The banks' secret weapon

There is such a thing as a free lunch, at least if you are a bank. Imagine this: I offer to lend you as much money as you like at 0.5 per cent interest and then I will immediately borrow it back at 4.5 per cent. Not a bad deal, eh? Just borrow £10mi from me and you pocket £400,000. Borrow £10bn, and you earn £400m. Now I am neither so flush nor so stupid as to make that offer—but that is precisely what our governments are doing right now, and that is why banks and financiers are returning to profitability while the rest of us are still struggling.

It is called the yield curve, and right now it is unusually steep. If you don’t work in finance you probably don’t know what a yield curve is but if you do it is your bread and butter. It works like this: generally lenders demand a higher interest rate the longer they lock up their money. A ten-year bond will normally yield more than an overnight loan. Historically the spread between the 20-year US treasury and its three-month bill is around 2 per cent. Today it is almost double that, not because long-term rates are high (they are not) but because the central banks have driven the short term rates (the only rates they control) very very low.



Standard economic theory tells central banks to set interest rates low during a recession in order to stimulate lending, and consequently investment and economic activity. If banks can secure funding cheaply, they should be able to lend at lower rates, which creates incentives for firms to invest in capital projects, for households to borrow and spend, allowing the economy to return to its normal growth rate. But banks are not lending vigorously right now. In part this is because they are hoarding cash. During the boom optimism reigned and banks would lend to anyone. Now fear is king, and even qualified borrowers find it difficult to obtain funds. But also banks have little reason to lend to you and me when they can make a risk free 4 per cent buying government bonds (and using government money to do it).

Now one can argue, that considering the deficits the British and American governments have had to incur due to the financial crisis, buying a bond yielding 4.5 per cent for the next 30 years is a tad optimistic. Even if the risk of default is overstated, all the new money slopping around the world economy might well spark inflation, raising yields and forcing down the value of the bond. But of course no trader buying a 30-year bond expects to hold onto it for the next 30 years. As long as these markets remain liquid, his 4 per cent spread is safer than houses.

So are Ben Bernanke and Mervyn King being bamboozled by wily financiers? Not at all. Our central bankers know precisely what they are doing. They have done it before. The steep yield curve is a time-honoured way of recapitalizing the banks, replenishing the coffers emptied by all those bad loans. In the past 30 years, the big banks have essentially been insolvent three times: in the early 1980s in the wake of the Latin American debt crisis, in the late 1980s and early 1990s after the junk bond/commercial real estate bust, and today. Each and every time, the central banks engineered a steep yield curve, giving financiers the opportunity to capture that fat risk-free spread. After a few years of these taxpayer subsidies (combined with a few accounting tricks) bank balance sheets are healthy enough so they can spark the next bubble. A steep yield curve is yet another hidden subsidy to the banks, bankrolled by the taxpayers, that is to say, you and me.

In his latest book, Whoops!: Why Everyone Owes Everyone and No One Can Pay, John Lanchester tells us that the great division today is between the people who can speak the language of finance and the rest of us. Bankers profit mightily by our lack of interest in their machinations. Ordinary middle class taxpayers rail against benefit cheats, against immigrants living in subsidised housing. If they understood the yield curve, perhaps they would rail even more at financiers who we habitually subsidise at much greater cost.