What securities lending says about the state of the world

Agent lenders have taken in recent years to describing securities lending as an investment management discipline. This has numerous advantages. For agent lenders, it distances their trade from its origins in settlement inefficiency and tax arbitrage. A cynic familiar with how investment management works might say it also signals to the asset owners lending portfolios that scale is more important than profitability, loss of asset value is only to be expected, and intermediaries need ample rewards for the risks they run on behalf of their clients and the complex and demanding work they undertake to identify opportunities.

The only problem is that it is not true. Securities lending is just what it sounds like: a banking discipline, not an investment management discipline. Investment managers manage savings. Bankers lend savings. There is nothing unusual about this. The entire system of modern banking consists of institutions that are entrusted with the property of others profiting from their legal right to take that property out of safekeeping, and sell or pledge it to third parties, at considerable risk of loss. There are respectable schools of thought that do not hesitate to describe this process as misappropriation, fraud, and even embezzlement.

It is nevertheless an activity sanctioned by the law. The enormous profitability of banking, and its sickening volatility, depends upon the right to keep only a fraction of the depositors’ money on hand to meet requests for re-payment while lending the rest to multiple third parties, and hoping that not all of them will ask for it back at the same time (a bank run is synonymous with those occasions when they do). It is a system which creates money, and leverage, and the fragility intrinsic to the mismatching of the maturity of deposits and the maturity of loans.

Securities lending works in much the same way. The only real difference is that institutional lenders, unlike retail depositors, give their consent to the loan of their property to third parties. Otherwise, the process is the same. Investors deposit securities with custodian banks. Custodian banks lend those securities to investment banks, which either use them to fund their own business or on-lend them - after extracting a suitable mark-up - to hedge funds. They in turn may pledge them to a further counterparty in exchange for cash. The hedge fund borrower will, as likely as not, collateralise the initial borrowing with the cash raised from the short sale. That cash will be reinvested in funds invested in money market instruments, not all of which will mature in time to re-pay the lenders, should all of them require their money back at once.

The indemnifications offered by agent lenders may not appear on bank balance sheets, because they are more than fully collateralised, but they are without doubt a commitment of credit of the most orthodox kind. The sums are not insignificant. At the end of the first quarter of this year, State Street was indemnifying assets on loan worth $323.4 billion, collateralised with $334.6 billion of cash and securities. The equivalent figures for BNY Mellon were $264.9 billion and $272 billion. The value of those indemnities is equivalent to $100 billion more than the total balance sheet footings of the two banks.

Both banks have in recent years found that the reinvestment of that client collateral via off-balance sheet vehicles set up at the behest of yield hungry institutional investors created unanticipated risks. Even though they did not indemnify clients for losses incurred on the reinvestment of cash collateral, they elected to make whole clients that lost money when cash was invested in paper of issuers that failed, such as Lehman Brothers. In this sense, the risks ended up on the balance sheet of the bank, even if the cash collateral reinvestment funds (unlike the so-called “conduits” backed by the banks) have never had to be formally consolidated. The decision by some if not all custodian banks to incur unindemnified losses on behalf of clients is a clear reminder of the fact that securities lending is ultimately a banking business, as risky as any other, which in extremis entails the commitment of the balance sheet of the bank to shield investors-cum-depositors from loss.

But there is another sense in which securities lending can be seen even more completely as a banking business. This is through the part it plays in creating money and leverage by facilitating the re-use - or re-hypothecation, as the technical term has it - of securities. Re-hypothecation is still a standard feature of any prime brokerage agreement where the hedge fund is not prepared to pay a premium to borrow from an investment bank. In the United Kingdom, as opposed to the United States - where re-use is constrained by Reg T - there are no limits on how often the same security can be re-used. This is why investment banks took to channelling their securities financing business through London rather than New York in the last stages of the credit boom.

Whether the industry chooses to acknowledge the fact or not, securities lending is a major source of the collateral used by investment banks and hedge funds to borrow money. It is part of a complex financial eco-system, in which institutional lenders, fund managers and investment bankers deposit cash and collateral with each other. As recent studies published by the IMF have reminded bankers and regulators, re-hypothecation gives collateral a velocity which is exactly comparable to the progress of money through the ordinary banking businesses of deposit-taking and loan-making. Those studies also suggest its velocity has shrunk from over three times the original value of the collateral in 2007 to just 2.3 times in 2010 (see 'Collateral, Contagion and CCPs' at http://www.thomasmurray.com/component/idoblog/viewpost/264).

