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Citation: Sgambati, S. (2019). The art of leverage. A study of bank power, money-making
and debt finance. Review of International Political Economy, 26(2), pp. 287-312. doi:
10.1080/09692290.2018.1512514

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City Research Online: http://openaccess.city.ac.uk/ publications@city.ac.uk
The art of leverage. A study of bank power, money-making and debt finance

(Pre-proofed version, Review of International Political Economy)

Stefano Sgambati

Abstract

There are two main theories of banking which seem to be incompatible by nature. According to the
first, banks intermediate money through their credit infrastructure but are not themselves able to
create new money. By contrast, the second argues that banks do create money out of nothing in the
process of lending their credit. Significantly, despite their contrasts, both theories conceptualise
banking in functionalist terms as the financing of other people’s indebtedness. In so doing, they
relegate to the side-lines the fact that banks are in the business first and foremost to ‘make money’
for themselves as they leverage their unique market position as dealers of other people’s debts. The
article thus investigates the phenomenon of modern banking as the art of leverage. After showing the
specificity of bank leverage relative to other forms of leverage across society, it delineates the
fundamentals of a political economy of banking, money-making and debt finance. Finally, the article
turns to an analysis of how contemporary banks make money and at once weave the infrastructure of
financial markets through leverage-enhancing techniques rooted in repurchase agreements.

Keywords

Banking Theory; Leverage; Money-Making; Debt Finance; Repos;.

JEL classifications: E02; E44; F3; G2; N20;.

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1. INTRODUCTION: BANKING IN THEORY

What do banks do? How do they make money (in the twofold sense of both ‘producing liquidity’ and
‘making profits’)? Are banks neutral intermediaries – the middlemen of global finance – or do they
take a distinct, net position in today’s struggles between creditors and debtors? Ultimately, how do
they wield power? Significantly, IPE offers no distinctive answer to these and other important
questions about theory and practice of banking. The general tendency is to go along with economics
and adopt an implicitly functionalist stance whereby both agency and purpose of banks are largely
justified in terms of their capacity to finance others. In many cases, bank power is either assumed or
assumed away, leaving no more than an impression on a field of inquiry that is dominated by two
purely economic paradigms: the orthodox and the heterodox. The two stand against each other, as
seemingly impermeable and ontologically incompatible theories, and yet they converge on some
fundamental propositions that altogether contribute to delivering the current image of banking as a
function of other people’s finance.

According to the former position, banks intermediate money through their credit infrastructure but
are not themselves able to create money ex nihilo. Its fundamental proposition is that ‘deposits make
loans’: the total amount of monetary savings held in deposit by banks must necessarily pose a physical
limit to the total quantity of money that they can raise for loans. The supply of ‘loanable funds’ can
be elastically expanded thanks to the ‘fractional reserve mechanism’ and the ‘money multiplier’ (for
a critique, cf. Sgambati 2016; Bianco and Sardoni 2017). However, as in a peculiar conservation law
of finance, through banking no money is truly created or destroyed: instead, all money is transformed
from one’s saving (credit) into another’s investment (debt), and banks only serve the function of
equilibrating the supply and demand for monetary funds and clearing the market gap between
borrowers and savers – the principal agents of finance.

By contrast, the heterodox position contends that banks genuinely create money out of nothing in the
endogenous process of making loans. The core assumption is that ‘loans make deposits’ and not vice
versa. Indeed, each loan by a bank implies the instantaneous creation of money in the form of a
deposit at another bank – money is simultaneously debited and credited, so that at any point in time
“for the banking system as a whole, total loans equal total deposits” (Moore 2003: 120). Far from
being a necessary precondition to bank lending, the act of saving is its logical consequence: “saving
is the accounting record of investment” (Moore 2006: 156). Alas, the heterodox understanding of
banking similarly lends itself to functionalist interpretations of bank agency, such as the idea that

2
banks could create money by keystrokes and in whatever quantities they deem sufficient to
accommodate the general, market-driven demand for credit 1.

More generally, despite moving from opposite premises, both orthodox and heterodox views
converge on the following points. First, they understand bank profits as the by-product of lending
money at interest. Second, they frame bank lending as originally (both logically and historically) a
form of productive credit to firms and/or consumptive credit to households. Thirdly and related to the
previous point, they give scarce consideration to the fact “that a significant portion of credit is created
to finance purchases of financial assets” (Dow 2006: 44), thus relegating to the side-lines the question
of how money and banking bear upon speculation in financial markets. The latter is usually intended
either as an irrational outgrowth (in the orthodox story), or as the inescapable feature of a
fundamentally unstable financial system (in the heterodox story). Either way, banks appear to enjoy
little or no agency relative to market forces and investor sentiments – the “animal spirits” driving
finance out of equilibrium.

1.1. The myth of the bank-market dualism

The theoretical debate on whether banks intermediate or create money (with its structural-
functionalist undertones and idiosyncrasies about the nature of money, banking and speculation) is in
turn compounded by the question of how banks and financial markets relate with one another. Until
recently, the predominant position in economic sociology and financial theory was drawn upon
Zysman’s (1983) seminal work on varieties of capitalism. Zysman retained the orthodox view of
banking as intermediation (Hardie et al 2013: 699) and understood the bank-market relationship as a
dichotomy and a zero-sum game: more banking equals less financial markets and vice versa
(Christophers 2015). Following Zysman, scholars have begun to distinguish between respectively
‘bank-based’ and ‘market-based’ financial systems. The former are non-competitive (qua

1
Indeed, endogenous money theory assumes the existence of “a market mechanism that induces banks to supply just the
amount of money that the public wants to hold” (Glasner 1992: 869; see also Lavoie 1999; Le Maux 2012). If money is
supplied in excess, the private sector will get rid of it by either paying off its debts to, or by purchasing securities from,
the banking system. In any event, excess money will be destroyed as a result of its flowing back to the banking system
(Lavoie 1999: 111). This means that while “[o]n a theoretical level, the banking system could create money endlessly”
(Realfonzo 2003: 62), on a practical level, due to a structural market imperative, the banking system is compelled to
generate money ex nihilo until the demand for credit is saturated. In the end “only desired money can exist” (Le Bourva,
quoted in Lavoie 1999: 109).

3
oligopolistic) in nature, based on personal ties and long-term credit relationships between banks and
their borrowers. Here banks retain the power to influence prices (starting from the price of money)
and allocate capital on a long-term basis, thus acting ‘patiently’ as a bulwark against market pressures.
By contrast, market-based systems are highly competitive and based on arm’s length financial
relations: in this case banks have lost their capacity to price money and allocate capital, and are subject
to market pressures coming from ‘impatient’ shareholders and institutional investors, which banks
transmit to their borrowers (Engelen et al 2011: 102).

In recent years, critics of the varieties of capitalism approach have rightfully pointed out how the
analytical distinction between bank-based and market-based financial systems no longer holds in the
age of shadow banking (Hardie et al 2013; see also Erturk and Solari 2007; Sawyer 2014). Starting
from the 1980s, all economies have converged towards the market-based, neoliberal regime. Rather
than constituting a ‘variety’ of capitalism, the latter represents the culmination of an evolutionary
process marking a secular transition from traditional banking, based on the classic ‘originate-and-
hold’ model, to contemporary globalised banking, based on the ‘originate-and-distribute’ template of
securitisation. Today all financial systems rely on growingly deeper and globally integrated financial
markets, with Wall Street as their epicentre (Gowan 2009), and both banks and their borrowers have
come to rely on myriads of ‘functionless investors’ funding financial markets.

However, pace the varieties of capitalism approach, the growth of market-based finance has not
spelled the downscaling of banks and their disintermediation in favour of markets. On the contrary,
more markets have gone hand in hand with more banking (Christophers 2015). Since the 1980s, banks
have grown in size and increasingly diversified their activities (also due to bank mergers and
acquisitions). Today banking encompasses asset management, securities dealing, brokerage and
proprietary trading – namely a set of practices that do not so easily lend themselves to conventional
economic theories (with their implicit bias towards retail and commercial banking), and which depart
in many ways from the ideal-type of investment banking (with its emphasis on M&A, underwriting
and other services offered to non-financial corporations) since they involve the provision of liquidity
services to other financial corporations (the money-manager complex, see section 3).

