Getting that djinn out of the system

Think of the tomatoes.

A hosepipe pours a constant stream of water on them, which comes directly from the tap. Then one day an evil djinn clamps his hand around the middle of the hose. Two things happen. Firstly, the water pouring on to the tomatoes suddenly stops. Secondly the pressure at the top of the hose, which is connected to the tap, builds up to such an extent that the hose ruptures and bursts; water all over the place!

Still thinking of the tomatoes?

The tomatoes are getting dry and there’s now no more water that can feed them. The solution? To take a bucket and fill it with the water now gushing out of the ruptured nozzle of the hose, then manually take this to the tomatoes. Empty. Return. Refill. Back to the tomatoes. Empty. Return. Refill. And so on.

At least the tomatoes are getting watered, but is it the best way of doing things? Water splashing everywhere, some getting lost as you jog back and forth to feed the tomatoes, an exhausting manual exercise to bypass a hole in a hose pipe that perhaps you ought to think about fixing.

Oh well, some other day.

This parable was told to me by the CEO of a mid-sized French insurance company as we sipped cappuccinos outside a Parisian café, marvelling at how deserted the city’s streets are on VE Day.

The tomatoes are equities. The tap is the banking system. And the ruptured hose is the line of credit that once flowed so freely from lender to borrower.

In France, the story is no different from the rest of Europe. Banks have slashed lending, stemming the flow of credit upon which many small enterprises depend.

Enter shadow banking – lending by any institution that isn’t a bank. Like life insurers, who not only have a bit of extra cash but have predictable liabilities that are pretty long-term in nature.

Shadow banking is starting to become a big thing in France, as it is in many other European countries.

Until August last year, it wasn’t possible for insurers to engage in shadow banking, but thanks to a highly-successful lobbying effort by industry it now is.

The veteran insurance chief reflected upon this for a moment. With persistently low interest rates – though they may go up in the next year or two – the lure of lending to business for an insurance company is obvious: better returns, which they need to meet policyholder commitments. But the CEO reflect that this was not the best approach for the market in general.

“It’s like those tomatoes,” he said, a little wistfully. “The buckets of water go everywhere, and sometimes you get wet yourself. It would be so much better to get the djinn out of the system instead.”

But of course the temptation for better returns remains, and this particular insurance company is working on its own shadow banking initiative that should be launched in the next few months, despite this particular CEO personally thinking it not a good idea.

This may not be the most efficient way of doing things, and there is concern that it could be transferring additional risk to insurance companies, risk that they are not being adequately regulated for, but as long as they can turn a quick buck by fulfilling an obvious need they will.

The CEO pushed the meringue that came with his coffee towards me. He said he didn’t want it. I took it. I hadn’t had breakfast.

Of course, not everyone agrees that shadow banking is a bad thing. At the airport, waiting for a flight down to Naples, I caught a glimpse of the cover of this month’s Economist. Coincidentally enough it was about shadow banking and can be found here. In the article, the correspondent was trying to show what a wonderful thing shadow banking could be, if only properly regulated – it finally allows businesses to get those loans that the traditional banking system is currently denying to them.

But are we – as this CEO suggested – perhaps missing the point. Wouldn’t it be better to focus on why the system is broken in the first place? Even if it means that everyone only has one meringue.

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