blue trane's Journal: I.O.U., by John Lanchester

From page 25:

This is how it's supposed to work. A well-run bank is a machine for making money. The basic principle of banking is to pay a low rate of interest to the people who lend money and charge a higher rate to the people who borrow it. The bank borrows at 3 percent (say), and lends at 6 percent, and as long as it keeps the two amounts in line and makes sure that it lends money only to people who will be able to pay it back, it will reliably make money forever.

This institution, in and of itself, will generate activity in the rest of the economy. The process is explained in Philip Coggan's excellent primer on the City, The Money Machine: How the City Works. Imagine, for the purpose of keeping things simple, a country with only one bank. A customer goes into the bank and deposits $200. Now the bank has $200 to invest, so it goes out and buys some shares with the money - not the full $200, but the amount minus the percentage it deems prudent to keep in cash, just in case any depositors come and make a withdrawal. That amount, called the "cash ratio," is set by the government: in this example, let's say it's 20 percent. So our bank goes out and buys $160 of shares from, say, You Inc. Then You Inc. goes and deposits its $160 in the bank; so now the bank has $360 of deposits, of which it needs to keep only 20 percent - $72 - in cash: so now it can go out and buy another $128 shares of You Inc., raising its total holding in You Inc. to $288. Once again, You Inc. goes and deposits the money in the bank, which goes out again and buys more shares, and on the process goes. The only thing imposing a limit is the need to keep 20 percent in cash, so the depositing-and-buying cycle ends when the bank has $200 in cash and $800 in You Inc. shares; it also has $1,000 of customer deposits, the initial $200 plus all the money from the share transactions. The initial $200 has generated a balance sheet of $1,000 in assets and $1,000 in liabilities. Magic!

From page 36:

These were the ratios for the big European banks on June 30, 2008, when the financial tsunami was just about to hit: UBS, 46.9; ING Group, 48.8 to 1; HSBC Holding, 20.1 to 1; Barclays Bank, 61.3 to 1; ...

The figures for the big American banks aren't quite as bad, but they're bad enough: what they boil down to is median leverage ratios of 35 to 1 in the United States and 45 to 1 in Europe. Another way of looking at these ratios is to say that they represent the amount fo the bank's assets which have to go bad for the bank to be insolvent. In the United States, on average, if 1/35th of the bank's assets go bad, the bank is bust; in the European Union, 1/45 of bad assets would have the same effect.

From page 45:

Finance, like other forms of human behavior, underwent a change in the twentieth century, a shift equivalent to the emergence of modernism in the arts - a break with common sense, a turn toward self-referentiality and abstraction, and notions that couldn't be explained in workaday English. In poetry, this moment took place with the publication of The Waste Land. In classical music, it was, perhaps, the premiere of The Rite of Spring. Dance, architecture, painting - all had comparable moments. (One of my favorites is in jazz: the moment in "A Night in Tunisia" when Charlie Parker plays a saxophone break, which is like the arrival of modernism, right there, in real time. It's said that the first time he went off on his solo, the other musicians simply put down their instruments and stared.) The moment in finance came in 1973, with the publication of a paper in the Journal of Political Economy titled "The Pricing of Options and Corporate Liabilities," by Fischer Black and Myron Scholes.

From page 49:

Even once it's explained, however, it still seems wholly contrary to common sense that the market for products that derive from real things should be unimaginably vaster than the market for the things themselves. With derivatives, we seem to enter a modernist world in which risk no longer means what it means in plain English and in which there is a profound break between the language of finance and that of common sense. It is difficult for civilians to understand a derivatives contract or any of the range of closely related instruments. These are all products that were designed initially to transfer or hedge risks - to purchase some insurance against the prospect of a price going down, when your main bet was that the price would go up. The farmer selling his next season's crop might not have understood a modern financial derivative, but he would have recognized the use of it.