The Next Financial Crisis Starts Here

I laughed out loud when reading yesterday's FT article on plans for an investment fund to enable banks to "unlock" capital that would otherwise be tied up under Basel III rules. Surely a spoof?

"The CRC Capital Release Fund will work by entering into “bilateral synthetic securitisations” with banks, whereby the fund will effectively buy a small amount of exposure to the riskiest portion of a segregated pool of bank assets, cushioning the bank with a “first loss” position.
The potential capital unlocked could be large, fund documents said.
In one example, the fund could reduce money required to be set aside by a bank against a €3bn ($4.1bn) pool of enterprise loans by up to 85 per cent.
The fund is expected to make between seven and 15 deals with four to six European banks.
It is targeting an average annual return of 20 per cent over its lifespan."

Wait, don't tell me. The six European banks will all "put" a share of their interests in pretty much the same underlying risky assets into the fund, which in turn will be rated AAA by one of a few major ratings agencies adopting the same old approach to due diligence and 'audited' by one or more of the Big Four accountancy firms (which will also provide the accounting advice on how to structure the fund and how one or more of the six European banks can reduce the capital they need to hold under the Basel rules). Then a bunch of other banks - and maybe the lucky six banks themselves - will invest in the fund, directly or indirectly, attracted by the 20% "return".

And pretty soon, the same structure will be replicated throughout the whole banking sector...

Image from Globlogisation.

Social Impact Bonds: Enough Social Impact?

The "Social Investment Bank" is an interesting experiment that's taken more than three years to bring to pilot stage. Its vision is to leverage money in dormant bank accounts ("unclaimed assets") to help the non-profit sector (aka "the third sector") "to grow and meet its goal of supporting marginalised communities in a way that neither the state nor the private sector can." To leverage the unclaimed funds, the SIB will raise money from 'non-government' investors by issuing "social impact bonds" - each being "a contract between a public sector body and Social Impact Bond investors, in which the former commits to pay for an improved social outcome."

For example, the pilot project "will prepare around 3,000 short term prisoners for their lives post-release [from Peterborough prison] and will work with them to prevent a return to a life of crime... If ... re-offending drops by more than 7.5 per cent within six years, investors receive a payment [from the Ministry of Justice] representing a proportion of the cost of re-offending. The payment will increase based on the reduction in re-offending with the total cost of the project capped at £8m. Social Finance [expects to raise £5m] from social investors that will be used to pay for the services in the prison and outside in the community."

There is a bit more complexity in the way it is explained here and in the Guardian, but perhaps you get the drift.

I'm not sure that I share the reported view of "sceptics" that this is "about city slickers making a fast buck," though the board and executives have some roots in the City and are offering "commercial investors, and high net worth individuals... greater financial return as the social return improves." This is "a risky business", as the Guardian article notes, so it's probably a bit hot for you and me anyway, even on such small numbers and moving at such a glacial pace. Public sector figures are notoriously, shall we say, inexact. And, by definition, we're talking about an area where the public sector body concerned doesn't have a good grip on the situation now, and obviously will be starved of funds to monitor closely in future (otherwise, there will be duplication in resources).

If I were a sceptic, however, I might prefer to consider this initiative as consistent with New Labour's reputation for public sector financial engineering, albeit gratefully endorsed by the Coalition as a "Big Society" initiative that might partially compensate for public funding cuts, at least in the justice budget. A sceptic might also consider that the focus on areas of apparent public policy failure begs certain questions that I'm sure have already been answered, or will be during the pilot:

1. Is it purely for lack of funds that the government doesn't grasp the nettle and reform the public policy areas in question? In other words: If the bonds don't sell, will no one implement the proposed fixes?
2. Does this proposal merely allow the public sector to outsource its accountability for difficult policy areas to a special purpose vehicle?
3. Does this proposal encourage public sector bodies to dump more of their work into the "too hard" basket and hope it will be picked up by taxpayers or private investors directly? Note the irony, for instance, in the quote from "Paddy Scriven, general secretary of the Prison Governors' Association, [who] has welcomed the scheme but warned those running it not to "cherry-pick" the least difficult offenders and leave the hardline cases to the prison and probation services." Isn't it his members' job to reduce recidivism?
4. If the bonds for one type of project perform well for investors, will the government ensure the policy lessons are learned and reap the savings, or allow repeat projects/returns?

Personally, I am left with two concerns, which are really two sides of the same coin, as it were:

1. The nature and scale of the risks to capital may be hugely under-estimated, giving rise to complaints and compensation awards that are underwritten by the taxpayer; and

2. The nature and scale of the risks to capital may be hugely over-estimated, giving rise to windfall gains to investors, again, underwritten by the taxpayer.

Yes, like all investment banks, this one comes with a taxpayer guarantee. Which means we're all on the hook for this in the end, whichever way it goes.

Don't get me wrong. It's fantastic that we are getting excited about making improvements and saving costs in these very difficult areas of public policy. And we should never lose sight of the root causes of apparently intractable social problems, nor cease in trying to resolve them. I just don't see the need for all the chicanery around getting the liability for fixing them off the public books when the liability sits there anyway.

