'The Shadow Banking System' and 'Off-balance sheet finance'

These are two phrases that the conspiracy theorists like to bandy around - and our former Prime Minister popularised the expression shadow banking system in order to try and shift the blame - when I try to explain that the UK banking system is:
• nowhere near collapse. I calculated net total cash inflows from mortgage and other lending at £136 billion a year back in 2008, which might be down to £100 billion by now, as interest rates have fallen,
• would not go *pop* even if house prices fell by half, and
• is in no need of taxpayer-funded subsidies (unless your aim is merely to re-inflate the credit and house price bubbles, which would require subsidies that are so huge that the golden goose, the productive economy, would be slaughtered).

The conspiracy theorists mutter darkly that all my calculations don't include 'off balance sheet finance' or 'the shadow banking system', therefore they won't work, without offering any sort of explanation of what they are talking about - are the UK banks hiding assets or hiding liabilities? what sort of sums are involved?

The whole point is that UK banks are not omitting assets or liabilities from their balance sheets, they are wildly over-stating assets and liabilities - if anything there is too much on their balance sheets, making them look much bigger than they really are (see Note G below). Here is the consolidated balance sheet of UK banks. I'll explain all the double counting in the notes:
Notes:

A. The figure for loans to customers looks 'about right'. According to Credit Action, total residential mortgages and other household debts are £1,457 billion, plus add 50% for business lending. The Bank of England's Table C1.2 also shows £2,208 billion as at January 2010 (Excel).

B. I can't be bothered digging any deeper into this, but the 'securities for sale' (assets) are largely all the mortgage backed rubbish which they bought from other banks. Similarly each bank has repackaged its own mortgages and issued bonds secured thereon and/or the money they raised from bonds issued (liabilities) was lent on as mortgages, so the two B's are two halves of the same equation, and could in theory be netted off to very little indeed.

Some mortgages were genuinely 100% sold on and can be removed from the banks' balance sheets entirely, some were with recourse and so had to stay on. There is a theory that Northern Rock still included a lot of the former category on its balance sheet on the assumption that they were with recourse to the bank, whereas actually it should have excluded them.

C. The same logic applies to inter-bank lending, it's just two halves of the same equation. In this example, the amount borrowed from other banks is more than the amount lent to other banks, so I assume that the net figure of £121 billion is from non-UK banks.

D. The figures for derivatives looks big and scary, but I wouldn't worry too much about that either. This is because of accounting rules (see Note G).

To give a simple example of what this might be, let's imagine
i. A UK importer who intends to buy €120,000s worth of goods from the Euro-zone each year, who is worried that sterling will fall even further against the Euro, which will increase his sterling costs. So he enters into a forward agreement at today's exchange rate of say 1.2. He commits to pay the bank £100,000 next year and in return the bank will give him €120,000.

ii. A UK exporter who intends to sell €120,000s worth of goods to the Euro-zone each year, who is worried that sterling will bounce back, so he enters into a forward agreement at today's exchange rate to pay the bank €120,000 next year and in return the bank will give him £100,000.

The bank takes a small margin deposit from each business to cover counter-party risk, and even if the bank didn't hedge these payments elsewhere, you can see it runs no currency risk whatsoever - it will simply take the €120,000 from the exporter and give it to the importer; the £100,000 goes in the other direction. The bank couldn't really care less what happens to the exchange rate and still earns its commission.

But, because of accounting rules, the bank has to include £100,000 as an asset and as a liability; and it also has to include €120,000 as an asset and a liability (at whatever the relevant exchange rate is).

E. This is the aftermath of Quantitative Easing and the bank bail outs. The government gave the banks a couple of hundred billion in soft loans, included under 'bonds' (liabilities), but told them they had to invest in 'quality assets' (government bonds, natch). Then it told them it would overpay slightly for those bonds if the banks were prepared to leave the sale proceeds on deposit with the Bank of England (which is just a form of government borrowing, but as it was just one form of borrowing replacing another, is of little relevance to the outside world).

The Treasury could quite easily get a couple of hundred billion back off the banks by netting off the two figures.

F. Besides the bail out money, the banks also owed the government £5 billion in tax, but have a deferred tax asset (i.e. they can offset past losses against future profits) of £20 billion. This can be thrown in the pot with E, seeing as the Bank of England and HM Revenue & Customs are all part of HM Treasury, which is in turn part of the UK government.

G. Accounting rules discourage you from netting off closely related assets and liabilities (such as the £200,000 assets and £200,000 liabilities disclosed under D above, which don't really exist), and banks are quite happy to go along with it, because it makes them look 'too big to fail'.

The only UK banks that were sorted out properly via debt-for-equity swaps, being broken up etc are the smaller ones such as Northern Rock or the Bradford & Bingley. The point is that this would work just as well for the big banks. Of course it would have to be controlled and managed so that savers and depositors don't panic, separate topic.