Tag: financial system

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Commercial banking: the emerging risks from the shadow-banking sector

Recently, a flurry of bankruptcies among non-bank financial intermediaries (NBFIs) in the USA has drawn attention to the risks associated with alternative credit channels in the shadow-banking sector – lending which is not financed with deposits. There is concern that this could be the start of a wave of bankruptcies among such NBFIs, especially given concerns about a potential downswing in the economic cycle – a time when defaults are more likely.

While providing alternative sources of funding, the opacity of lending in the shadow-banking sector means it is not clear what risks NBFIs face themselves and, more significantly, what risks they pose to the financial system as a whole. There is particular concern about the impact on regulated banks.

Already, JP Morgan Chase in its third quarter earnings report announced a $170m charge stemming from the bankruptcy of Tricolor, which specialised in sub-prime car financing. Mid-sized banks, Western Alliance and Zions Bancorp, have reported losses from loans to a group of distressed real estate funds. This has highlighted the interconnectedness between NBFIs and regulated banking, and the potential for problems in the shadow-banking sector to have a direct impact on mainstream banks.

In this blog, we will trace the secular trends in the financial systems of more advanced economies which have given rise to alternative credit channels and, in turn, to potential banking crises. We will explain the relationship between regulated banks and shadow banks, analysing the risks involved, the potential impact on the financial system and the policy implications.

What are the secular trends in banking?

The traditional model of commercial banking involved taking deposits and using them to finance loans to households and firms. However, cycles of banking crises, regulatory changes and financial innovation over the past 50 years produced new models.

First, banks diversified away from direct lending to providing other banking services – on-balance sheet activities, such as investing in financial securities, and off-balance sheet activities, such as acting as agents in the sale of financial securities.

Second, alternative credit channels based on financial markets have grown in significance.

In the 1980s, international regulations around traditional banking activities – taking deposits and making loans – were being formalised by the Bank for International Settlements (BIS) under what became known as the Basel framework (see, for example, Economics section 18.2 or Economics for Business section 28.2). For the first time, this stipulated liquidity and capital requirements for international banks relating to their traditional lending activities. However, at the same time the deregulation of financial markets and financial innovation provided banks with opportunities to derive revenues from a range of other financial services.

After the financial crisis, liquidity and capital requirements for banks were tightened further through the Basel III regulations. Commercial banks had to have even higher levels of capital as a buffer for bad debts associated with direct lending. A higher level of capital to cover potential losses increases the marginal cost of lending, since each pound of additional loan requires additional capital. This reduced the marginal return, and consequently, the incentive to lend directly.

These regulatory developments created an incentive to pursue activities which do not require as much capital, since their marginal cost is lower and potential return is higher. Consequently, banks have placed less emphasis on lending and more on purchasing short-term and long-term financial securities and generating non-interest income from off-balance sheet activities. For instance, research by the Bank of England found that during the 1980s, interest income accounted for more than two-thirds of total income for large international banks. In contemporary times, non-interest income tends to be greater than interest income. Figure 1 illustrates the declining proportion of total assets represented by commercial and consumer loans for all regulated US banks. (Click here for a PowerPoint.)

With banks originating less lending, activity has migrated to different avenues in the shadow-banking sector. This sector has always existed, but deregulation and financial innovation created opportunities for the growth of shadow banking – lending which is not financed with deposits. Traditionally, non-bank financial intermediaries (NBFIs), such as pension funds, hedge funds and insurance companies, use funds from investors to buy securities through financial markets. However, new types of NBFIs have emerged which originate loans themselves, notably private credit institutions. As Figure 2 illustrates, a lot of the expansion in the activities of NBFIs has been the due to increased lending by these institutions (defined as ‘other financial institutions (OFIs)). Note that the NBFI line includes OFIs. (Click here for a PowerPoint.)

Since, NBFIs operate outside conventional regulatory frameworks, their credit intermediation and maturity transformation are not subject to the same capital requirements or oversight that banks are. As a result, they do not need to have the same level of capital to insulate against loan losses. Therefore, lending in the shadow-banking sector has a lower marginal cost compared to equivalent lending in the banking sector. Consequently, it generates a higher rate of return. This can explain the large growth in the assets of OFIs illustrated in Figure 2.

