times of July 27, 2017).

|2| Retrieved on November 9, 2017: https://www.federalreserve.gov/rele...

|3| Financial Times, “US consumer debt pile deters big banks from $1.2tn car-loan market”, May 30, 2017.

|4| Federal Reserve Bank of New York

|5| Financial Times, “Canada’s housing rally owes a debt to Europe”, July 27, 2017

|6| See Eric Toussaint, “The mountain of corporate debt will be the seed of the next financial crisis”, http://www.cadtm.org/The-mountain-of-corporate-debt

|7| These can be loans or financial securities. These can also be structured CDO products rated AAA to AA- before the crisis started in 2007-2008.

|8| This table is based on documents adopted by the Basel Committee: see the Basel II version of 2004 https://www.bis.org/publ/bcbs107.pdf ; see Basel II version revised in 2006: https://www.bis.org/publ/bcbs128.pdf ; for risk weighting, read from page 19.

|9| These 90 banks accounted for 65% of the European banking assets. See : https://www.lesechos.fr/18/07/2011/... (in French). Note that the two Cypriot banks bearing full brunt of the March 2013 crisis had also passed the test successfully. Of these 90 banks, 59 (the biggest) followed their own model for risk-weighting assets (IN model).

|10| This paragraph provides the equity-to-asset ratio. For Barclays and Deutsche Bank, see the Liikanen Report, tables 3.4.18 and 3.4.19.


Eric Toussaint

is a historian and political scientist who completed his Ph.D. at the universities of Paris VIII and Liège, is the spokesperson of the CADTM International, and sits on the Scientific Council of ATTAC France. He is the author of Bankocracy (2015); The Life and Crimes of an Exemplary Man (2014); Glance in the Rear View Mirror. Neoliberal Ideology From its Origins to the Present, Haymarket books, Chicago, 2012 (see here), etc. See his bibliography: https://en.wikipedia.org/wiki/%C3%89ric_Toussaint He co-authored World debt figures 2015 with Pierre Gottiniaux, Daniel Munevar and Antonio Sanabria (2015); and with Damien Millet Debt, the IMF, and the World Bank: Sixty Questions, Sixty Answers, Monthly Review Books, New York, 2010. Since the 4th April 2015 he is the scientific coordinator of the Greek Truth Commission on Public Debt.




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