More puzzlingly, bank profits are less and less derived from the interest component of income (Erturk
and Solari 2007; Engelen et al 2011). Return on assets (ROA) – a proxy measure of the profitability
of bank loans and an indicator of the relevance of interest-based payments to banks – has been meagre
and steadily declined, especially starting from the mid-2000s, offset by return on equity (ROE) – a
proxy measure of bank leverage. The latter reached above a record 25 percent for some investment
banks before the crisis (Engelen et al 2011: 98). In general, despite a progressive disengagement from

4
canonical interest-earning activities, banks saw their profits grow significantly, especially between
2002 and 2006. Over this period, in the United States commercial banks averaged aggregate net
income of about 50 percent (and this is without taking into account off-balance-sheet activities).
However, the great bulk of money was made by the largest U.S. investment banks, with Bank of
America and JP Morgan Chase averaging respectively 129 percent and 243 percent increase in net
income (Schleifer and Vishny 2010: 316).

1.2. Market-based banking or market-driven banking?

Although scholars recognise that in the contemporary financial ecology the banks’ capacity to supply
liquidity to the system, as well as their ability to make money for themselves, relies less and less on
the ‘core’ service of money-lending, and more on (allegedly) ‘non-core’ services of asset
management, securities dealing and proprietary trading, and while they register that in the age of
market-based finance banking has become all the more central to the financing of positions in capital
markets, they are still reluctant to attribute autonomous agency and power to banks. The latter might
be flooding markets with ever-growing liquidity and yet, in most cases, they are still conceptualised
in mainstream terms as intermediaries – the middlemen rather than the principal agents of global
finance.

Paradoxically, this view of banks as mere go-betweens especially applies to investment banking,
despite the fact that in the last quarter century the latter has become heavily involved with proprietary
trading – what Engelen et al (2011: 124) have caustically termed “banking for itself”. With the
exception of a few (e.g. Nersysian and Dantas 2017), heterodox proponents of endogenous money
theory still hesitate to assign money-creating power to investment banks, or anyway to banks that do
not lend money directly for productive and/or consumptive purposes. From a post-Keynesian
perspective, investment banks are understood as facilitators of what Graziani and Davidson termed
respectively ‘final finance’ and ‘investment funding’ (cf. Lavoie 2006: 67) – all in all, the provision
of services (such as underwriting and M&As advising) to non-financial corporations (NFCs) that wish
to finance their activities by issuing bonds or equities to be traded in capital markets.

With the financialisation of NFCs and the consolidation of shareholder-value principles of corporate
management (Lazonick and O’Sullivan 2000; Krippner 2005; Knafo and Dutta 2016), final finance
is said to have become part and parcel of a “dysfunctional rentier outgrowth” (Mitchell 2016: 8)
fuelled by shadow banking: it is today a transaction fee-based, money-making machine for investment
5
banks et alia which in large part “involves the trading of already existing credit claims” (Mitchell
2016: 9). More importantly, the (dysfunctional) ‘final finance’ offered by investment banks is
understood as logically posterior and subordinate to (functional) ‘initial finance’, namely “the power
of commercial banks to endogenously create loans and deposits” (Mitchell 2016: 9). Ultimately, it is
commercial banks that take net positions and originate ex-nihilo money – yesterday to finance
production, today to finance consumption. Investment banks, by contrast, cannot create additional
money claims but only transfer existing surpluses from retail and institutional investors to firms in
need of market-based financing.

In general, global market-based banks are represented as lacking power. Hardie et al (2013: 712;
720), for instance, see securitisation as a sign of the secular decline of banks’ financial power relative
to market forces. Supposedly, financial power got dispersed in the ‘daisy chain’ of bank and non-
bank financial intermediaries that ought to borrow from retail and institutional investors in order to
fund their liquidity transformation processes and ‘lend’ (cf. Claessens et al 2012). The subtext is that
the ability of global banks to function as a platform for ‘capital market lending’ is constrained by
their capacity to tap on already-existing ‘money market funding’ provided by institutional investors
– the ultimate creditors of global finance. Accordingly, global banks are caught between the rock of
a purely speculative demand for liquidity by hedge funds et similia (the broader constellation of
levered-up asset managers), and the hard place of a growingly impatient supply of ‘funding liquidity’ 2
by money market funds and other institutional cash pools (Pozsar 2014; 2015).

The bottom line is that global banks might be making money, yet their agency is inexorably nullified
by a peculiar version of Say’s Law: an iron law of financial markets whereby the funding liquidity
that is globally supplied by institutional investors determines (the price and volume of) the liquidity
generated locally by banks to meet the demand of their borrowers. The circle is now complete and
we are back to the functionalist view of banks as go-betweens – intermediating funds from savers to
borrowers (Claessens et al 2012: 4) – updated to the age of market-based finance.

And yet, global banks should be able to wield considerable power these days, considering the fact
that they make the very markets they are supposed to be subject to (cf. Mehrling 2010; Mehrling et
al 2013; Christophers 2015; Nersysian and Dantas 2017). ‘Primary dealers’, for instance, are
committed to both buying and selling government securities as a way to generate liquid markets for
them. In the process, they leverage their privileged position as the exclusive dealers of sought-after

2
Brunnermeier and Pedersen (2008) distinguish between ‘market liquidity’ and ‘funding liquidity’. The former represents
the ease with which traders can trade whereas the latter corresponds to the ease with which traders can obtain funding.
Global banks that deal in debts in financial markets at large fund their liquidity via the money market.
6
sovereign collaterals (cf. Gabor and Ban 2016). More generally, broker-dealer banks make markets
in multiple financial assets, and these markets “are seldom anonymous or perfectly competitive; they
are more often institutionally concentrated and hierarchical” (Chistophers 2015: 86). Crucially, the
bank praxis of ‘making markets’ casts a long shadow not only on the varieties of capitalism heuristics,
but also on the very analytical separation between banks and markets (Christophers 2015). To recast
Keynes’ (1930: 5) famous metaphor, in their capacity as market-makers, banks claim the right to
enforce and write the dictionary of financial markets: they are by far the most powerful “market
force”, articulating the very infrastructure on which financial markets operate.

While this study does not neglect the existence of pressures and demands coming from various
financial agents (money managers and investors), its purpose is to shed light on the autonomous
agency and power of banks. This power, it is argued, is ultimately drawn upon the banks’ ability to
fund their own indebtedness in view of making money for themselves – the financing and refinancing
of others being a means to this end. What banks normally do to increment their power is captured by
a single, resounding word: leverage. To expand their liquidity provision services and renew the daily
miracle of multiplying money for themselves as well as for others, banks must systematically and
sustainably leverage their market position so as to acquire those raw materials of debt upon which
they can establish their financial dominions (and build empires). They way banks leverage, however,
defies common sense and a leap of imagination is required to grasp it. We know that leverage involves
taking “a position in an asset without having to provide all or any funds for the position” (Nersysian
and Dantas 2017: 291): in practice, it involves buying stuff with borrowed money. And yet banks
leverage not when they borrow money but as they lend it! This paradox is the subject of the next
section.

2. BANKING IN PRACTICE: LEVERAGE

In finance, the word ‘leverage’ describes the ability to borrow, not primarily in order to settle
obligations, but in view of making investments in financial markets. As a manifestation of the desire
to borrow to invest (rather than strictly to pay), leverage is an inherently speculative practice insofar
as it meddles with the future. As such, leverage is not for everyone, for it requires knowledge,
precision, timing and – what’s more important – capital. The latter attribute is perhaps what best
explains the difference between a debtor who owns nothing but her own ability to work, and who
therefore earns not enough money but ought to borrow to pay for her expenditures, and a debtor who

7
on the contrary needs not borrowing, but chooses to do so on expectation to add more money to her
capital “from knowing better than the market what the future will bring forth” (Keynes 1936: 170).
The act of leveraging is therefore entangled with the existence of organised markets (for both
commodities and money). Indeed, when we borrow to invest in a certain asset, we are not simply
playing the odds and making a bet on the future profitability derived from the ownership of that asset.
Instead, we are leveraging our position in a specific market, thus magnifying in a more or less
conscientious manner our power to affect the market itself. In other words, when we leverage we gear
the market towards meeting our expectations.