Risks in shadow banking

Banking involves trade-offs and this is the case whether the activities happen in the regulated or shadow-banking sector. Increasing lending increases profitability. But as lending continues to increase, at some point the risk-return profile becomes less favourable since institutions are lending to increasingly higher-risk borrowers and for higher-risk projects.

In downturns, when rates of defaults rise, such risks become apparent. Borrowers fail and default, causing significant loan losses for lenders. With lower levels of capital, NBFIs will have a lower buffer to insulate investors from these losses, increasing the likelihood of default.

Is this a problem? Well, for a long-time regulators thought not. It was thought that failures in the shadow-banking sector would have no implications for deposit-holders in regulated banks and the payments mechanism. Unfortunately, current developments in the USA have highlighted that this is unlikely to be the case.

The connections between regulated and shadow banking

The financial system is highly interconnected, and each successive financial crisis has shown that systemic risks lurk in obscure places. On the face of it, NBFIs appear separate from regulated banks. But banks’ new business models have not removed them from the lending channel, merely changed their role. Short-term financing used to be conducted and funded by banks. Now, it is conducted by NBFIs, but still financed by banks. Long-term loan financing is no longer on banks’ balance sheets. However, while the lending is conducted by NBFIs, it is largely funded by banks.

NBFIs cannot be repositories of liquidity. Since they do not have deposits and are not part of the payments system, they have no access to official liquidity backstops. So, they do so indirectly by using deposit-taking banks as liquidity insurance. Banks provide this liquidity in a variety of ways:

  • Investing in the securities issued by private capital funds;
  • Providing bridge financing to credit managers to securitise credit card receivables;
  • Providing prime broker financing to a hedge fund engaged in proprietary trading.

Furthermore, banks have increasingly made loans to NBFIs. Data for US commercial banks lending to the shadow-banking sector are publicly available only since 2015. But, as Figure 3 illustrates, it has seen a steady upward trend with a surge in activity in 2025. (Click here for a PowerPoint.)

Banks had an incentive to diversify into these activities since they are a source of revenue requiring less regulatory capital. The model requires risk and return to follow capital out of the banking system into the shadow-banking sector. However, while risky capital and its associated expected return have moved in the shadow-banking system, not all of the liquidity and credit default risk may have done so. Ultimately, some of that risk may be borne by the deposit-holders of the banks.

This is not an issue if banks are fully aware of the risks. However, problems arise when banks do not know the full risks they are taking.

There are reasons why this may be the case. Credit markets involve significant asymmetric information between lenders and borrowers. This creates conditions for the classic problems of moral hazard and adverse selection.

Moral hazard is a hidden action problem, whereby borrowers take greater risks because they share the possible downside losses with the lender. Adverse selection is the hidden information problem, whereby lenders do not have full information about the riskiness of borrowers or their activities.

The economics of information suggests that banks exploit scale, scope and learning economies to overcome the costs associated with asymmetric information in lending. However, that applies to direct lending when banks have full information about credit default risk on their loan book. When banks finance lending indirectly through NBFIs, there is an extension of the intermediation chain, and while banks may know the NBFIs, they will have much less information about the risks associated with the lending they are ‘underwriting’. This heightens their problems of asymmetric information associated with credit default risk.

What are the risks at present?

The level of debt in the global economy is at unprecedented levels. Data from the International Monetary Fund (IMF) show that it rose to $351 trillion dollars in 2024, approximately 235% of weighted global gross domestic product (GDP). It is in this environment that private credit channels through NBFIs have been expanding. With this, it is more likely that NBFIs’ trade-off between credit risk and return has tilted greatly in favour of the former. Some point to the recent collapse of Tricolor and First Brands – both intermediary financing companies funded by private credit – as evidence of elevated levels of risk.

Many are pointing out that the failures observed in the USA so far have a whiff of fraud associated with them, with suggestions of multiple loans being secured against the same working capital. However, such behaviour is symptomatic of ‘late-cycle’ lending, where the incentive to squeeze more profit from lending in a more competitive environment leads to short-cuts – short-cuts that banks, at one stage removed along the intermediation chain, will have less information about.

It is in a downturn that such risks become apparent. Widening credit spreads and the reduced availability of credit causes financial stress for higher-risk borrowers. Inevitably, that higher risk will lead to higher defaults, more provision for loan losses and write-downs in the value of loan assets.

