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