Significantly, the notion of leverage allows us to historicise the peculiar character of debt in modern
times. For much of the history of civilisation, debtors would either throng to the bottom of social
hierarchies (as bonded labour) or sit on top of them (as kings). Either way, being in debt was for them
a social burden – the foremost economic symptom of ‘not having’ or ‘lacking’ sufficient political
power. By contrast, starting from the modern era, being in debt has progressively become a basic rule
for enabling one’s agency in society and an instrument of emancipation that has gone hand in hand
with the historical development of financial markets for all sorts of debts (commercial, public,
corporate, household). The notion of leverage captures this radical transformation in the significance
of debt as a “technology of power” (Di Muzio and Robbins 2016). Once framed as leverage, debt
stops bearing its negative connotation and becomes a “dynamic, productive force” with “an
indisputably positive aura, suggesting quite literally a means of transformation and a way to maximise
opportunities” (Allon 2015: 687-8). Leverage thus redefines debt as a positive technology of power:
a social relation that, rather than enabling a despotic, disciplinary control over debtors, can actually
empower them in their struggles and negotiations with creditors by activating their power to affect
prices and markets through levered-up investments.

Curiously, when searching for practical examples of leverage in textbooks, one often finds the story
of a mortgagee who borrows from a bank to buy real estate, possibly amidst a housing bubble (e.g.
see Admati and Hellwig 2013). Leverage is portrayed as a method by which individual borrowers can
obtain liquidity from banks. And yet, in practice, leverage is usually neither a una tantum activity,
such as getting a mortgage, nor an individual practice. Instead, it is a painstakingly professional,
highly sophisticated and well-organised practice involving numerous parties. Only rarely will the
successful Wall Street leverager be an occasional gambler moved by ‘animal spirits’. Most likely, she
will be a professional ‘money manager’ (Wray 2009) working in the asset management industry,
driven by a relentless and systematic effort at making money, based on a cold calculation and
valuation of risk.

8
The point is that while leverage involves making money ‘out of debt’, rather than ‘out of labour’, it
nevertheless requires both technique, organisation, and time in order to pay off. And so, when we
think about it, rather than the once-in-a-lifetime mortgagee who is rather passively caught in the eye
of a housing bubble, we should consider the hedge fund whose job is to administer on a daily basis
large volumes of money from different sources in view of generating capital gains for its distinguished
clients. Unlike a mortgagee, the hedge fund is born with the mission to leverage its position, affect
prices and move markets (Erturk et al 2010; Ben-David et al 2013), possibly contributing to setting
up the very bubble the mortgagee gets caught in (this argument will be put forward in section 3.2).

However, an even better example of a highly leveraged agency is provided by banks. Normally
portrayed as financial intermediaries and enablers of other people’s leverage, banks are in fact masters
of leverage. According to Stefan Ingves (2014), former chairman of the Basel Committee on Banking
Supervision (BCBS), “[b]anking is all about leverage”. To one’s great perplexity, banks’ capacity to
lever is unparalleled. Unlike banks, most economic agents (households, non-financial corporations,
governments and even hedge funds) ought to rely on far greater margins of capital to finance their
activities and sustain ‘balanced’ levels of leverage, funding their assets around 50:50 with debt and
equity. By contrast, “in banking, a more common ratio is 95:5 (and that can be before off-balance
sheet exposures are taken into account” (Ingves 2014: 2). In other words, banks are able to expand
their monetary liabilities (or claims) almost ad infinitum whilst relying on a ridiculously small amount
of capital to back them up. As Mackenzie (2013: 7) explains, it is perfectly possible for a bank to
fully comply with Basel III whilst having a ratio of regulatory capital to total assets of less than 5 per
cent – which is another way to say that banks are uniquely able to leverage out of all proportions.

2.1. The specialty of banks

How is it possible that banks are able to leverage beyond reason, with ratios that settle very
comfortably around 15 or more (cf. Kalemli-Ozcan et al 2012)? Why are they so ‘special’? A clue to
answer lies in the fact that banks lever according to a different logic relative to everybody else.
According to a well-established literature (e.g. Adrian and Shin 2010; Schleifer and Vishny 2010;
Kalemli-Ozcan et al 2012; Brummitt et al 2014), leverage is always pro-cyclical for banks whereas
it is counter-cyclical for the rest of society. This means that when the prices of assets go up,
everybody’s leverage ratios go down, except for banks. This is because banks, in contrast to

9
everybody else, “aggressively expand their balance sheets and debt levels when asset prices are
rising” and “contract balance sheets when asset prices are declining” (Brummitt et al 2014:1).

The pro-cyclicality of bank leverage is a consequence of the fact that banks leverage their positions,
not when they take deposits, but as they make loans – something they predominantly do upon the
surety of debtor’s collateral. Significantly, as banks collectively engage in asset collateralising loans,
not only do they increase their leverage, but they are also likely to inflate the price of collateral assets
against which they lend (Werner 2005: 228; Fostel and Geanakoplos 2008). Reciprocally, when
(collateral) asset prices fall, banks are most certainly bound to face liquidity problems as some of
their risky borrowers may become insolvent. Depending on the severity of their liquidity problems,
banks may become risk averse and seek to reduce their debt exposure to the point where they might
even stop lending to each other – whence the pro-cyclical, magnifying nature of their leverage.

Due to its pro-cyclical and disproportionate nature, bank leverage can be extremely destabilising.
Minsky, who understood banks as prototypical speculative organisations (Minsky 1986: 231) 3,
argued that “[t]he leverage ratio of banks and the import of speculative and Ponzi financing in the
economy are two sides of a coin” (Minsky 1986: 265). This is because banking involves routine
“balance-sheet adventuring” (cf. Minsky 1986: 48): as banks carry out their loans, they are bound to
take net positions in other people’s debt that at any point in time are not immediately matched by
incoming cash flows. Because of this fundamental dissymmetry in the time-structure of their balance
sheets, banks are plagued by a structural liquidity problem consisting of daily cash-flow deficiencies,
the magnitude of which is directly proportioned to their “willingness to lever or debt-finance positions
in inherited capital assets, financial assets, and newly produced capital assets” (Minsky 1986: 208) 4.

At the most basic level, banks’ cash-flow deficiencies are funded by attracting deposits. In turn, when
the primary channel of deposit-taking becomes too expensive or is no longer available, banks may be
forced to pledge, lend or sell assets to other banks or to genuine ‘buyside’ investors. This backup
financing strategy is known as ‘liability management’. Significantly, the funding liquidity channels
offered by interbank credit and money markets are only “proximate lenders of last resort” (cf. Minsky

3
On the speculative nature of bank leverage see also Konings (2018: 13-21; 75-83).
4
Minsky (1986) used the terms ‘debt finance’ and ‘speculative finance’ as synonyms with leverage. For him, speculation
had nothing to do with the quality of investments - namely whether money is channelled towards industry, consumption
or financial markets. Rather, he understood speculation as the practice of financing investments through debt, therefore
as a form of leverage that, when considered at a systemic level, is always bound to lead to “financial arrangements in
which borrowing is necessary to repay debt” (Minsky 1986: 48). Following Minsky, in this study I will refer to
‘speculation’ as the debt financing of loans and investment (regardless of what these loans and investments are for) – an
activity of which banks are the original masters. In turn, I will call professional (or active) speculators all those levered-
up investors who affect prices and move markets in view of making money.

10
1986: 48) that cannot fully withstand the banks’ overall demand for liquidity. Ultimately, banks’ net
liabilities ought to be financed and refinanced through “the rolling over of maturing debt” (Minsky
1986: 230) – they are discharged by yet more debt issued by the central bank 5.