The securities lending industry has certainly shrunk as a provider of re-useable collateral. According to Data Explorers, lendable supply fell from a peak of $15.3 trillion at the end of 2007 to a low of less than $8 trillion at the nadir of the first phase of the crisis in March 2009, before climbing back up to just over $13 trillion last year. It is around $12.5 trillion now. Over the five years since 2007, demand has actually fallen much further than supply, from $3 trillion at the end of 2007 to half of that today. Supply is down 20 per cent, but demand is down 50 per cent. The lendable/lent ratio tracked by Data Explorers, which was less than five times in 2007, is now roughly eight times.

That fall is mirrored in the decline of reverse repo, or the lending of securities by investment banks to raise cash. The value of reverse repo is down by over 80 per cent at Goldman Sachs, Morgan Stanley and Jefferies & Company since early 2007. Even after making allowances for the considerable amount of re-hypothecation taking place off the balance sheet of the investment banks - the Morgan Stanley balance sheet for end-2011, for example, records that the value of assets re-used was $48 billion, but the notes recorded that no less than $335 billion worth was actually sold or re-pledged - a decline of four fifths is still a dramatic fall.

The picture is much the same at the leading agent lenders. At BNY Mellon, the value of securities on loan is 60 per cent below the 2007 peak. At State Street, the equivalent is 44 per cent lower. Revenues have fallen further still. In the first quarter of this year revenue from securities lending was down on 2007 by 72 per cent at State Street, 84 per cent at BNY Mellon, and 86 per cent at Northern Trust. At Goldman Sachs, the only prime broker to publish revenue numbers for its prime brokerage business alone - an interesting echo of the once intense profitability of that business is how opaque its earnings remain - revenue in the first quarter of this year was 63 per cent lower even than 2008.

No wonder banks are still so reliant on central bank money. The haemorrhaging of $4-5 trillion of financing from re-hypothecation since 2007 had to be replaced if the banking and investment banking industries were not to collapse. Even now, it is not hyperbolic to describe the securities lending and financing eco-system as one of the largest banking systems in the world. Until recently, it was also largely unnoticed. But it has now dawned on regulators that the cash proceeds of short sales end up as collateral in the hands of the investment bank which borrowed the stock from a custodian bank, also in exchange for collateral, and that the net result is a significant increase in the volume of leverage at work in the financial system.

In other words, regulators have realized, in the wake of the collapse of MF Global, if not of Lehman Brothers, that client cash and client securities are being used in the principal risk-taking activities of investment banks and their hedge fund clients. This realization is the origin of the "shadow banking" initiatives that are causing so much concern in the securities lending, repo, hedge fund and prime brokerage industries. For lenders of securities, that concern and those initiatives have potentially profound implications for their obligations, liabilities, opportunities and earnings from securities lending.

Paul Tucker, the deputy governor of the Bank of England and the man responsible for the financial stability of the United Kingdom, summarised the challenge facing the securities lending industry rather neatly in a speech in Brussels on 27 April. "Anyone holding a securities portfolio can build themselves a shadow bank using the securities lending and repo markets," he said. "One simply lends out the securities at call for cash, and then one employs that cash by making loans or buying credit assets with a longer maturity. This is leverage and maturity mismatch." [1] As he also said, leverage and maturity mismatch are not "shadow" banking activities. They are banking activities.

Which is why Tucker went on to advise that banks only should be able to use client monies and unencumbered securities to finance their own business, and that broker-dealers should be obliged to segregate client cash and securities and not use them to finance their own business to a material extent. Although this suggestion clearly permits broker-dealers to continue to engage in margin lending, any restriction on the ability of non-bank financial firms to use client cash and securities to fund their own business threatens to undermine the economics of the prime brokerage business. Since prime brokers and hedge fund managers are the primary source of demand to borrow securities, the restriction also threatens to undermine the economics of the securities lending industry.