While investors in NBFIs are first in line to bear the losses, they are not the only ones exposed. At moments of stress, the credit lines that banks have provided get drawn and that increases the exposure of banks to the risks associated with NBFIs and whoever they have lent to. As NBFIs fail, the financing provided by banks will not be repaid and they will thus have to absorb losses associated with the lending of the NBFIs. So, while it appears that risk has left the banking system, it hasn’t. Ultimately, the liquidity and credit default risk of the non-bank sector is financed by bank deposits.

Furthermore, the opaqueness of the exposure of banks to risks in the shadow-banking sector may have issues for the wider financial system. In 2008, banks became wary of lending to each other during the financial crisis because they didn’t know the exposure of counterparty institutions to losses from securitised debt instruments. Now, as more and more banks reveal exposures to NBFIs, concerns about the unknown position of other banks may produce a repeat of the credit crunch which occurred then. A seizing up of credit markets will worsen any downturn. However, unlike 2008, the financial resources available to central banks and governments to deal with any consequences are severely limited.

Only time and the path of the US economy will reveal the extent of any contagion related to lending in the shadow-banking sector. However, central banks are already worried about the risks associated with the shadow-banking sector and have been taking steps to identify and ameliorate them. Events in the USA over the past few weeks may accelerate the process and bring more of that lending within the regulatory cordon.

Articles

Academic paper

Data

Questions

  1. Explain why the need to hold more capital raises its cost for banks.
  2. Why does this reduce the lending they undertake?
  3. What is the attraction of ‘off-balance sheet transactions’ for regulated banks?
  4. Analyse the asymmetric information that banks face when providing liquidity to non-bank financial institutions (NBFIs).
  5. Examine the dangers for the financial system associated with regulated banks’ exposure to NBFIs?
  6. Discuss some policy recommendations regarding bank lending to NBFIs.
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Financialisation: Banks and the economy after the crisis

In the blogs The capital adequacy of UK banks and A co-operative or a plc? we focus on how British banks continue to look to repair their balance sheets. To do so, banks need to ‘re-balance’ their balance sheets. This may involve them holding more reserves and equity capital and/or a less risky and more liquid profile of assets. The objective is to make banks more resilient to shocks and less susceptible to financial distress.

This will take time and even then the behaviour of banks ought to look like quite different from that before the financial crisis. All of this means that we will need to learn to live with new banking norms which could have fundamental consequences for economic behaviour and activity.

The increasing importance of financial institutions to economic activity is known as financialisation. It is not perhaps the nicest word, but, in one way or another, we all experience it. I am writing this blog in a coffee shop in Leicester having paid for my coffee and croissant by a debit card. I take it for granted that I can use electronic money in this way. Later I am going shopping and I will perhaps use my credit card. I take this short term credit for granted too. On walking down from Leicester railway station to the coffee shop I walked past several estate agents advertising properties for sale. The potential buyers are likely to need a mortgage. In town, there are several construction sites as Leicester’s regeneration continues. These projects need financing and such projects often depend on loans secured from financial institutions.

We should not perhaps expect economic relationships to look as they did before the financial crisis. The chart shows how levels of net lending by financial institutions to households have dramatically fallen since the financial crisis. (Click here for PowerPoint of chart.)

Net lending measures the amount of lending by financial institutions after deducting repayments. These dramatically smaller flows of credit do matter for the economy and they do affect important macroeconomic relationships.

Consider the consumption function. The consumption function is a model of the determinants of consumer spending. It is conventional wisdom that if we measure the growth of consumer spending over any reasonably long period of time it will basically reflect the growth in disposable income. This is less true in the short run and this is largely because of the financial system. We use the financial system to borrow and to save. It allow us to smooth our consumption profile making spending rather less variable. We can save during periods when income growth is strong and borrow when income growth is weak or income levels are actually falling. All of this means that in the short term consumption is less sensitive to changes in disposable income that it would otherwise be.

The financial crisis means new norms for the banking system and, hence, for the economy. One manifestation of this is that credit is much harder to come by. In terms of our consumption function this might mean consumption being more sensitive to income changes that it would otherwise be. In other words, consumption is potentially more volatile as a result of the financial crisis. But, the point is more general. All spending activity, whether by households or firms, is likely to be more sensitive to economic and financial conditions than before. For example, firms’ capital spending will be more sensitive to their current financial health and crucially to their flows of profits.

