Lessons not learnt from 2008
connections were exposed as the globalised financial system’s intricate linkages became a conduit for transmitting contagion. It led to a sharp fall in cross-border capital flows, which remain well below the pre-crisis levels.
Fourth, frequently (untested) financial innovations create new risks, both for the individual institution and systemically. It also allows rent seeking by banks and financiers, who exploit the asymmetry of information between sellers and buyers of complex products. It also creates control issues as managers, directors and regulators are unable to keep up with new developments. During the 2007/ 2008 crisis, the problems of higher risk mortgages, CDOs and the shadow banking system populated by off-balance sheet vehicles illustrate these risks.
Fifth, the identified problems are amplified by the leverage of financial firms. In the last 20 years, capital ratios and liquidity reserves of banks have fallen sharply. Leverage is increasingly used to drive higher and more volatile returns on equity. During the global financial crisis, the high leverage, both on and off-balance sheet, accentuated the problems.
Sixth, the increase in size of the banking system, risk and complexity is implicitly underwritten by the state, a fact recognised by rating agencies. It typically takes the form of deposit insurance, liquidity insurance and implied capital support. Given the central role of banks in payments and credit provisions, it is difficult for governments to allow banks to fail.
The Bank of England’s Andrew Haldane wrote about “a progressive rise in banking risk and an accompanying widening and deepening of the state safety net”. He referred to this as the “Red Queen’s race”, where the system is running to stand still with governments racing to make finance safer while bankers create more risk.
Following the crisis, governments in the US, UK, Ireland and Europe were forced to step in and support their banks. Many other governments indirectly supported their banks by increasing the scope of deposit guarantees.
In the years since, banks have not grown smaller, with size and concentration increasing.
In the US, the six largest US banks now control nearly 70% of all the assets in the US financial system, having increased around 40% (against overall asset growth of only 8%). JP Morgan, the largest US bank, has over US$2.4 trillion in assets, larger than most countries.
The growth and increased concentration is the result of forced consolidation (“shotgun” mergers) and the effect of new capital and liquidity regulations which favour larger banks. A flight to the perceived safety of TBTF (Too Big Too Fail) banks combined with contraction of alternative funding sources, such as securitisation, has reduced competition from smaller entities. Governments and regulators have also favoured larger banks which are national champions that are internationally competitive and theoretically easier to regulate.
The increased importance of banks also reflects their role in now financing beleaguered states by increasing their holding of government bonds, often financed by the central banks. Italian, Spanish and German banks hold around 24% (over € 400 billion) of all government bonds, 41% (around € 300 billion) and 15% (around € 240 billion).
The banking system has also gained from such policies such as quantitative easing. Liquidity fuelled asset price rises have also encouraged a return of dubious banking practices.
In a 2013 study McKinsey found that in the US between 2007 and 2012, lower interest rates resulted in a net transfer from households, pension funds, insurers and foreign investors to the government, non-financial business and banks of around US$1.36 trillion. The benefit to US banks was around US$150 billion from an increase in effective net interest margins and a cumulative increase in net interest income.
In Europe and the UK, loose monetary policy and low rates benefited governments and nonfinancial business but banks lost through lower net interest income. Banks also lost as a result of having to shed assets and buy government bonds, which made them even more dependent on governments.
The confluence of government support (protects depositors and creditors), limited liability (which protects shareholders), profit maximisation and incentive pay for financiers encourages a culture of “rational carelessness”. Rather than dismantle the financial doomsday machine, governments and regulators have perpetuated a large financial system, which increases the risks for the economy. In June 2013, then Bank of England governor Sir Mervyn King said: “It is not in our national interest to have banks that are too big to fail, too big to jail, or simply too big.”
Approached to provide government aid to a company that claimed it was too big to fail, George Schultz, secretary of Treasury under Nixon advised: “Get smaller!” Policymakers would do well to heed Schutlz’s advice. – The Independent