Banking crisis: a crash course

The shadow banking system

In the old-fashioned, familiar banking system, the banker's job was to take in savers' deposits and hand them out to worthy borrowers - making a profit by charging a higher rate of interest than that offered to depositors. But in the era of very low-interest rates that followed the stock market boom of the 1990s, investment banks – US ones in particular – sought to exploit the extraordinary availability of cheap credit by enticing businesses and homeowners with a whole new range of financial offers. In the past 10 years, these new products, and the institutions that trade them, have grown so large – and so opaque to the understanding of Joe and Jo Public – that they have been dubbed a "shadow banking system" existing alongside the traditional, highly regulated one. It is the imbalances of that system that have created the present crisis.

Hedge funds and other 'shadow' institutions

The traders of the 'shadow banking system' are those in control of large investment funds (investment banking divisions, hedge funds, private equity groups) – investors, in other words, who use techniques such as 'short-selling' (see below), or taking on large amounts of debt ('leverage') that are deemed too risky for ordinary commercial banks. Not that the two worlds are completely distinct. The trading carried out by these funds was fuelled by the same mixture of cheap lending and rising property prices that has persuaded millions of people on both sides of the Atlantic to increase their personal debt in recent years. The difference is that their products have been off-limits to ordinary investors, not least because they typically deal in fantastically complicated financial instruments, known as derivatives, rather than simple mortgages or credit card bills.

Derivatives

Betting on the future derivatives are a way of investing in a product without always having to pay for it, not unlike a bet. An example is a 'future', where you agree to buy, say, a chicken, for a given price at a future date. For a small fee, you could, for example, buy a contract to purchase a chicken for £6 this time next year. If the price of chickens then goes up to £10, you can sell the chicken as soon as you buy it and make a profit of £4… without ever having had to look after the chicken. Your only outlay has been the small cost of buying the 'future'. The flip side, of course, is that chicken prices can also go down, and then you're left holding an expensive bird. Precisely because of that risk, derivatives like 'futures' had for centuries been an insurance policy, not the main event. Investors used them to hedge against the risk of failure. All that changed with the era of cheap money.

Cheap money

In the 1970s, computer modelling helped create newer, and apparently safer, kinds of derivatives, but the real shift occurred in the late 1990s, as mathematicians-turned-bankers devised new contracts based on the apparently limitless supply of cheap credit. To counter the economic jitters caused by the bursting of the dotcom bubble and by 9/11, the chairman of the US Federal Reserve, Alan Greenspan, slashed US interest rates from 6.5 per cent to one per cent in the space of two years, making money incredibly cheap to borrow, and encouraging the shadow banking system to develop entirely new types of derivative based on the buying and selling of debt. In the boom of the early 2000s, these looked like surefire bets, but not everyone was sanguine. In 2003, as the world was preoccupied with Iraq, Warren Buffett, the most celebrated investor of modern times, dubbed the new derivatives "financial weapons of mass destruction".

CDOs, CBOs and CDSs: 21st-century derivatives

The new types of derivatives, also known as 'credit-backed securities', came in various forms: Collateralised Debt Obligations (CDOs); Collateralised Bond Obligations (CBOs); Credit Default Swaps (CDSs). But all were based on the packaging of loans, and paid different returns according to people's ability to repay them. CDOs, for instance, were often used to repackage 'subprime' mortgages lent to risky customers in among other varieties of debt. As long as banks and investors were happy to trade the derivatives, they seemed a good way of spreading risk: in 2008, the market in CDSs alone had grown to more than $60trn - four times the size of the entire US economy. But once property prices began to slide and interest rates rose, banks and pension funds realised they were exposed to liabilities they could only guess at, and held 'toxic' contracts they didn't properly understand.

Toxic assets

The removal of such toxic assets from the financial system is the main aim of the $700bn rescue package designed by the US Treasury Secretary Hank Paulson. In short, the junk that bankers can't sell and are terrified to hold – the worst of the derivatives, subprime mortgages and convoluted bonds – is what taxpayers are now buying. The hope is that removing the junk will unblock the pipes of the system and allow credit to start flowing again.

Moral hazard

The dilemma regulators face in trying to contain the crisis is that if you bail out the miscreants and let them go unpunished, you reinforce their tendency to behave badly (ie moral hazard). Hence some institutions have been allowed to fail (Lehman Brothers has filed the biggest bankruptcy in history) while others, like the arguably worse behaved AIG, have been rescued. Being 'Too Big To Fail', or having the deposits of ordinary savers, seems to be the key factor in the survival of a shadow institution – one reason that Goldman Sachs and Morgan Stanley, the last surviving pure investment banks, changed their legal status this week to become normal commercial banks subject to greater regulation. When the taxpayer is on hand to bail you out, other threats – such as City bonuses being curbed – can sound meek by comparison.

Short-selling: profiting from loss

Short-selling is a way of making money from falling stocks. First you identify a share you think will fall; then, for a small fee, you borrow (say, from a pension fund) a batch of the shares and immediately sell them to a third party. If all goes well, the shares fall dramatically, you buy them back at a fraction of what you sold them for, and return them to the original owner. In last week's hyper-volatile markets, short-sellers were blamed for driving share prices down, especially in the case of HBOS, a business that insisted it was healthy but was ultimately driven into a merger with Lloyds TSB. British regulators reacted by banning the short-selling of financial stocks – an unprecedented move – and were rewarded with the biggest one-day rise in the history of the FTSE. But for those who believe in the market's ability to correct itself, shortselling remains a useful way to rein in overvalued stocks, and is only worthy of condemnation when investors conspire and manipulate the market. ·