We can expect particular markets and sectors to be especially affected by new financial norms. An obvious example is the housing market which is very closely tied to the mortgage market. But, any market or sector that traditionally is dependent on financial institutions for finance will be affected. This may include, for example, small and medium-sized enterprises or perhaps organsiations that invest heavily in R&D. It is my view that economists are still struggling to understand what the financial crisis means for the economy, for particular sectors of the economy and for the determination of key economic relationships, such as consumer spending and capital spending. What is for sure, is that these are incredibly exciting times to study economics and to be an economist.

Data

Statistical Interactive Database Bank of England

Articles

Cut in net lending to non-financial firms raises credit worries Herald Scotland, Mark Williamson (25/5/13)
Loans to business continue to shrink despite Funding for Lending Scheme Wales Online, Chris Kelsey (3/6/13)
Factbox – Capital shortfalls for five UK banks, mutuals Standard Chartered News (20/6/13)
UK banks ordered to plug £27.1bn capital shortfall The Guardian, Jill Treanor (20/6/13)
Barclays, Co-op, Nationwide, RBS and Lloyds responsible for higher-than-expected capital shortfall of £27.1bn The Telegraph, Harry Wilson (20/6/13)
UK banks need to plug £27bn capital hole, says PRA BBC News (20/6/13)
Barclays and Nationwide forced to strengthen BBC News, Robert Peston (20/6/13)
Five Banks Must Raise $21 Billion in Fresh Capital: BOE Bloomberg, Ben Moshinsky (20/6/13)
Co-operative Bank to list on stock market in rescue deal The Guardian, Jill Treanor (17/6/13)
Troubled Co-operative Bank unveils rescue plan to plug £1.5bn hole in balance sheet Independent, Nick Goodway (17/6/13)
Co-op Bank announces plan to plug £1.5bn hole Which?(17/6/13)
The Co-operative Bank and the challenge of finding co-op capital The Guardian, Andrew Bibby (13/6/13)
Co-op Bank seeks to fill £1.5bn capital hole Sky News (17/6/13)
Central banks told to head for exit Financial Times, Claire Jones (23/6/13)
Stimulating growth threatens stability, central banks warn The Guardian (23/6/13)

BIS Press Release and Report
Making the most of borrowed time: repair and reform the only way to growth, says BIS in 83rd Annual Report BIS Press Release (23/6/13)
83rd BIS Annual Report 2012/2013 Bank for International Settlements (23/6/13)

Questions

  1. What is meant by equity capital?
  2. How can banks increase the liquidity of their assets?
  3. Explain how Basel III is intended to increase the financial resilence of banks.
  4. What do you understand by the term ‘financialisation’? Use examples to illustrate this concept.
  5. How might we expect the financial crisis to affect the detemination of spending by economic agents?
  6. Using an appropriate diagram, explain how a reduction in capital spending could affect economic activity? Would this be just a short-term effect?
  7. What does it mean if we describe households as consumption-smoothers? How can households smooth their spending?
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Making sense of Basel

Big challenges face the global community in making its financial institutions more resilient to withstand the difficulties that arise from the macroeconomic environment and, at the same time, better aligning their private interests with those of wider society.

This is no easy task. It is not easy either to keep tabs on the international responses to try and deliver these aims.

This is no better illustrated by some of the recent changes to the capital requirements of financial institutions outlined by the Basel Committee on Banking Supervisions. (Click here for a PowerPoint of the above chart.) The so-called Basel III framework will, in effect, increase the capital that banks are required to hold and, in particular, specific types of capital. In the process this will reduce gearing, i.e. the amount of assets relative to capital. Recent announcements have detailed how large global banks will have to hold even more capital. This blog tries to make sense some of the changes afoot. Further reading is identified below.

The details of the Basel III framework are complex, there are an enormous amounts of financial acronyms to sift through and the definitions of capital change from time. But, at the heart of the proposals is the aim of increasing the resilience of our financial institutions. To do this the proposals focus predominantly on the liability side of a bank’s balance sheet. More specifically, they focus on long-term liabilities which help banks to resource their assets, i.e. to fund their provision of credit (their assets). This capital is ranked by its quality or by tiers; this terminology has recently changed.