To be sure, the banks’ ability to valorise other people’s debts with their relentless provision of
liquidity makes them a most dynamic and productive force of capitalism – something “that makes it
possible for us to pursue today dreams for the future that would otherwise be impossible” (Mehrling
2010: 11). However, precisely because of their inherent dynamism, banks are a most disruptive
element of capitalism. Their practices are in fact a “driving force behind the privatisation of gains and
the socialisation of losses, multiplying profits and bonuses in good times and multiplying losses and
bailouts in bad times” (Engelen et al 2011: 112) – offering a ‘financial fix’ for structural global
imbalances and capital-labour disparities (Taylor 2012; Pozsar 2014; Fernandez and Wigger 2017).

2.3. Fundamentals of a political economy of banking, money-making and debt finance

Interestingly, bank leverage has advanced to a whole new level in relatively recent years. Starting
from the 1980s, we have witnessed what Taylor (2012) has termed the “Great Leveraging”. Banks
have been able to further increase their leverage ratios and “skirt capital requirements by using off-
balance sheet investment vehicles” (Kalemli-Ozcan et al 2012: 285). Crucially, the globalisation of
banking (as linked to securitisation and shadow banking) has coincided not only with a spectacular
growth of bank profits, but also with a secular decoupling of bank loans from the traditional measures
of ‘broad money’ (Taylor 2012). This decoupling has been mirrored by the explosive growth of new
money market instruments – in fact, debt instruments that can be liquidated in the short term at par
or quasi-par – often called ‘quasi-money’, ‘near-money’ or ‘cash equivalents’. According to a
growing body of literature, these instruments have come to bear monetary attributes and should be
included in the lists of what counts as ‘money’ (Pozsar 2014; Gabor and Vestergaard 2016; Ricks
2016).

5
Net liabilities that cannot be matched by incoming cash flows via both primary and backup funding channels are indeed
recorded as debits against the central bank – the “ultimate fallback source” (Minsky 1986: 48) of funding liquidity for the
banking system at large. In normal times, for every bank holding a debit against the central bank there will be another
bank holding a credit against it – the central bank will thus serve primarily as a clearinghouse, keeping a record of how
much banks owe to each other. Conversely, in exceptional times the central bank might be forced to expand its balance
sheet and act as a net creditor of the banking system at large – the central bank will thus genuinely serve as the ‘lender of
last resort’.
11
While there is little doubt about the fact that shadow banking provides the main explanans for the
Great Leveraging, it must be pointed out that banks were on a mission to leverage and expand their
balance sheets before they became embroiled with the most recent financial innovations and bubbles.
The U.S. ‘flow of funds’ data provided by Adrian and Shin (2010) shows that the leverage ratios of
U.S. investment banks have been steadily growing between 1963 and 2006. In fact, if we exclude the
stock market crash of 1987, ROE for all U.S. banks has been on the rise since the mid-1930s (Walter
2006: 71). More generally, scholars have stressed how equity levels of U.S. banks have been
decreasing relative to total assets starting from the late nineteenth century – from 45-50 percent of
total assets down to 6-8 percent or less today (Admati and Hellwig 2013: 30-1; Mackenzie 2013).
This seems to suggest that well before they became officially ‘market-based’, and implicated with
shadowy dealings in the upper layers of global finance, banks at large were already driven by a
‘shareholder value’ mentality that privileged ROE over ROA and aimed at growing leverage. This
mentality is the explanandum of this study.

Alas, an extensive history of modern banking – its motives and rationalities – is beyond the scopes
of this article. Its purpose is rather to shed light on the power and autonomous agency of contemporary
banks through a study of how their leverage-enhancing practices increase their infrastructural
capacity to make markets for debts and how this feeds into their power to make money itself. Hence,
in the next section I look at contemporary banking and the global financial infrastructure it gives
shape to. After providing a heuristics of the diverse pecuniary interests and agencies populating
today’s complex financial ecology, I examine the bank-engendered practices and processes through
which cash equivalents are forged. In particular, I focus on how repos enable bank leverage and at
once provide a stable interface between the capital market, where money is made by professional
speculators, and the wholesale money market, where money claims are validated by institutional
investors as temporary abodes of purchasing power (routinely rolled over by banks).

The analysis of contemporary banking is consistent with the following set of theoretical propositions,
which altogether lay out some fundamentals of a political economy of banking, money-making and
debt finance:

1. Banks make money for themselves and provide liquidity to the system at large as they leverage
pro-cyclically and out of proportions. Their agency defies common sense, for banks truly
borrow not when they accept deposits from savers (the ultimate creditors), but as they make
loans to their borrowers and supply them with liquidity in the form of bank IOUs that trade at
par.
12
 2. Bank practices that are often categorised as ‘loan-making’ have very little to do with the
semantics of ‘money-lending’ (cf. Minsky 1986: 256; 278; Werner 2005: 176). When banks
make ‘loans’, they are in principle discounting other people’s debts with their own debts. That
is, banks monetise their own debts upon capitalising other people’s debts (Sgambati 2016:
281-4). Hence, the liquidity they supply is not based on the classic creditor-debtor relationship
but is the outcome of a swap of debts (Mehrling 2010). The latter establishes a unique
relationship of mutual indebtedness – i.e. a debtor-debtor relationship – between banks and
their borrowers (Hawtrey 1919: 9; Kim 2011; 2014; Sgambati 2016).

3. Accordingly, the banks’ initiative in providing liquidity does not lie with ultimate creditors.
Through banking, new money can be created without prior saving, therefore without the direct
involvement of any genuine creditor whatsoever 6. Creditors are not the original providers of
money but, if anything, its final acceptors and validators. Bank money is utterly a debtor’s
money, part and parcel of a regime of ‘debt finance’ that is not predicated upon the final
settlement of debts, but upon their funding for the time being (cf. Sgambati 2015; 2016).

4. Upon making loans, banks do not act as proxies of ultimate creditors, let alone remain neutral.
On the contrary, they are impelled to protect and prioritise the interests of debtors over those
of creditors, (if only) because their ability to elastically expand their balance sheet, increase
their debt exposure and get their money accepted is above all linked to their debtors’ solvency,
hence their ability to earn money (to repay principal and service their debt). To paraphrase
Palan (2015: 372), “in contrast to creditors”, banks are interested in debtors “as living and
growing entities that are likely to generate income in the future”. Crucially, for bank
borrowers to generate income and earn the money they need to stay solvent, said money ought
to be produced by banks as they “move forward in step” (Keynes 1930: 26) with their
unceasing debt financing.

5. The above is fundamentally in line with the heterodox idea that ‘loans make deposits’. Having
said this, while the volume of bank loans is never constrained by the volume of existing
savings, bank capital and/or reserves, it is not possible for loans to occur “to which no savings
corresponds” (Keynes 1936: 81). In the end, banks can only fund their indebtedness as long
as their net money claims are validated as deposits. This is easier said than done, for “everyone
can create money. The problem is to get it accepted” (Minsky 1986: 255). Having one’s debt

6
This strongly resonates with post-Keynesian circuitist theories of money (see Lavoie 2006; Mitchell 2016: 15).
13
 circulated and stored as money – virtually unredeemed for the time being – involves
generating and sustaining a demand for it.

6. While many accounts of banking are inclined to attribute the generalised acceptability of bank
money to factors that are beyond bank agency 7, it is clear that banks themselves must play a
crucial role in generating and sustaining the demand for loans as well as deposits. In particular,
banks generate confidence (trust, security) in their money as they make markets for debts that
at once bring forth: a) new investment opportunities for holders of bank money, thus feeding
their desire to hold, borrow and/or invest money for speculative reasons 8, and b) novel
strategies of liability management for banks. Indeed, it is no coincidence that, historically, the
monetisation of bank debts has been mirrored by the development of lucrative markets for
other people’s debts (commercial, public, corporate, household debts) to which the ownership
of bank money could offer exclusive access.

7. Ultimately, the significance of bank money ought to be sought in its liquidity. The latter is not
simply a synonym for universal exchangeability (the medium of exchange function) but is a
historically-specific relationship of exchangeability that only occurs between money and debt.
Making money ‘as we know it’ involves generating liquidity which, in turn, entails producing
debts as commodities that can be readily bought and sold in organised markets. In this respect,
the ultimate concern of banks is not to ensure the solvency of debts (as liabilities) but to boost
their capacity to trade and accumulate (as assets). This goes along a great tradition of financial
studies that conceptualise banks as dealers in debts (Macleod 1866; Bagehot 1873; Hawtrey
1919; Minsky 1986; Mehrling 2000; 2010).

