Financial Stability, + Website

CHAPTER 4 Bagehot’s Dictum (a.k.a. the Greenspan Put)

Henry Wadsworth Longfellow probably did not have financial markets in mind when he wrote

There was a little girl,

Who had a little curl,

Right in the middle of her forehead.

When she was good,

She was very good indeed,

But when she was bad she was horrid.

Banking is a business of leverage. Potential return on a bank’s shareholder equity is magnified and multiplied by issuing debt (such as deposits and bonds) to multiply the amount of assets (loans to customers) that the bank can own. Leverage, however, is a “little girl” with a “little curl . . . in the middle of her forehead.” When leverage is “good,” banking is “very good indeed,” and when “she” is “bad,” banking is “horrid.”

Credit is built on trust and the legal capacity to enforce contracts of trust. Disclosed leverage (e.g., today’s central bank investments in the debt of nations) openly portrays the trust that we place in each other. It is disclosed so that the world can see whom the bank trusts and for how much. Hidden leverage is used when bank managers bully investors (in debt and equity), accountants, lawyers, and regulators to let them hide leverage (e.g., using off-balance sheet liabilities and shadow banks) without earning trust by open disclosure. When hidden leverage generates a positive return, it generates magical profits out of thin air. When it generates loss, however, the magic becomes a monster that devours shareholder value, and leads to insolvency ...