Tier 1 capital is now split into two groups: Common Equity Capital (CET1) and Additional Tier 1 (AT1). The former – the ‘best’ capital – is made up of common equity (ordinary share capital) and retained profits. Holders of common equity can expect to receive dividend payments, but these are discretionary, largely dependent on the financial well-being of the firm. The remainder of CET1 are the retained profits of the firms and, hence, that parts of profits which are not distributed to its shareholders (owners). Additional Tier 1 capital – ‘second best’ capital – comprises preference shares and perpetual subordinated debt. Preference shares are more akin to bonds and provide regular coupons. However, their payment continue to place a burden on firms during more difficult financial times. Subordinated debt is debt where the creditors would not have any financial redress before depositors and other creditors have been attended to. Perpetual subordinated debt (bonds) is debt with no maturity date. Finally, Tier 2 capital is subordinated debt where the time to maturity is greater than five years.

The Basel III framework outlines a series of ratios known as Capital Adequacy Ratios (CARs) that financial institutions should meet. The ratios define a type of capital (numerator) relative to risk-weighted assets (denominator). The denominator involves weighting a bank’s category of assets by internationally agreed risk factors. These range from zero for government debt instruments to 1.5 for certain types of loans to companies. In other words, the more risky a given level of assets are the greater is the denominator and the lower is the financial institution’s capital adequacy.

From January 2013, the so-called ‘hard core minimum’ of Basel III, which is a combined level of Tier 1 and Tier 2 capital, will need to be the equivalent to 8 per cent of the bank’s risk-weighted assets. This is actually unchanged from Basel II. But, it is not quite as simple as this. First, the composition of capital matters. The overall 8 per cent ratio must be meet by a Common Equity Capital (CET1) ratio, including retained reserves, of no less than 4.5 per cent (previously 2 per cent). Second, there is the phasing-in between 2016 and 2019 of additional Common Equity Capital (CET1) equivalent to 2.5 per cent of risk-weighted assets. This is known as the Capital Conservation Buffer. Third, depending on the assessment of national regulators/supervisors, like the Bank of England here in the UK, financial institutions generally could be required to hold further Common Equity Capital of between 0 per cent and 2.5 per cent of risk weighted assets. This is known as a Counter-Cyclical Buffer. So, for instance, if the regulators/supervisors become unduly worried by rates of credit growth, they can impose additional capital requirements. This is an example of macroeconomic prudential regulation because it focuses on the financial system rather any one single financial institution.

In September 2011, Basel III added a fourth qualification to the ‘hard core’. This too will be phased-in from 2016. It is to be applied to those financial institutions, which through a series of indicators, such as size, are to be identified as global systemically important financial institutions (G-SIFIs). Depending on their global systemic importance the amount of CET1 relative to risk weighted assets could increase by between a further 1 to 2.5 per cent (and even by as much as 3.5 per cent, if necessary). These four qualifications could take the overall capital adequacy ratio from 8 per cent to as much as 15.5 per cent: 8 per cent plus 2.5 per cent capital conservation buffer plus 2.5 per cent for G-SIB surcharge plus 2.5 per cent for counter-cyclical buffer.

However, capital requirements may be even more stringent in the UK for retail banks. The UK’s Independent Commission on Banking has proposed that retail banks in the UK become legally, economically and operationally independent of the investment part of banks. In other words, that part of the bank which focuses on deposit-taking from households and firms be separated from the investment bank which largely provides services involving other financial institutions. The ICB proposed in its report last Autumn that the separate retail subsidiary faces an overall CAR of between 17 to 20 per cent with a CET1 ratio of at least 10 per cent. We will have to wait to see whether this comes to pass as the government’s legislation passes through Parliament, but it is not expected that the ICB’s proposals come into force before 2019.