3. CONTEMPORARY BANKING AND ITS GLOBAL FINANCIAL INFRASTRUCTURE

7
The most popular explanations attach paramount significance to the regulatory powers of monetary authorities, focusing
for instance on their ability to generate confidence by devising deposit insurance schemes, lender of last resort facilities,
regulatory frameworks for risk-taking and capital requirements (e.g. Rethel and Sinclair 2012). Others emphasise the
fiscal power of the state, its ability to impose a tax liability which ultimately gives value to money (e.g. Wray 2012). Very
few, however, seem to appreciate the autonomous workings of banks as ‘market-makers’ for both other people’s debts
and their own monies.
8
In his General Theory, Keynes identifies three motives for wishing to hold money (and, reciprocally, for being willing
to pay a price to borrow it): transactional, precautionary and speculative motive. Of the three, only the speculative motive
is ‘interest-elastic’ insofar as it refers to the desire to hold money in a strategic fashion as a hedge against fundamental
uncertainty concerning the future course of interest rates (Keynes 1936: 168). Hence Keynes primarily relates liquidity
preference (the store of value function of money) to the prospect of making gains and “securing profit from knowing
better than the market what the future will bring forth” (Keynes 1936: 170).

14
When today we talk about banks, it is not clear what we are talking about. In the paroxysm of
confusion, the gap between theory and practice of banking is often filled negatively, by stressing what
banking is not. The jargon of contemporary finance abounds of terms such as non-bank financial
intermediaries, non-bank financial institutions, and even non-bank banks – labels that are used to
refer to the ever-growing bulk of activities performed by non-licensed and/or largely unregulated
banking institutions that do not take ‘ordinary’ deposits or make ‘ordinary’ loans, but preponderantly
operate through markets. Ironically, according to current definitions, the largest banks on earth are
somewhat not banks.

While this terminology is highly contestable for the semiotic blind spots that it produces, it is true
that banks have been subsumed within a multi-layered infrastructure encompassing a ‘daisy chain’ of
financial entities whose activities extend far beyond what can be captured by a single balance sheet
and be regulated as such. In particular, banks have further intensified their ability to expand their
assets under management by setting up off-balance-sheet structures, vehicles and conduits operating
in the shadows (e.g. Thiemann 2012; Lysandrou and Nesvetailova 2015; Fernandez and Wigger
2017). The liquidity transformation that used to be carried out by a single banking institution is now
broken down “into several discreet steps” (Helgadottir 2017: 920). In this connection, it would not be
inappropriate to speak of contemporary banking as ‘financial Taylorism’ on a global scale: a money-
making industry based on a scientific management of debt production, with each element of the daisy
chain having a ‘special purpose’ in collectively transforming the diverse raw materials of debt into
highly fungible, and extremely liquid, short-term debt instruments generally accepted as ‘cash
equivalents’.

And yet, despite the incomparably greater complexity of contemporary banking relative to the fairly
primitive practices of debt financing performed by goldsmith bankers at the time of the English
financial revolution in the late seventeenth century, there is nothing new under sun. Today, like 350
years ago, banking equally involves making money out of debt: a process that is ultimately concerned
with generating ‘liquidity’ in the form of bank IOUs that trade at par on demand (Merhling 2010;
Pozsar 2014; Gabor 2016; Murau 2017). However, while the liquidity generated by London’s
goldsmith bankers was primarily based on the discounting of self-liquidating commercial debt (Knafo
2008; Kim 2011), the liquidity produced by today’s global banks has so far relied on two main
financial innovations that have deeply altered the institutional landscape of global finance in the last
35 years: (a) the securitisation of consumer debt and (b) the collateralisation of public debt via
securities lending and repurchase agreements (repos). Both innovations are predicated on the routine

15
‘shiftability’, rather than ‘self-liquidability’, of debts (Mehrling 2010) – whence on the deepening of
both primary and secondary financial markets.

Although in the past ten years a great deal of studies in IPE and cognate social sciences have been
devoted to the phenomenon of securitisation and uncovered its linkages with shadow banking (e.g.
Nesvetailova and Palan 2013; Nesvetailova 2015), only a small, yet growing, body of literature has
investigated how repos enable bank leverage and money-making. The remaining of this paper will
thus focus primarily on the role of repos in articulating the current global financial infrastructure. The
focus on repos is also for an empirical reason: following the 2007-09 global financial crisis, the
securitisation channel seems to have lost its ability to produce cash equivalents in a sustainable
fashion. Before the crisis, cash equivalents issued by global banks included two main classes of
instruments: asset-backed commercial paper (ABCP) that was issued by bank-sponsored conduits via
the securitisation channel, and which was based on collateralised debt obligations (CDOs); overnight
repos issued by securities dealers, backed by the prime collateral offered by both triple-A CDOs and
Treasury bills (T-bills). With the crisis, the market for CDOs has collapsed and ABCP have lost their
capacity to trade at par on demand – they have been essentially demonetised (see Murau 2017: 23-4).
By contrast, overnight repos that are fully collateralised by T-bills (i.e. T-repos) have proven to be
resilient 9, in spite of the fact that the crisis ultimately unfolded as a “run on repo” (Gorton and Metrick
2012).

One explanation for the resilience of repos is that their liquidity has been sustained by the “dealer of
last resort” intervention by the Fed and other monetary authorities following the onset of the crisis
(Mehrling 2010; Murau 2017). Another, complementary explanation, which is explored in the
remaining of the article, is that these instruments bear two exclusive attributes for making money in
a sustainable fashion: (a) they carry a highly responsive, in-built mechanism of pro-cyclical bank
leverage; (b) they offer negotiable security rooted in legal trust over tradable collateral, which makes
it easier for banks to operate on a ‘matched-book’ basis 10 and provide a stable interface between
capital and money markets (see section 3.2).

Following the crisis, repos have become the prevalent channel of what has been termed the “money
market funding of capital market lending” (Mehrling et al 2013; Pozsar 2014), preserving global
banks’ infrastructural capacity to waive the fabric of contemporary financial markets, by linking

9
The centrality of repos in today’s global finance is further corroborated by the fact that, following the crisis, there has
been a “shift from unsecured funding to secured funding; formerly the central rate for global dollar funding was LIBOR
in the Eurodollar market, but now increasingly it is the tri-party repo rate” (Mehrling 2017).
10
Briefly, the matching of books is the bank practice of equalising the maturities of bank assets (loans) and liabilities
(deposits).
16
money and capital markets. In the former, the preference for liquidity is largely motivated by what
Keynes (1936: 196-7, see also Fantacci 2010) termed ‘transactions’ and ‘precautionary’ motives; in
the latter, the demand for liquidity is driven by a ‘speculative’ motive, namely by the possibility for
levered-up investors to realise capital gains and high returns by affecting securities’ prices and
moving markets. By connecting these two markets, repos make it possible for global banks to
harmonise the diverging, often polar, interests of numerous parties populating the financial ecology
of “money manager capitalism” (Wray 2009; 2011).

On the basis of Pozsar (2014; 2015), global banks’ clients can be heuristically grouped in two main
categories of money managers: risk asset managers (risk AMs) and safe portfolio managers (safe
PMs) 11. The first group includes hedge funds and analogous levered-up funds in the asset
management industry (e.g. mutual funds, equity funds, vulture funds). Risk asset managers are active
investors: they are in the business to “beat the benchmark” (Pozsar 2014: 54) and generate high
returns for their customers and shareholders. To that purpose, they borrow money from banks to
invest in capital and derivatives markets. I will get back to risk AMs in section 3.2.