Paul Tucker does not of course rule the world, and regulatory regimes will continue to vary between jurisdictions, but his remarks are indicative of a new and richer understanding by regulators of how institutional investors, hedge fund managers and prime brokers interact. It represents potentially the most substantial change in the environment for securities lenders since the 1930s. Indeed, the regulatory attack on so-called "shadow banking" is the first direct assault on securities lending as a source of instability in the financial markets. It marks a shift of focus from short-selling as the primary source of that instability to its twin, securities lending.

This has in turn required a higher level of analytical sophistication on the part of regulators. Its consequences threaten to reach far beyond the familiar (and counter-productive) efforts to contain the sale part of short sales, through periodic or specific or temporary bans, uptick or downtick rules, or restrictions on naked short-selling such as Regulation SHO in the United States, or the forthcoming "hard locate" rule in the Short Selling Regulation recently agreed by the European Council. [2] Short selling is directional in nature, while securities lending is part of a complex eco-system by which money flows through the money and banking and securities markets.

So it would be a mistake for the securities lending industry to believe that the wide variety of regulatory measures now being brought to bear on the lending and borrowing of securities are inspired by a degree of expedience similar to those measures which have sought to suppress short selling. The two activities cannot be separated completely - securities lending is obviously vital to the process of short-selling - but the gathering regulatory assault on securities lending is of an entirely different character to the frivolous political attacks on short selling, which even regulators understand to be counter-productive. The regulation of securities lending is part of the wider re-regulation of the banking industry, of which it is such an important part.

Seen in this light, an apparently random collection of regulatory steps affecting the securities lending industry are entirely consistent with the growing regulatory conviction that securities lending is an important source of under-regulated leverage in the global financial system. Unfortunately, many in the securities lending industry continue to believe that regulators simply do not understand how their business works and that, as soon as they do, they will reverse the measures they propose rather than risk losing the activity to another jurisdiction. Even the complete defeat of lavish efforts to mitigate the impact of the Short Selling Regulation agreed in February this year by the European Council has not shaken the conviction that the regulators will in the end see sense.

Take the Short Selling Regulation, for example. It obliges short sellers to disclose to the regulator any short position equivalent to more than 0.2 per cent of the capital of the issuer, and to the entire market any position of more than 0.5 per cent of issued capital. It also eliminates "naked" short selling by obliging short sellers to locate the stock borrow to cover the short in advance. It is clear that these measures will deter hedge funds from investing in and trading European equities, cutting their demand to borrow stock, and clog up liquidity in the market that remains by forcing short sellers to reserve stock in advance. For the securities lending industry, that implies reduced opportunities to lend, and lower revenue. For the regulators, the same measures promise increased stability in the European equity and sovereign bond markets, and a reduced risk of downward price spirals in stressed markets. They may be (and almost certainly are) wrong about that. But it fits their overall goal of reduced systemic risk.

The various measures in Dodd Frank that affect the securities lending industry are best understood by the same standard. Section 165, for example, restricts single counterparty exposures (including stock loan) to 25 per cent of the capital of the lender, and just 10 per cent of it for the largest, systemically important counterparties. The same section also wants regulators to specify the haircuts applied to collateral. [3] Securities lending industry insiders warn that all this will disrupt relationships between systemically important investment banks (as borrowers) and systemically important custodian banks (as agent lenders), render various assets useless as collateral, and cut the value of the indemnities that agent lenders can offer to asset owners. Regulators, on the other hand, want to reduce the interconnectedness between large financial institutions, mitigating the risk of a domino effect when a large counterparty fails. Likewise, the Volcker Rule, seen as the death knell of demand to borrow from prop traders, is seen by regulators as a key tool in preventing investment banks using their capital to support risky trading activities.

Other measures in Dodd Frank will force securities lending market participants to disclose more about their short selling and stock loan activities (Sections 417, 984(b) and 929(x)), allocate more capital to stock loan exposures (Section 171) and increase the risk of lent assets getting trapped in prolonged, Lehman-style liquidations (Title II, Orderly Liquidation Authority). Simultaneously, the European Securities Markets Authority (ESMA) is threatening to impose new rules forcing UCITS fund managers to disclose revenue splits with agent lenders and investors, limit the percentage of portfolios lent, accept uncorrelated collateral only, and invest all cash collateral received in so-called "risk-free" assets. Arguments by the industry against these proposals were not even heard politely. Nor were complaints that custodians could not bear the unlimited liabilities imposed upon them by the Alternative Investment Fund Managers Directive (AIFMD), though the measures will make them reluctant to custody lent assets or collateral.