Recommended Materials
Final Report: Recommendations Independent Commission on Banking , September 2011. (See Chapter 4 for a readable overview of Basel III and the general principles involved. See Chapter 3 for a discussion of the functional separation of retail and investment banking).
Basel Committee on Banking Supervision reforms – Basel III Bank for International Settlements

Articles

Basel III – the case for the defence Financial Times (23/1/12)
Finance: Banks face a perfect storm that is getting worse Financial Times, Patrick Jenkins (24/1/12)
Banks in EU, US and Japan to face capital reviews BBC News (9/1/12)

Questions

  1. What is meant by capital and by capital adequacy?
  2. Explain the construction of a Capital Adequacy Ratio. Distinguish between the CET1 ratio and the overall CAR ratio.
  3. What do you understand by macro-prudential regulation?
  4. How do liquidity and capital adequacy differ?
  5. If financial institutions provide deposits to individuals who can draw out their money readily but extend credit over long periods of time, why don’t financial institutions regularly face financial problems?
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Recession ‘easing’ – or is it?

The global economy has been in a recession since December 2007, but have we now passed the worst of it? Whilst companies are still going bankrupt, unemployment is still rising, the housing market is still looking pretty gloomy and government debt surely can’t go up anymore, there are indications that we’ve reached the bottom of the recession. There are murmurs that the economy may start to recover towards of the end of the year.

But, of course, economics wouldn’t be economics if there wasn’t considerable disagreement. Many still believe that the worst is yet to come. According to the OECD, the recession is ‘near the bottom’. Yet, output in the UK is still set to decline by 4.3% in 2009, and by 2010 the budget deficit is predicted to have grown to 14%. Unemployment is at its highest since November 1996, but US consumer confidence is said to be rising and the pound is climbing. Read these articles and make up your mind about the state of the UK and global economy!!

Business and Consumer Surveys (After following link, click on chart) European Commission, Economic and Financial Affairs (29/6/09)
Pound climbs against euro as King sees signs recession easing Bloomberg, Lukanyo Mnyanda, Gavin Finch (20/6/09)
Bank says banking crisis easing BBC News (25/6/09)
First signs of optimism returning to some parts of financial services CBI PRess Release (29/6/09)
Darling and King agreed on tentative recovery Guardian, Ashley Seager (17/6/09)
Sharp contration for UK economy BBC News (30/6/09)
Housing market knocked by price falls Moneywise (22/6/09)
OECD says recession ‘near bottom’ BBC News, Steve Schifferes (24/6/09)
US Federal Reserve says recession is ‘easing’ Telegraph, James Quinn (24/6/09)
Public borrowing at record levels BBC News (18/6/09)
Leading index suggests recession easing UPI.com (18/6/09)
US consumer confidence up in June BBC News (26/6/09)
Blow for housing market as prices fall The Independent, David Prosser (22/6/09)
Most UK businesses freeze pay as recession bites, CBI says Telegraph, Peter Taylor (23/6/09)

Questions

  1. What are the typical characteristics of a recession? Do the current statistics of the four main macroeconomic objectives fit in with what economic theory tells us?
  2. Which policies would governments normally implement to get a economy into the expansionary/recovery phase of the business cycle and how do they work?
  3. Why is consumer confidence so key to economic recovery?
  4. What type of banking regulation is needed to prevent a similar crisis happening again?
  5. Movements in the housing market are often seen as indicators of the state of the economy. Why is this?
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Marx – back from the dead?

In a remarkable turn around, the current financial crisis has seen mentions of Karl Marx and Marxism creeping their way back into the economic media. Whilst no-one expects a resurgence of Marxist economics, the current financial crisis has led people to wonder whether his work may have some relevance in trying to analyse the current instability in the capitalist and financial system. Even the Archbishop of Canterbury has argued that Karl Marx was right in his assessment of capitalism. So is Marx turning in his grave, or is he due for a revival of fortunes?

Banking crisis gives added capital to Karl Marx’s writings Times Online (20/10/08)
The red Archbishop? Guardian (25/9/08)
Marx is dead: don’t resuscitate him Guardian (27/9/08)

Questions

1. Summarise the key tenets of Marxist economics.
2. Step 5 of Karl Marx’s ten essential steps to Communism was “Centralisation of credit in the hands of the state…..“. Assess the relevance of this as a possible solution to the current financial crisis.
3. “An over-expansion of credit can enable the capitalist system to sell temporarily more goods than the sum of real incomes created in current production, plus past savings, could buy, but in the long run, debts must be paid”. Discuss the extent to which this quote from Marx is relevant in the analysis of the current financial crisis.