The second group of money-managers is formed by a constellation of retail and institutional investors
that are predominantly risk-averse: their primary goal is to meet liabilities and their mandate is ‘do
not lose’ (Pozsar 2014: 62). Retail and institutional investors are passive investors: they allocate their
surpluses to varieties of safe portfolio managers – pension funds, sovereign funds, corporate funds,
etc. – which often go by the name of ‘institutional cash pools’. Prominent among institutional cash
pools are ‘money market funds’ (MMFs), also called ‘money market mutual funds’ (MMMFs).
Typically, a MMF gathers funds from retail and/or institutional investors (including other funds) by
issuing Net Asset Value (NAV) shares, usually worth 1 unit of the currency in which they are
denominated (e.g. $1, £1). The NAV shares promise at par redemption on a daily basis. The MMF
will seek to keep the value of its shares constant – this is known in jargon as not ‘breaking the buck’
– by investing its shareholders’ funds in the wholesale money market, where it will mostly acquire
cash equivalents supplied by global banks.

Crucially, a MMFs is a trust scheme (Kim 2014): its portfolio managers are the trustees and agent
lenders, retaining legal ownership of the portfolio of cash equivalents purchased on the wholesale

11
Pozsar (2014) adopts slightly different nomenclatures: he distinguishes between ‘risk portfolio managers’ (risk PMs)
and ‘cash portfolio managers’ (cash PMs). However, he applies the same heuristic principle for separating them: the
former employ leverage and are risk-seekers; the latter avoid leverage and are risk-averse. Once again, this distinction is
heuristic, not analytical: in practice it is impossible to neatly separate money-managers that are completely risk averse
and employ no leverage at all from money-managers that on the contrary reach for high yields and gear their portfolios.
Many money managers are hybrid funds that seek both safety and risk in varying proportions. For a nuanced account of
the asset management complex, see Office of Financial Research (2013).
17
money market. Its retail and/or institutional investors are the beneficiaries of the trust, holding claims
to abstract pecuniary value in the form of NAV shares. What is more important, MMF investors are
also the tacit creditors of the global banks issuing cash equivalents. By storing their income by means
of what is in effect a two-tier, market-based savings system, investors are literally giving credit to
banks, de facto validating – giving value to – their money claims.

3.1. Validating money in the money market: repos and institutional cash pools

Although scholars might disagree as to whether cash equivalents are truly money or not, central
bankers, managers of foreign exchange reserves, corporate treasurers, and institutional investors
unequivocally refer to them as simply ‘cash’ (Ricks 2016: 4). For them, “money begins where M2
ends” (Pozsar 2014: 4). And indeed, according to Ricks (2016: 44) “calling the holders of these
instruments ‘investors’ is somewhat misleading. Holders of cash equivalents usually think of these
instruments, together with currency and checkable deposits, as precisely the resources they are not
investing (emphasis added)”. A number of reasons can be provided as to why safe PMs choose not to
store their liquid funds in conventional money forms (qua ordinary bank deposits): to name a few,
the possibility to earn interest on deposits and avoid taxation. However, the foremost rationale is the
lack of security that ordinary deposits provide: the size of institutional cash pools is simply too large
to be covered by deposit insurance, and it would be unthinkable to hold such large surpluses in a
narrower money form (Pozsar 2014; 2015).

And so, rather than investing (saving) their funds in the ‘core’ liabilities (deposits) issued via ordinary
banking, safe PMs choose to satisfy their liquidity preference by investing (saving) in the ‘non-core’
liabilities (deposits) issued via market-based banking, which offer both redemption at premium and,
we shall see, collateral security to make up for the lack of institutional insurance. Seen from a banking
perspective, banks are able to secure “funding liquidity” (Brunnermeier and Pedersen 2009) via the
wholesale money market, where they can obtain funds from safe PMs by issuing demand deposits
that are ‘as good as cash’ for transactional and precautionary motives. Generally known as ‘securities
financing transactions’, these instruments are equivalent to bank deposits (cf. Mitchell 2016: 19).
Crucially, safe PMs seek especially overnight T-repos because the latter provide the greatest
“proximity to the government” in terms of institutional insurance and guarantee of at-par redemption
(Pozsar 2014: 4, 25). In effect, of all cash equivalents, repos alone seem to bear the promise of

18
delivering a new monetary and financial infrastructure capable of enduring trust, security and
liquidity (cf. Gabor and Vestergaard 2016; Murau 2017).

Prima facie, repos appear as sale and repurchase contracts: in fact, they are collateralised loans (see
Gorton and Metrick 2012: 426; Kim 2014; Gabor and Vestergaard 2016: 11). More importantly, like
MMF shares, repos too articulate trust as a (collateral) double ownership scheme: when a bank issues
a repo deposit, it loses the legal ownership of the collateral in favour of the repo buyer (typically a
safe PM). The bank, however, remains the beneficiary owner of the collateral, meaning that it still
bears the risk and receives the return on the collateral (Gabor 2016: 971). The ownership of the
collateral is thus duplicated, giving rise to a complex legal-economic relationship: while the repo
buyer now owns the collateral ‘at law’, the bank owns it ‘in equity’ and therefore retains the equitable
claim over the quasi rent that it may or may not yield. The significance of the repo trust scheme lies
in its capacity to bring together the otherwise conflicting interests of creditors-buyers and debtors-
sellers on a crucial point: their reciprocal need to assess, preserve and sustain the value of collateral.
It is precisely around this ‘institutional need’ that a relationship of trust (in both sociological and legal
terms) is constructed between creditors and debtors and financial negotiations and struggles are
carried out on a daily basis.

The need of assessing and stabilising the value of repo collaterals practically translates into a number
of highly responsive mechanisms of collateral valuation for maintaining at par redemption of repo
deposits. These mechanisms involve: haircuts; mark-to-market valuation; margin calls (Gabor and
Ban 2016; Gabor 2016: 971). The haircut is a measure of the degree of over-collateralisation of a
repo: it stands in inverse proportion to the degree of confidence in the security of the collateral and
in direct proportion to the amount of capital that is required for a bank to set an effective margin of
safety for its repo sale. A zero haircut virtually means complete confidence in the collateral on the
repo-buyer side (the safe PM), and no capital buffer at all on the repo-seller side (the bank).
Significantly, before the crisis began to unfold in 2007, haircuts on collateral assets were
approximately zero: however, with the exception of overnight T-repos, they surged to reach nearly
50 percent at the peak of the crisis in 2008 (Gorton and Metrick 2012: 428).

The state of confidence in repo collateral is in turn assessed via mark-to-market valuation, an
accounting method for registering contingent variations in the market price of a firm’s assets. Because
of mark-to-market valuation, a fall in the market value of collateral before the repurchase day
translates into a margin call by the repo buyer: the latter can ask the repo seller to provide more
collateral to replenish the loss of value. Conversely, a rise in the market value of collateral makes it
possible for the repo seller to claim the capital gain. Needless to say, since it is so intimately linked

19
to the whims of financial markets, mark-to-market accounting magnifies volatility: a sudden fall in
the price of an asset (or class of assets) is immediately transmitted across the financial system, causing
a tidal readjustment/downsizing of balance sheets, whence a credit crunch or crash.

A case in point is the collapse of the market demand for CDOs. In August 2007 the demand for CDOs
abruptly fell when BNP Paribas announced that it could no longer assess the market value of the
CDOs held by three of its hedge funds (Lysandrou 2012: 243). At the time, CDOs were used both as
collaterals for repo deposits and as second-floor, backing materials for the provision of ABCP by
conduits (Lysandrou and Nesvetailova 2015). As confidence in the value of CDOs dropped, banks
stopped accepting them as collateral for repos and haircuts on existing CDO-based repos surged.
Hence repo buyers called margins, which put tremendous pressure on banks since they could not draw
on sufficient capital for margining purposes. The only other choice was to forego collaterals, which
was far from ideal. Indeed, failure to buy collaterals back triggered a ‘fire sale’: as panicking investors
started to sell collateral assets to regain the lost value of their repo deposits, the market value of
securities serving as repo collaterals dropped even further, alimenting a spiral of collateral asset-price
deflation: “lower prices, less collateral, more concerns about solvency, and ever increasing haircuts”
(Gorton and Metrick 2012: 428; see also Gorton and Ordoῆez 2014). This eventually created a general
distrust towards repo deposits’ ability to deliver at par value on demand, which ultimately resulted in
a run on repos. In short, failure to valuate collaterals for repos had quickly escalated to failure to
validate repos as money.

