Leverage ratios Sept12.pngOver the past 20 years, the financial sector has captured an increasing share of the wealth created by the rest of the economy. At its peak before the Crisis, it accounted for 40% of all profits in the US corporate sector, allowing financiers to claim they were ‘masters of the universe’.

A key reason for this growth was their success in creating the illusion that finance was too complex for most people to understand.

Prior to 1990, very few people had heard of EBITDA, quantum, VAR or the host of other acronyms that now dominate finance-speak. Instead, bankers, companies and regulators cheerfully talked about financial issues in simple terms that everyone could understand:

• Companies tracked Operating Profit for individual businesses
• Shareholders monitored net Profit after tax and interest payments
• Regulators checked to see if a bank’s capital could support its lending

But gradually, it came to be believed that only ‘the brightest of the best’ could truly understand finance. Simple terms were replaced by jargon and complex algorithms.

The end-result of the change is shown in the graph above, from a paper by the blog’s favourite regulator, Andy Haldane of the Bank of England. It shows the leverage of major global banks in 2006 (before the Crisis):

• The banks on the left of the chart had the lowest amount of capital
• The banks on the right had most capital

It also shows which banks have since gone bust, and which survived:

• Banks which have gone bust are shown in red
• Those that have survived are shown in blue

The conclusion is simple:

• No bank with a capital ratio above 8:1 went bust
• Most banks with ratios of less than 5:1 did go bust

As Haldane comments:

“Modern finance is complex, perhaps too complex. Regulation of modern finance is complex, almost certainly too complex. That configuration spells trouble. As you do not fight fire with fire, you do not fight complexity with complexity. Because complexity generates uncertainty, it requires a regulatory response grounded in simplicity, not complexity.

“Delivering that would require an about-turn from the regulatory community from the path followed for the better part of the past 50 years. If a once-in-a-lifetime crisis is not able to deliver that change, it is not clear what will.”