Worse still, it distracts our great regulatory minds from the real challenge of how to finance growth in the 'real economy' while the government and our ailing banks attempt to rebuild their balance sheets. To that end, rather than tinkering with yet another public sector investment bank, surely the government will achieve greater lasting social impact by clearing the way for genuinely private, social funding initiatives aimed at creditworthy people and small businesses, as well as alternative energy and other socially productive projects.

It took about 6 months to actually plan and launch Zopa, for example, and it's members generated about £100 million in the time it's taken to get the SIB to pilot phase. There are at least a dozen other examples out there, which have either launched or are in development, some of whom are no doubt engaged in needless technical analysis - as Zopa was - because the authorities lack the time or other resources to publish helpful guidance on how such platforms ought to be structured.

Image from The Tool Factory blog.

What Is More Socially Important Than The Creation Of Wealth?

I've been reading article after article, and book after book about our financial crisis, and the really bad news is not the continuing poor risk management and regulatory failings despite decades of warnings in the form of scandals and mini-crises, or bank ram-raids on the Treasury to cover their losses while they retain their profits and keep paying giant bonuses, or £81bn in public sector spending cuts, higher unemployment, lower house prices or a decade of economic malaise.

The really bad news is that all this stems from a western cultural problem that is nowhere near resolution, so that we are doomed to repeat the whole, sorry saga.

Of all that I've read so far, perhaps John Lanchester's Whoops! has been most emphatic in elucidating what that cultural problem is - recently borne out by the ending to Money Never Sleeps (and, indeed, "The Other Guys"). Lanchester alerts us to the fact that John Maynard Keynes, the great god of economic thought, wistfully looked forward to a new world without greed and acquisitiveness:

"When the accumulation of wealth is no longer of high social importance, there will be great changes in the code of morals. We shall be able to rid ourselves of many of the pseudo-moral principles which have hag-ridden us for two hundred years, by which we have exalted some of the most distasteful of human qualities into the position of the highest virtues."

J.M. Keynes, "Economic Possibilities for our Grandchildren", 1930

In other words, the root cause of all this financial mayhem is that we have no higher, universally accepted social ambition(s) than the accumulation of wealth.

So when will the accumulation of wealth cease to be of high social importance?

When there is enough wealth? Surely not. There will never be 'enough wealth', because we seem to have no idea what 'enough' is as a society, nor how to figure that out. And there will always be greedy people, and people in great need, who will be compelled to find a way to accumulate wealth. So don't look to change people's desire to accumulate wealth as a solution. That will never happen. Especially when the financial crisis is putting everyone under pressure to make a penny to survive, although an Age of Conspicuous Thrift and a focus on sustainable capitalism may help.

No, if we are going reverse an ugly trend in our financial system, our society must agree on at least one higher ambition than the accumulation of wealth.

What's it to be?

Learning?

Late Payments Directive And SME Trade Finance

The Late Payments Directive should produce a rush to implement reasonable supply chain finance arrangements for any private or public sector customers who want to try to insist that payment terms exceeding 60 calendar days are not "grossly unfair to the creditor".

That's all very well if the financing package is big enough to interest the usual suspects, but alternative models are needed to finance the early repayment of invoices on a smaller scale, and this bodes well for online social finance platforms.

A Social Finance Association?

The past 5 years have seen the launch of many innovative business models aimed at enabling people to provide funding directly to other people and businesses via online finance platforms, rather than 'traditional' financial institutions. The terms 'crowdfunding' or 'social finance' seem to encompass most models out there.

The 'social' element is critical to the success of these models, because there are very real social and economic benefits to people - rather than financial institutions - sharing most of the margin between savings/investment rates and funding costs.

But I've witnessed firsthand how social finance platforms and their members tend to wrestle with the problem that social finance does not fit neatly into our financial regulatory framework, which is designed, ironically, to force recalcitrant 'traditional' providers to deal fairly with consumers. We are also currently victims of the delay and uncertainty caused by reforms to that regulatory framework. Because when they aren't rescuing banks or attending to 'business as usual', the key regulatory staff are understandably taken up with figuring out the new regulatory regime rather than vetting the legality of innovative business models that may remain outside the regulatory perimeter.

These problems add a huge amount of time and expense to starting and developing a social finance business, precisely at the time when banks are both lending less and paying lower savings rates.

Of course, it's common for the participants in new market segments to jointly discuss the development of the sector, including the characteristics and boundaries of regulatory 'safe harbours' and if/how they ought to be regulated. An appropriate forum for such discussion makes it easier to innovate and compete. But it also creates an efficient contact point with regulatory officials and opinion formers for discussing policy and regulatory concerns which individual participants wouldn't otherwise voice for practical reasons of time and cost, or for fear of inviting adverse attention.

There is no need for incorporation or office space. Trade associations often begin on ad hoc, unincorporated basis in response to a threat or opportunity that presents to all the participants.

Has that moment arrived for social finance?

Image from the Trade Association Forum.