3.2. Making money in the capital market: reverse repos and the asset management complex

Repos can only tell half of the story of contemporary banking: “[f]or every repo, the other side of the
transaction is a reverse repo” (Gorton and Metrick 2012: 433). From a banking perspective, a repo
deposit in favour of a safe PM, e.g. a MMF, is normally matched by a reverse repo loan made to a
risk AM, e.g. a hedge fund (cf. Lysandrou 2012: 237; Adrian and Shin 2010: 428). In the former, the
bank sells collateral to the MMF (with the promise of repurchasing it) as a way to fund its liquidity;
in the latter, it buys collateral from the hedge fund through what is effectively a loan to the latter.
Significantly, the main difference between these two complementary instruments is one of maturity:
repo deposits are mainly overnight T-repos issued against general collateral (cf. Gabor and

20
Vestergaard 2016) and rolled over on a routine basis. By contrast, reverse repo loans are term repos
with longer maturity dates, issued against specific collateral and bearing a fixed interest rate.

Repos and reverse repos belong to two different markets. On the one hand, repo deposits are generally
issued via the tri-party repo market (cf. Gabor 2016) – a market that relies on the centralised clearing
function offered by custodian banks 12, and which since the crisis has become a prevalent site of data
collection and governance by regulators and policy-makers. On the other hand, reverse repo loans are
commonly issued in the bilateral repo market (cf. Adrian et al 2013) – an over-the-counter, upstairs
market where banks trade on their proprietary desks and deal directly with money-managers who can
get access to ‘lit’ or ‘dark’ pools of liquidity (Banks 2010; Hatch 2010; Mackenzie 2015; Garvey et
al 2016). Reverse repo loans supplied by global banks are relatively hidden from regulators (Bowman
et al 2017). As a result, while the literature on repos is flourishing, little data is available for reverse
repos (an exception is Baklanova et al 2017).

Reverse repo loans are a core source of leverage for the asset management complex. Risk AMs can
borrow from global banks mainly in three ways: a) via (reverse) repos, as they sell securities part of
their portfolio of assets with the promise to purchase them back at a later time; b) via securities
lending, as they lend securities; c) via margin loans, as they pledge securities as a capital buffer for
borrowing. In each of the above cases, risk AMs ought to commit securities as collateral to obtain the
liquidity that they will use to leverage their portfolios and ‘beat the benchmark’. With the borrowed
funds, risk AMs can pursue a variety of strategies in capital and derivatives markets. For example,
they can individually play against the market and go ‘long’ and/or ‘short’ on securities with the
purpose of arbitraging between price mismatches. Contrariwise, they can collectively play with the
market and drive asset-price bubbles (cf. Abreu and Brunnermeier 2002; 2003; Brunnermeier and
Nagel 2004; Knafo 2009; 2012; Griffin et al 2011), on the expectation that other ‘positive-feedback’
investors will manifest a ‘herding’ behaviour (Sias 2004; Choi and Sias 2009) and follow their lead
in the same inflated market. Finally, risk AMs can both profit from, and hedge, their bets via
derivatives margining (cf. Brunnermeier and Pedersen 2009: 2229-31; Ang et al 2011: 122;
Lysandrou 2012: 237; Pozsar 2014: 36).

It goes without saying, all these levered-up practices of money-making involve taking big risks with
potentially catastrophic consequences. Once again, the events leading to the collapse of the market

12
In the US tri-party repo market, the Bank of New York Mellon offers this clearing service. In Europe, the principal tri-
party agents are Clearstream Luxembourg, Euroclear, Bank of New York Mellon, JP Morgan and SIS
(https://www.icmagroup.org/index.php/Regulatory-Policy-and-Market-Practice/repo-and-collateral-markets/icma-ercc-
publications/frequently-asked-questions-on-repo/24-what-is-tri-party-repo/).
21
for CDOs in 2007 provide an exemplary case. According to Lysandrou (2012: 231), “[t]he rapid
growth in CDOs from 2002 onwards bears a close correlation with the growth of hedge funds assets”.
Although figures for CDO holdings for this period vary 13, there is no doubt about the fact that hedge
funds were actively involved in the market for CDOs. The latter promised high yields and for this
reason were considered very attractive. More importantly, CDOs could be used as collateral to obtain
(reverse repo) loans to purchase more CDOs! This created a self-reinforcing pattern of leverage-
driven, asset-price inflation. According to Lysandrou (2012: 237), hedge funds were able to leverage
their portfolios of CDOs by a fourfold magnitude. Ang et al (2011) offer a more detailed, yet
analogous estimate of hedge funds’ leverage between 2005 and 2010: while some funds enjoyed
leverage ratios well above 30, the average leverage ratio for hedge funds was 4.8 (with the exception
of the less levered-up equity funds).

Significantly, hedge funds started to ‘deleverage’ in a counter-cyclical fashion, therefore increasing

their cash holdings, “prior to the start of the financial crisis in mid-2007” (Ang et al 2011: 121; see
also Liu and Mello 2011). What happened was simple: after riding the CDOs bubble with the help of
investment banks, hedge funds ‘beat the gun’ and exited the market by promptly reducing their debt
exposure in a collective selling effort. It is worth noting in this connection that the CDO market
qualitatively changed starting from mid-June 2006 with the introduction of standardised forms of
Credit Default Swap (CDS) that boosted the growth of synthetic CDOs. The latter made it possible
for hedge funds to bet against the market and offset their ‘long’ positions in CDOs. As Mählmann
(2013: 537) put it, “[t]hat way, they could make some money as long as the CDOs performed, but
they stood to make more money as the entire market crashed”.

Hedge funds were not loose cannons acting unpredictably and out of control. On the contrary, they
were a “war machine” (Erturk et al 2010) oiled by banks. Indeed, far from resembling an impersonal
market made of ‘arm’s-length’ transactions, the market for CDOs grew between 2002 and 2007 as a
“dense network of personal relations between pairs of agents at the very centre of which was the
relation between the hedge funds and the investment banks” (Lysandrou 2012: 241). In some

13
According to Lysandrou (2012: 233), by the end of 2006, hedge funds “held a little over 1 percent of the world’s total
stock of securities” and “nearly 50 percent of the total stock of CDOs”. A different, though compatible, estimate is offered
by the Financial Crisis Inquiry Commission (FCIC 2011: 192). Upon surveying more than 170 hedge funds, its analysts
found that “of all the CDOs issued in the second half of 2006, more than half of the equity tranches were purchased by
hedge funds that also shorted other tranches”. By contrast, figures provided by the IMF director John Lipsky in July 2007
suggest that hedge funds held only 10 percent of the equity tranches in the CDO market (Dixon et al 2012: 45).
Conservative figures, however, are likely to underplay the hedge funds’ capacity to inflate the CDO market by leveraging
their position. “It is worth noting that a relatively small amount of hedge fund capital can enable a large amount of CDOs
to be issued” and “$1 million in hedge fund capital could support up to $50 million of CDOs” (Dixon et al 2012: 46).

22
instances, this special relationship was “cemented by the fact that investment banks owned the hedge
funds they were dealing with” (Lysandrou 2012: 241). In effect, in the same way as MMFs have been
functioning as the transmission chain in the two-tiered, market-based savings system, so hedge funds
have come to serve as the outer, over-the-counter platform of a two-tiered, market-based investment
system promoted by banks themselves: a network of ‘funds of funds’ of which banks are the limited
or general partners, seeking to protect the interests of their clients as well as to continue their
proprietary trading by other means.

We can envisage two main reasons why global banks supported hedge funds in inflating the capital
market for CDOs. A first, system-wide reason is that the latter provided a key “second-floor” security
for the production of ABCP (Lysandrou and Nesvetailova 2015) – a primary source of funding
liquidity for the securitisation industry at large prior to the crisis (cf. Lysandrou 2012). A second,
agency-centred reason is that the debt financing of the market for CDOs entailed increasing leverage
for banks: a power that the latter thought they could harness through the “screening mechanism” (cf.
Baklanova et al 2017: 4) offered by collateral. Significantly, both reasons converge on a crucial point:
making the market for CDOs was essential to producing the highly tradable collateral that banks so
eagerly “sourced” (Claessens et al 2012: 15) in order to satisfy the liquidity preference of institutional
cash pools (which could not be met by the supply of T-repos alone). In one word, it was instrumental
in making the market for cash equivalents at large.