At the level of the securities lender, borrower or intermediary, these regulatory measures are bound to appear irrational, even unjust. To insiders, regulation will deter borrowers and lenders, reducing demand to borrow and opportunity to lend, reduce earnings and increase transaction and margin costs, and inflate risks by curbing indemnities. Yet, like the propagation of central counterparties, the heavier capitalization of money market funds and the increased capital and liquidity ratios imposed by Basel III, every regulation affecting the securities lending industry is part of a pattern. That pattern is to take systemic risk out of the financial system. In essence, regulators believe that, by increasing disclosure and capital requirements, they are reducing the risk of banks making disastrous mistakes and, when they do (as they will), the risk of bringing the whole system down with them.

If they succeed in that ambition - it is a big 'if' - regulation might even be a good thing for the securities lending industry, at least for asset owners. A reduced supply of stock to lend, for example, might drive the price of equity collateral up. The price of borrowing CCP-eligible stock is almost bound to rise, since the proliferation of CCPs will in all likelihood create a shortage of high quality fixed income securities to borrow. That demand for eligible collateral will increase the volume of collateral upgrade trades. Nor is there is any reason for asset owners, as opposed to prime brokers or hedge funds or agent lenders, to fear fuller disclosure. They take virtually all of the risk in securities lending, so it is hard to argue that they are not entitled to know what others are paying themselves. At present, according to Data Explorers, asset owners as a group are collecting around a tenth of the total return from lending stock, on an intriguingly consistent basis too. [4] As to the risk they take to collect that return, it is hard to believe that tighter control over reinvestment, heavier haircuts on collateral, greater use of CCPs and third party custodians, and increased diversification of counterparties, will leave lenders worse off.

The inability of industry insiders to see this is not entirely self-interest. People working in a financial market tend to see its day-to-day workings - liquidity, transparency, price discovery, efficiency, and the trading, clearing and settlement infrastructure - not as the intermediate goals which they are, but as ends in themselves. Much of the case made in favour of those twin activities - short selling and securities lending - has tended to focus on exactly those goals: efficiency, transparency and operational infrastructure. The Oliver Wyman study of the likely impact of public disclosure of short positions, sponsored by industry insiders and published in February last year, actually managed to divide all of the negative impacts of regulation it identified into just three areas: liquidity, efficiency and infrastructure. It warned that business was leaving European equity markets, reducing liquidity in short selling and stock borrowing; that increased disclosure would restrict access to management and spawn copycat investment strategies, reducing market efficiency; and that heavier reporting demands would raise back office costs, inflating the price of infrastructure.

The wider, systemic implications of securities lending and short selling, as perceived by regulators, were not and are not on the agenda of the industry. Nobody denies that liquidity, transparency, efficiency and excellent infrastructure are desirable in any market. But the securities lending market - like the foreign exchange market (see "Why foreign exchange is not a market" at http://www.thomasmurray.com/component/idoblog/viewpost/270) - is curiously blind to a more important facet of its structure. There is virtually no customer-to-customer interaction in securities lending. Ultimately, the industry is dominated by a small number of custodian banks (as agents for the lenders) and a small number of investment banks (as agents for the borrowers). They set the terms of trade between the borrowers (hedge funds) and the lenders (asset owners), and extract the bulk of the value created.

In short, securities lending is a complex oligopoly, controlled by banks. This is why, despite Equilend - or perhaps because of it - there is epic duplication of technological and operational costs across virtually every participant in the marketplace. It is also why there is no centralized trading platform for lenders and borrowers to discover and check prices. In fact, one trading platform that attempted the modest goal of bringing a degree of transparency to parts of the bi-lateral market as it exists today has already failed. [5] Likewise, attempts to establish CCPs have run into fierce resistance from industry insiders, forcing their progenitors to effectively mimic the existing intermediary structure by excluding lenders and borrowers from direct participation. There is not even a centralized trade repository where lenders and borrowers can see what is happening in the securities lending markets after the fact (though Paul Tucker did recommend exactly this in his Brussels speech of 27 April).

