Banks getting fatter when they should be slimmer beasts

When the Bank of England released its latest, half-yearly Financial Stability Report yesterday, it featured an array of striking charts: leveraged lending is exploding, credit spreads are collapsing, securitisation is surging - and market volatility is hitting yet more lows.

But, for my money, the most thought-provoking image of all was a graphic I have never seen before - the size of global investment banks' balance sheet. In recent years, this data has not attracted much attention, since analysts tend to focus on issues such as profits these days and measuring the banks' assets is often hard.

However, the Bank has produced some estimates, based on reported accounts, and they make staggering reading; this decade, the assets of large complex financial institutions (LCFIs) have apparently swelled from $10,000bn to about $23,000bn. Most growth has occurred since 2003.

At face value, this looks extremely odd. After all, the golden mantra of the modern banking world is that LCFIs are currently removing risky assets from their balance sheets, in the name of improved risk management. Thus while banks used to hold loans on their books - leaving them exposed to associated default risk - they now often sell these to outside investors, either through direct loan sales or securitisation.

The consequence is a business model known as "originate and distribute". And it should imply that the LCFIs are becoming slimmer beasts - not fattening up.

So what on earth is going on? Some of the Bank's brightest brains have been puzzling about this recently, and think the main source of growth lies in an expansion of the banks' trading assets. That may simply reflect the fact that the pool of tradeable instruments has grown this decade - giving bankers more toys to play with.

But the Bank also suspects that trading assets are rising because LCFIs are now taking much bigger trading bets, in an effort to boost returns in a low volatility world. The banks themselves deny this is any cause for concern since the time-honoured tools they use to measure trading risk - namely "value at risk" (VAR) models - are not signalling problems. However, the Bank, quite rightly, suggests these VAR models are being distorted by low market volatility. Moreover, the sheer speed at which banks' revenues are rising implies that somebody, somewhere must be taking bigger punts. After all, it is hard to produce an annual 35 per cent rise in trading revenues on the basis of innovation alone.

In addition to this, however, the Bank also sees a second reason for the rise in trading assets: the "warehousing" effect. This is when banks use the "originate and distribute" model, they temporarily hold originated assets before selling them on. In theory, a warehousing period should be small. But if something ever made it hard to sell assets, these could unexpectedly back up on the banks' books, giving them a nasty shock - of the sort that occurred, on a small scale, when the sub-prime securitisation market temporarily shut down.

Of course, any sensible bank would respond to this risk by carefully limiting the volume of business it originates and distributes. But that is not how Wall Street or the City works. After all, bankers win bonuses by making hay when the sun shines -- not for crying wolf. Hence the pressure to keep ratcheting up risk. Or as the Bank says: "The incentive structures faced by managers may be contributing to a heightened emphasis on scale, revenue growth and market share."

Since central bankers are an understated species, the Bank carefully avoids sounding too alarmist about this. Perhaps that is wise: right now I cannot see anything likely to spoil this frenetic credit party, at least in the short term. Moreover, a veritable army of bankers keeps telling me that innovation and risk transfer is changing how leverage works - meaning some of the old rules about the credit cycle no longer apply. Some policymakers appear to believe this, too, particularly in Washington. But whenever I listen to these arguments about how we have moved into this Brave New World, I also hear uncanny echoes of the last internet boom. It is hard to read today's report from the Bank and not feel worried. Page 31 - and the chart titled "LCFIs' total assets" - is a good place to start.

http://www.bankofengland.co.uk/publications/fsr