In this respect, it is worth stressing one more time the superior efficiency and resilience of repos,
relative to other monies, for the overall performance of banks. According to Pozsar (2014: 9; 55),
about 80 percent of repo and reverse repo transactions are carried on a ‘matched books’ basis. That
is to say, a broker-dealer bank that buys a CDO from a hedge fund in a reverse repo loan can match
the loan by re-hypothecating the CDO in a repo deposit to a MMF (cf. Claessens et al 2012: 15;
Mehrling et al 2013; Park and Kahn 2017). Crucially, if the price of the CDO goes up, as was the
case between 2002 and 2007, all parties are satisfied. The MMF can deliver redemption of its NAV
shares at par, and the hedge fund can claim the capital gain on the repo collateral that is now legally
owned by the MMF. The capital gain thus serves to repay the hedge funds’ loan to the bank. Like
oxygen, it frees balance sheet capacity for the bank, which can now make yet another reverse repo
loan to meet the bullish demand of risk AMs and increase the breadth of its assets and liabilities.

Besides harmonising the complementary goals of risk AMs and safe PMs (Pozsar 2014: 54), the re-
hypothecation of collateral via repo transactions provides an elastic, in-built mechanism for pro-
cyclical bank leverage (see also Fuhrer et al 2016: 1171) and allows a broker-dealer bank “to operate
with a smaller stock of its own securities and thus reduce balance sheet costs (e.g. capital costs)”

23
(Financial Stability Board 2017: 4). What is more important, it also facilitates the matching of assets
(bank loans) and liabilities (bank deposits), thus providing a dynamic hedge and an active liability
management strategy to counteract the shortcomings inherent to bank leverage and asset
management. The problem is: books are never fully matched. As a matter of fact, banks routinely
make loans that are not immediately matched by deposits – that is, they generate market liquidity that
is not funded. Pozsar (2014: 55; 2015: 8) hypothesises that 20 percent of global bank activities occur
on a ‘speculative books’ basis. More recently, in their pilot study of the use of collateral in bilateral
repos, Baklanova et al (2017: 8) have found that “[o]ver three days, securities dealers lent, on average,
$1.6 trillion and borrowed, on average, $1 trillion”, which altogether suggests that nearly 40 percent
of loans might involve taking net inventory positions that are not immediately matched.

The bank problem of matching the books is the problem of making money via capital market lending
and having it validated via money market funding – that is, the quintessential problem of creating
money and having it accepted in the age of market-based banking. Following the establishment in
2008 of the Term Securities Lending Facility (TSLF) and the Primary Dealer Lending Facility
(TSLF), the daily shortfall generated by global banks’ loans can be readily shifted onto the balance
sheet of the Fed, which has de facto taken “the lending side in tri-party repo transactions” (Murau
2017: 18) – that is, the side of institutional investors/savers. At last, the Fed recognises the
infrastructural power of global banks as money-makers and, in its new vest, it acts as their creditor of
last resort – literally saving the day by serving as a substitute for institutional cash pools whenever
collateral assets fail to meet the latter’s appetite for safety. With its new repo-based credit facilities
and open market operations, the Fed is feeding repo markets and ultimately relaxing the survival
constraint for global banks, “pushing the day of reckoning off into the future” (Mehrling 2010: 4):
banks rest reassured about their ability to make money today and pay, maybe, tomorrow. Chi vuol
esser lieto, sia: di doman non v'è certezza.

4. CONCLUSION

Banking is a complex game of money-making in which banks are not simply playing the odds, like
all other participants, but are also dealing the cards. And so, while other players are more or less free
to exit the game (depending on whether they are outright debtors who ought to ‘borrow to pay’ or
24
active speculators who wish to ‘borrow to invest’), banks must see the whole game through – a game
that has no end other than making money. To that end, banks are impelled to come up with financial
innovations that, besides enhancing their leverage, propel an ever growing marketization of other
people’s debts. This says something about the significance of banking. As an industry that is geared
towards producing debts as commodities, the function of banking is not really to provide a
decentralised payment system (cf. Mehrling 2010), although its operations do enhance the
transferability of money claims. In fact, the point can be made that since banking involves dealing
other people’s debts then, logically, it cannot truly fulfil the function of extinguishing economic
obligations at a societal level. On the contrary, banking makes it possible for debts to be carried over
in the future, to be financed and refinanced in a more or less sustainable fashion through financial
markets. Bank leverage is therefore the art of making money in this ‘in-between’ dimension of finance
where the accounts between creditors and debtors are left opened, un-cleared for the time being.

Crucially, rethinking banking as leverage requires that we drop once and for all the notion of banking
as intermediation. The idea that banks borrow at a lower rate to then lend at a higher rate is a gross
mystification: regardless of whether one is looking at commercial, retail or investment banking, one
is always in principle witnessing a form of bank leverage that is executed without mobilising prior
savings.Besides repudiating the notion of banking as intermediation, this study also challenges a
generalised consensus in IPE and cognate social sciences which analytically sets banks and financial
markets apart. Although the relationship between banks and financial markets is no longer framed as
a zero-sum game, banks are still understood as market participants subject to pressures coming from
market forces. In contrast to this dualistic modelling, this study contends that global banks are more
than participants: they are the very makers of financial markets, holding their reins via a two-tier
investment and savings system that brings together all sorts of money managers. Drawing a line
between (market-based) banks and (bank-based) markets is not really possible since banks are in
principle merchants of debt. Their business implies no less than making markets for securities: an
activity whose ultimate aim is to promote and sustain a market for their own monies.

In this connection, the analysis of repos and reverse repos as market-based instances of respectively
deposit-taking and loan-making activities shows how bank leverage is part and parcel of a process of
money-making that runs from loans to deposits, in line with heterodox theories. Generating deposits,
however, is not as easy as pressing a key on a keyboard. For safe PMs to be able to ‘save’ and validate
their surpluses as ‘money’, a whole money-making industry ought to be in place which thrives upon
speculation, namely the leveraging of positions in financial markets. In particular, global banks and
the levered-up asset management complex need ab origine each other’s investment in the capital
market to transform the raw materials of private, corporate and public debt into money artefacts (debt
25
instruments that are equivalent to cash for practical purposes). Ultimately, it is in the fire of the capital
market, where debts are sourced, liquefied and channelled towards the money market, that the price
(and collateral security) of cash equivalents is forged. Repos, in particular, have proven to be a
resilient vessel of liquidity, thanks to their in-built mechanisms for enabling highly responsive bank
leverage and matched books.

Finally, this study points to a crucial element of the current financial regime that deserves more
attention: namely the perverse phenomenon whereby holders of monetary savings – ordinary bank
accountholders as well as retail and institutional investors in money markets who altogether act as
tacit creditors of global finance – can only retain their purchasing power as long as banks sustain their
leverage to ensure the unceasing debt financing of both active speculators (risk asset managers) and
outright debtors (households, small- to medium-size firms and governments). That is, under current
conditions, for money to exist and preserve its stable value, the smaller borrowers ought to keep
borrowing and paying their dues for the time being, not to creditors, but to the greater borrowers
leveraging their positions in financial markets. The latter are the “new aristocracy of finance” (Hager
2015) composed of global banks and associated professional speculators (and those behind them who
are amassing unspeakable financial wealth). And yet, unlike what many are inclined to think (e.g.
Hudson 2015), banks stand in principle as neither parasitical nor predatory agents. While banking
might result in blatant predation, the survival of banks as a system largely depends on their mutualism,
namely on their ability to establish relationships of mutual dependence among debtors, as well as on
their unique capacity to build trust and harmonise the diverging interests of those debtors and creditors
which are nevertheless invested in the same game of money-making. Tautologically, as long as banks
will enable this game by making markets for other people’s debts, their money claims will be
validated and come true.

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