Ironically, there was more transparency in the New York stock loan market of the buccaneering 1920s than there is in the heavily regulated markets of today. In those days, you could read the price of borrowing securities every day in the Wall Street Journal, because borrowing rates were formally quoted by stock loan market markers on the floor of the New York Stock Exchange. Borrowers knew who was lending the stock, and could check the price in a public marketplace. That is a more open marketplace that the current one, in which no real prices are published, and the price of borrowing stock is carved out between agent lenders and prime brokers. The main reason both these sets of intermediaries are horrified by Section 165 of Dodd Frank is that counterparty credit risk in securities lending is heavily concentrated among a small group of banks and investment banks, most of them with modest balance sheets.

In short, securities lending is an industry characterised even now by bi-lateralism rather than multi-lateralism, a high degree of self-interested intermediation, and a deep cloak of opacity in pricing. It is a tribute to the power and influence of the incumbents that the industry has retained this character despite the wrenching financial crisis. Lendable assets have retreated, along with their lenders. Demand to borrow has shrivelled, as prime brokers have lost their nerve and their funding, and hedge funds have lost their conviction. Agent lenders have endured the embarrassment of losses and law suits occasioned by cash collateral reinvestment pools that went wrong. Even now, with revenues 70 to 80 per cent below their pre-crisis peak, the leadership of the securities lending industry has shown no serious appetite for meaningful change. The custodian banks went into this crisis with an unstable business model - giving away the core service, and getting paid by lending the assets of the customers to third parties - and they have found no motive or means to change it, except to warn that they will have to put their prices up.

This would be funny if it was not impertinent. There are not many markets in which demand has fallen three times as fast as supply where intermediaries could plausibly argue that the only solution is to put their prices up. In fact, this is the clearest possible evidence that the securities lending and financing markets are in a deeply dysfunctional condition. It is also a depressing reminder of the want of strategic imagination at work in the securities services industry. The intermediaries in the securities lending business want to re-price their services, because they do not know how to reinvent them. As a strategy, it amounts to Micawberism: a belief that one day the prolonged financial crisis will end, normality will return, stock markets will rise, and the borrowing of money will resume.

In the banking industry, the only agent of change is the regulator. For 30 years, there was deregulation, but even then bankers managed their balance sheets to ensure they never pierced the capital floors set by the central bankers. Now the industry faces the prospect of 30 years of re-regulation, and its denizens cannot imagine how they will ever pay themselves as much again unless they charge more or the regulator reverses the measures taken over the last five years. This is, to a large extent, the price bankers pay for their uniquely dangerous business model. If they were not allowed to re-use repeatedly the assets of their customers, there would be no need for intrusive regulation. Equally, that same privilege makes it far too easy to make money in banking. This is why banking neither spawns nor attracts entrepreneurs. In fact, the biggest single difference between the banking industry and other industries is that, in other industries, entrepreneurs are at work.

This is another sign of dysfunctionality. In any properly functioning market, the only true agent of change is the entrepreneur: the individual who takes the risk of producing innovative products and services in the hope that they will appeal to customers. Thanks to entrepreneurs, and their use of innovative technologies and production techniques, including bringing China and India into the world economy, productivity in the real economy has increased massively over the last 30 years. By this means, entrepreneurs have helped to keep consumer price inflation under control in the face of an unprecedented expansion of the production of money by the central banks. Indeed, if the central banks had not printed so much money, consumers would have enjoyed a sustained rise in their standard of living, not from rising incomes, but from falling prices.

In banking, by contrast, there are no entrepreneurs, and so there is no innovation either. Instead, there is endless variations of the same techniques of discounted cash flow and the Black Scholes model, designed chiefly to bamboozle customers into buying a treasury bill or a beta return at five times the price they would achieve by going directly. Banking, as the e-mail correspondence of Fabrice Tourre, late of Goldman Sachs, so vividly demonstrated, is not a business in which pleasing the customer counts for much - or at least not as much as attracting the assets of the customer so that they can be re-used. The legal privilege that allows bankers to do that is what reduces the conflict between bankers and regulators and their political masters to a ruse, a façade, a Potemkin village designed to persuade voters that the crisis is all the fault of the bankers, and that the government is on their side. If the regulators were serious about resolving the financial crisis, they would not seek to contain the consequences of that privilege, but to remove it.

