There are already more books about the credit crunch than solvent banks.  These volumes range from racy descriptions of how bond salesmen plied their trade in German brothels to clunking accounts of the intricacies of risk management models and debt-based securities.  This book is definitely at the heavy end of the spectrum, as its publication by Cambridge University Press, and the credentials of the author, suggest.  Milne is an economist who has worked on the supervision of financial institutions at the Treasury and Bank of England and is now Reader in Banking and Finance at the Cass Business School.

       If you want a serious, clear and authoritative guide to the crisis, this book is as good as it gets.  Milne writes extremely well, both in his prose style and his clarity of exposition of complex issues.  Unlike many of its competitors, this book does not show signs of the speed with which it has been written.  The author not only knows his CDO from his ABS but can ensure that you will too.  He moves comfortably between macroeconomic issues of global imbalance and microeconomic issues of securitisation, regulation and risk management within the financial system.

       Milne sets out what he describes as two broad explanations of the crisis.  The first, the mainstream view, begins from the macroeconomics.  Asia ran – and runs – a massive trade surplus, matched by corresponding deficits in the West, primarily in Britain and the United States.  Trade surpluses were necessarily matched by capital inflows into the debtor countries.  These inflows have not only financed excessive consumption but fuelled asset price bubbles, especially in the housing market.  The bubbles then burst, as bubbles do, and the banks who acted as intermediaries in the process were left with large losses from excessively risky lending.  The banks responded by indiscriminate withdrawal from both good and bad lending and plunged not only debtor but creditor countries into recession.

       Milne prefers an alternative explanation, which focuses on the microeconomics.  What happened in banks, rather than outside them, is key.  Milne’s thesis focuses on the creation of tranched mortgage-backed securities.  If you are about to turn over to the glossier pages of this magazine on reading that, bear with me, and him, for a moment. The completely understandable desire not to get involved in the intricacies of what has been going on in wholesale money markets has cost taxpayers billions of dollars and created the worst depression for a generation.

       Tranching is the process by which business risk is divided into more and less safe components, with compensating differences in expected return.  The idea is as old as the business loan.  And you can never have too much of a good thing, and especially the fees generated.  In Milne’s illustrative example of an MBS, a single pool of mortgages was divided into no less than twelve tranches of escalating riskiness.  Banks engaged, on a massive scale, a trade in which they funded senior tranches of securitised products with short term borrowings, benefiting from an interest margin which they believed were low risk products.  When confidence in the value of securitised products evaporated after the sub-prime mortgage crisis, banks couldn’t refinance their borrowings, and the system imploded.

       The alternative explanations translate into alternative policy prescriptions.  For those who emphasise the macroeconomics, the remedies are also macroeconomic.  Address the risky lending, and its consequences for both over-indebted households and over-lent banks.  For those who emphasise the microeconomics, the remedies are principally microeconomic.  Milne stresses the important point that much of the difficult banks encounter lies not with toxic assets – the riskiest layer of securitised products – but with slightly tainted ones –senior tranches of securitised products, which they hold in large quantities.  The fundamental problem, he believes, is not that such assets are impaired but that panicky investors no longer trust them.   He advocates large scale insurance by government of senior asset tranches.  Then the banks will start lending again.

       I’m not sure that the explanations and options are as distinct as Milne seems to suggest.  Unsustainable macroeconomic imbalances made unpleasant global adjustments inevitable, while the microeconomic foolishness of banks made a financial crisis inevitable.  In 2007-8, microeconomic and macroeconomic weaknesses coincided, and created that perfect storm.  And are more senior tranches of asset backed securities basically sound, but seriously undervalued?  I don’t know, and nor does Milne, and nor, really, does anyone else – which is why the market in them is so thin.

       Like so many people, Milne wants to believe that matters are fundamentally ok because, like many people, he desperately wants to keep the show on the road.  But, as MT readers know well, the general rule of the market economy is that failed firms with failed business models.  Ask Woolworth, or Swissair, or Enron.  That process of failure and rebirth is what gives a market economy its dynamism, and promotes the kinds of innovation that offer consumers new products and services.  The major banks in Britain today were the major banks in Britain at the end of the nineteenth century.  There is no other industry which shows that stability.  We gave banks a deal in which relative freedom from product market competition was tolerated in return for economic stability.  The banks reneged on that deal, and we should tell them it is off.  We should break up banks and establish smaller institutions in a more competitive market.