Capital-market inflation (and financial instability) in pictures

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The RBA and APRA maintain the line that Australian banks and other financial institutions are not vulnerable – as US and European banks were revealed to be, in spectacular fashion, during recent years – to insolvency when asset prices fall and creditors refuse to refinance loans.

But a quick look at the balance sheets and lending data of Australian banks, pension and insurance funds shows that the local financial sector has shared in the same multi-decade trends that issued in the so-called North Atlantic financial crisis.

Of course these are the same trends that have led to the inflation of financial assets, enriching fund managers, investment bankers and others whose primary income comes from financial activities, tying union bureaucrats to this layer through subcontracting the administration of pension funds, replacing state provision as the primary source of retirement income (especially for an upper-salaried layer), serving as collateral for borrowing by this same layer, and re-directing firms away from commercial and industrial activities and towards balance-sheet restructuring as their chief source of profits.

First the banks.

Here is the most low-risk liquid asset, the monetary base or high-powered money (central-bank reserves, i.e. RBA deposit liabilities or ‘exchange-settlement funds’, plus notes and coins) as a proportion of total Australian bank assets:

Another low-risk asset, Commonwealth government securities, as a proportion of total bank assets:

Now to a riskier, relatively illiquid asset, cash flows from which depend on repayment by less creditworthy borrowers.

Here are household loans for residential property as a proportion of total bank assets:

Banks and other deposit-taking institutions seek to maintain solvency margins in the form of low-risk liquid assets that can be used to meet liabilities (e.g. withdrawals) when they fall due. Here is the ratio of liabilities to primary assets (high-powered money, the exchange-settlement funds shown in the first chart).

This ratio (the inverse of the reserve ratio) is more important for maintaining liquidity, if not bank solvency, than the capital-adequacy requirements set out in the various Basel accords. The probability of default (or of leaning on the central bank’s capacity as lender of last resort) rises with the ratio of bank liabilities to state money:

Bank fragility of this sort, leading to periodic financial crises, is an inherent feature of capitalist development. Economic growth means expanding the circulation of commodities, and thus a growing number of transactions that need to be settled (as well as investment that needs to be financed).

Increasing turnover is financed by exponential growth in bank-created credit money (endogenous money). And, because ‘loans create deposits’, by the recirculation of funds this greater mass of loans leads to a growing burden of bank liabilities and inter-firm debt.

Over time the ratio of commercial debt to state money will rise. The assets that form the collateral for borrowing will be of successively lower quality (riskier, more illiquid).

For a time these can be squirreled away in off-balance sheet special-purpose vehicles. But it gradually will become clear (due to falling prices in some asset class, or rising default rates) to financial institutions that the consolidated balance sheets of other big institutions are similarly impaired to their own.

Eventually the interest rates at which banks can borrow on the wholesale interbank market will rise, or creditors will refuse to roll over short-term debt. This leads to a credit crunch, and to demands on the state for emergency liquidity through the discount window, or through bailouts, of the sort that emerged in 2007.

Such liquidity problems are at bottom solvency problems.

Yet massive debt is sustainable, for a period, so long as asset prices keep rising. Loans can be refinanced against the expectation that realized capital gains will produce cash flows allowing repayment of debts.

To understand why financial assets appreciated so spectacularly for twenty years from the mid-1980s, we need only observe the inflow of money to the financial sector set off by compulsory subscription to pension funds, which channelled worker savings into the stockmarket, and by the growth in insurance-fund premiums.

Total assets of superannuation funds:

Total assets of insurance funds:

When financial assets are appreciating all round, securities without a fixed repayment value (i.e. stocks rather than bonds) provide the best opportunity for investors to realise capital gains.

Commonwealth and State government securities as a proportion of total superannuation fund assets:

Commonwealth and State government securities as a proportion of total insurance fund assets:

Equities as a proportion of total superannuation fund assets:

Equities as a proportion of total insurance fund assets:

Thanks to the growing savings pool of institutional investors, and the latter’s preference for allocating those flows to equity purchases, during recent decades firms could issue shares cheaply. This became the preferred method of long-term financing, ahead of borrowing via bank loans or commercial paper.

Meanwhile the loss of their chief customers (commercial lenders) led banks towards real estate, and fee-related activities in derivative markets, brokerage and debt issuance.

Thus the diverging trajectories of commercial loans and household plus fixed and revolving personal loans as a proportion of bank lending:

These banks were obliged by regulation to hold capital in proportion to the risk-weighted size of their balance sheets. Therefore the majority of equity issuance was conducted by financial corporations and was purchased by other financial corporations; purchase of newly-issued stock thus did not take out of the market any excess net inflow of money into the financial sector or alter the net balance sheet of the non-financial sector.

In other words, the amount needed to finance commercial and industrial operations was not (when we look at the past three decades) sufficient to absorb the inflow of funds into the financial sector.

Lack of demand for funds to finance real investment in fixed capital is, I have argued elsewhere, a stage in the maturation of capitalist economies. The average return on real investment becomes low enough relative to the interest rate that firms withhold their funds from deployment in productive activity; they either cannot service debt or choose to receive higher revenues from loaning money out. It is more advantageous for them to lend out their capital than to invest it productively in plant and equipment.

Corporations thus develop bloated balance sheets and greater exposure to risky financial markets. To hedge this risk they must hold liquid assets (short-term deposits, financial paper, etc.). Using these liquid assets (or issuing new stock) to repay debt is an easy way to raise profits.

The upshot was an accelerating inflow of funds to the financial sector, without a compensating outflow. This excess inflow, as it circulated around, bid up prices of stocks, real estate and other financial assets. Yet price appreciation could not of itself absorb savings. Net lending and borrowing must balance.

Thus the outflow from the financial sector – balancing the inflow of excess savings from the rentier class – went as bankers’ bonuses and executive salaries, interest and dividend payouts, consumer credit for current expenditure.

Thus the flipside to financial instability, fragile banks, sluggish real investment, slow employment growth, and household indebtedness, was the luxury consumption of the financial elite.

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2 Responses to “Capital-market inflation (and financial instability) in pictures”

  1. The southern anchor: APEC and Canberra’s so-called Asian engagement since the 1980s « Churls Gone Wild Says:

    […] (i.e. funding investment in new plant and equipment). Therefore it was absorbed in the form of consumer credit, borrowed mostly on US and European financial markets. Unproductive consumption was financed by […]

  2. The survival constraint bites at Fortescue « Churls Gone Wild Says:

    […] and specifically capital-adequacy requirements have been tightened since 2008, and the much-vaunted stability of Australian-based banks stems in large part from their relatively low leverage ratios (though I’ve suggested the […]

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