They do not do so because, in reality, bankers and politicians are not antagonists, but accomplices. There is a reason that banking is the only legitimate business in which the law of the land permits the owners and managers of the business to take the property of their customers and lend it, for profit, to dozens of other customers. That is what manufactures the money that buys the bonds that fund the government deficits. It also funds the banks that lend the money to consumers to buy the goods in the shops that create the pre-election booms. Where there is more money, there is more deposits; and where there is more deposits, there is more lending; and where there is more lending, there will be even more deposits; and where there is even more deposits, there will be even more lending; and where there is even more deposits and even more lending there is even more votes.

The financial crisis is at bottom no more than the cumulative effect of this process over many decades. The persistent unwillingness of successive generations of politicians and central bankers to face up to the fact that real increases in the standard of living cannot be faked, but have to be earned through the investment of real savings in real technologies and real techniques which really produce more for less, has led to decades of misdirected investment using borrowed money. The refusal to liquidate unproductive investments - the last man to recommend it, treasury secretary Andrew Mellon, is now a stock figure of fun in the mainstream economic literature - has preserved all of the errors on the supply-side of every developed economy. Those errors now date back not just to the last turn of the credit cycle, but to the one from before that too. Indeed, they date back to at least to 1980, which was the last occasion on which high real rates of interest were allowed to purge the system of accumulated errors.

Inevitably, the potential loss of value these accumulated errors represent is massive. They include mountains of securities that will never be re-paid, and the pension promises and health benefits and scores of other entitlements that were never funded and now will never be fulfilled. At present, the principal function of the financial system is to obscure this truth. Political leaders have reduced all of the problems facing the world - unsustainable government deficits, the threat to the survival of the euro, fragile bank balance sheets, even unredeemed cash collateral reinvestment pools - to a problem of financing. If governments cut enough public spending, runs the argument, they can re-finance their debts. If central banks loosen their collateral criteria enough for long enough, it continues, they can finance the banks for long enough to buy them enough time to re-build their balance sheets. It is the same logic that applies to asset owners trapped in cash collateral reinvestment pools. If they keep lending, they can keep financing the assets until all have matured.

The worrying aspect of this logic is that the money to fund them comes from the central banks. The developed economies have in the last five years passed through a period of monetary incontinence that is unprecedented. On January 1 1918, the monetary base of the United States stood at $4.8 billion. On January 1 2008, it stood at $851 billion. By 1 March this year, it stood at $2,684 billion. In other words, in the last four and a quarter years the Federal Reserve has printed twice as much money as it had in the preceding 90 years. [6] The dirty secret of the modern financial system is that banks all over the world are sitting on trillions of dollars of assets, many of them mortgage-backed or sovereign debt, whose only value rests upon the willingness of the central bank to fund them, or at least to fund the banks which fund them. Since the beginning of May 2007, the balance sheet of the Federal Reserve has increased more than three-fold, or by $1.9 trillion. [7] That of the Bank of England has increased four and a half-fold in the last five years, by £276 billion - a sum equivalent to an eighth of the entire national income of the United Kingdom. [8] Even the European Central Bank, the reluctant money printer of the early years of the crisis, has under its new Italian leadership started to catch up. Its balance sheet has inflated two and half times since May 2007, or €1.8 trillion. [9]

What this money represents is a collective refusal to face up to reality. Bankers nostalgic for a return to normality - crudely speaking, the financial markets of the pre-crisis era - are failing to recognise that it was not normal at all. It was in reality the last, bloated stage of an age of illusion, in which the world believed that the incessant borrowing of money by governments and the printing of money by their central banks had abolished, in the notorious phrase of Gordon Brown, "boom and bust." Even now, attempting to spend and borrow difficulties away ignores a singularly important fact. Demand does not create supply. Demand is constituted by supply. It is by selling goods and services that people generate the money to pay others. The problem of the world is not a lack of spending and borrowing but too much spending and borrowing, and not enough working and saving. This has over the decades since the introduction of pure fiat currencies in the early 1970s created a series of dislocations on the supply side of the economy, not least in financial markets and among financial institutions, where the dislocation showed up in asset price inflation in the markets for financial instruments.

The purpose of present policies is to reflate sunken asset prices. The theory is that rising markets will lower the cost of capital, inducing investment, and re-start the credit cycle. Once it has run for long enough, the central banks will be able to restore their support. There is a view, and it is one which is held strongly in the prime brokerage and hedge fund industries on which the lending of securities depends, that the central banks cannot withdraw from their role as funders of last resort until they let the "shadow banking" industry - the eco-system of investment banks, hedge fund managers and agent lenders depositing cash and collateral, of which securities lending is a part - revive. On this view, "shadow banking" is not a sinister force adding unseen leverage to an already over-leveraged financial system, but a benign, reflationary force that can take the strain from the central banks. In other words, the massive increases in the production of money by the central banks are the obverse of the shrinkage in the supply of collateral and the diminution in the velocity of the re-use of collateral. If governments are determined to suppress the shadow banking industry, say the advocates of this point of view, they are condemning themselves to keeping public deficits high, interest rates low, and the printing presses working overtime.

It is not hard to discern why those who advance this argument are making it. If an increase in GDP driven by the expenditure of borrowed and printed money is the chief criterion of economic success, the argument is a sound one. But, stripped of its pretensions, the call to bring back to life the "shadow banking" industry of the early years of the 21st century is really no more than a sophisticated plea for life in the financial markets to get back to normal. Unfortunately, the problems in the financial system are more fundamental than whether it is funded with central bank money or commercial bank money. It is worth asking why governments and central banks are so determined that interest rates should not be allowed to rise that they are prepared to print money without limit, and then use it to buy assets whose price would otherwise collapse. The answer is that a rise in the price of money would expose all those "fair value" valuations, whose methodologies are so meticulously explained in page after page of the annual reports of the banks and investment banks, as fiction. It would expose the "savings" recorded in the net asset values of every professionally managed fund as worth much less than the current, artificially lowered, rates of interest project.

Whether private balance sheets are underwritten by central bank money or commercial bank money is of secondary importance beside the fact that the developed world is choosing, quite deliberately, to pretend that trillions of dollars of assets are worth a lot more than they really are. Even a fully resuscitated "shadow banking" industry could not conceal that reality for long. After all, the debt and equity securities which the securities lending industry provides are the readiest sources of collateral for a new burst of leveraged financing, and their value is already inflated. The supply of genuinely high quality fixed income collateral is narrowing, as successive governments in Europe in particular are seen for what they are: bankrupt. In addition, despite the de-leveraging which has taken place, the balance sheets of the banks which are the immediate source of demand to borrow stock, are still remarkably fragile. The leverage ratios, measured by assets over equity, of the ten largest prime brokers average more than 14 times. That means a loss of just 7 per cent of the value of the assets of the average prime broker would be enough to wipe out the equity capital of the average prime broker.

Far from central bank money being withdrawn from a market whose leading institutions are in as fragile a state as this, the involvement of the state in the funding of the banks of the world is likely actually to increase in the coming years. The central banks are already supporting the artificially high prices and artificially low yields of a far wider range of assets than they could ever have imagined possible as recently as 2007. That process will continue. Indeed, it will in all likelihood intensify, as private sector creditors shun banks as far too risky a counterparty to contemplate. It will continue and intensify because the scale of the misallocations of capital built up over the last 30 years are simply too great for normality to return without an intervening episode of prolonged catastrophe. This makes it difficult to contemplate the future other than with a deep sense of foreboding.

The future is likely to be characterised not just by the money-printing and regulation which are so familiar already, but by rising taxation on financial transactions, the nationalization of pension funds, the collapse of currencies, controls on the movement of capital, permanent bans on short selling and securities lending, sinking stock markets, and especially the monetization of sovereign debt, probably as the prelude to an inflationary breakdown of some kind. After all, central banks are already the biggest marginal buyers of government bonds in the United States, the United Kingdom and Continental Europe. True, none of this may happen soon. It may even be decades away. As the case of Japan proves, a rich country can spend 20 years refusing to face reality, and somehow carry on. But happen it will, one day. For the developed markets have reached that stage at which the consequences of turning off the printing press, and facing problems squarely, are thought to be so damaging that current policy cannot be reversed before it ends in catastrophe. So it must, of necessity, end in catastrophe.