Lessons from the credit crunch

US banks are notably less weak than Europe’s where stress tests have been un­stress­ful

Muscat Daily - - FINANCIAL TIMES - By John Plen­der

Ten years on from the credit crunch that marked the start of the great­est fi­nan­cial cri­sis in his­tory, two im­por­tant ques­tions arise. Af­ter ex­ten­sive re­me­dial work, is the global fi­nan­cial sys­tem now fit for pur­pose? And are the ad­vanced economies vul­ner­a­ble to a fur­ther cri­sis of com­pa­ra­ble mag­ni­tude?

With the US and UK economies show­ing con­tin­u­ing, if un­ex­cit­ing, growth and the eu­ro­zone fi­nally en­joy­ing a syn­chro­nised up­turn, the banks ap­pear no longer to be hold­ing back re­cov­ery. In its re­cent mone­tary pol­icy re­port, the US Fed­eral Re­serve stated that vul­ner­a­bil­i­ties in the US fi­nan­cial sys­tem re­mained mod­er­ate. That view is echoed by cen­tral bankers in Europe and Ja­pan. Yet the un­der­ly­ing pic­ture is com­pli­cated.

The US bank­ing sys­tem is notably less weak than its Euro­pean coun­ter­part. That is be­cause Amer­i­can pol­i­cy­mak­ers learnt from the ear­lier Ja­panese ex­pe­ri­ence of boom and bust. Among the lessons were the im­por­tance of timely recog­ni­tion of losses af­ter the cri­sis, rig­or­ous stress test­ing and the need for care­fully judged strength­en­ing of bank bal­ance sheets, while main­tain­ing a flow of credit to the real econ­omy.

In the eu­ro­zone, by con­trast, pol­i­cy­mak­ers were re­luc­tant to con­front the chal­lenge of the sov­er­eign debt cri­sis head on. Stress tests have been un­stress­ful and banks re­main un­der­cap­i­talised rel­a­tive to the US. South­ern Europe is dogged by non-per­form­ing loans. And banks across the eu­ro­zone main­tain big hold­ings of their own gov­ern­ments’ debt.

That high­lights one im­por­tant sense in which the sys­tem is not fit for pur­pose. The risk-weighted Basel cap­i­tal ad­e­quacy regime, de­spite post-cri­sis tweak­ing, is fun­da­men­tally flawed. Sov­er­eign debt en­joys ex­ces­sively favourable treat­ment so eu­ro­zone banks stuff their bal­ance sheets with the IOUs of se­ri­ously over-in­debted gov­ern­ments. A par­al­lel prob­lem in the English speak­ing coun­tries is the ex­ces­sively favourable treat­ment of mort­gage debt, which en­cour­ages as­set price bub­bles and puts home own­er­ship out of reach for young peo­ple.

As for threats to fi­nan­cial sta­bil­ity, there has been much reg­u­la­tory re­form since the col­lapse of Lehman Brothers bank in 2008. This was aimed at curb­ing ex­ces­sive risk tak­ing, re­duc­ing de­pen­dence on whole­sale mar­kets for fund­ing and se­cur­ing or­derly res­o­lu­tion (un­wind­ing) of fail­ing banks. Macro­pru­den­tial poli­cies such as caps on loan to value ra­tios and coun­ter­cycli­cal cap­i­tal re­quire­ments have been in­tro­duced. Yet vul­ner­a­bil­i­ties re­main.

One of the big­gest, iden­ti­fied long ago by the Bank for In­ter­na­tional Set­tle­ments, the cen­tral bankers’ bank, is asym­met­ric mone­tary pol­icy. Since Alan Greenspan’s ten­ure at the Fed, which ended in 2006, there has been a ten­dency for cen­tral banks to ease ag­gres­sively dur­ing busts while fail­ing to lean against booms. This has led to a down­ward bias in in­ter­est rates and an up­ward bias in debt. Among lead­ing coun­tries, with the no­table ex­cep­tion of Ger­many, gov­ern­ment debt has spi­ralled since the cri­sis.

At to­day’s freak­ishly low in­ter­est rates, to which cen­tral banks have con­trib­uted through quan­ti­ta­tive eas­ing, this ap­pears man­age­able. Yet it is also a debt trap from which it may be hard to es­cape with­out a bond mar­ket col­lapse, which would raise gov­ern­ment bor­row­ing costs while hit­ting the value of as­sets in bank bal­ance sheets.

Equally prob­lem­atic is that banks that are too big and too in­ter­con­nected to fail have grown big­ger through merg­ers and ac­qui­si­tions since the cri­sis. Risks are opaque and con­cen­trated, most notably in de­riv­a­tives ex­po­sures. Many are sim­ply too big to be man­age­able. JPMor­gan Chase is widely re­garded as the best man­aged in­ter­na­tional bank. But when a group of traders lost US$6bn in 2012 in the so-called Lon­don Whale scan­dal it was clear that top man­age­ment in New York had ab­so­lutely no clue as to what was go­ing on.

Pol­i­cy­mak­ers’ an­swer to the too big to fail prob­lem is bank bail-ins, which aim to pro­tect the tax­payer by mak­ing cred­i­tors bear the cost of restor­ing a fail­ing bank to health. Yet some fear that they would be in­ad­e­quate in a full-blown sys­temic cri­sis and that plans to co-or­di­nate cross-bor­der res­o­lu­tion will prove prob­lem­atic.

Even so, there seems lit­tle like­li­hood to­day of a cri­sis like the one that be­gan ten years ago be­cause credit ex­pan­sion has not reached bub­ble pro­por­tions. The risk is rather of an atyp­i­cal cri­sis in which a bun­gled exit from cen­tral banks’ quan­ti­ta­tive eas­ing and an in­ter­est rate spike in the bond mar­ket ex­poses the fragility of an over-in­debted sys­tem and prompts cen­tral banks to re­sume ul­tra-loose mone­tary pol­icy.

How much of the re­sult­ing losses would fall on bank cred­i­tors or tax­pay­ers is an open and ul­ti­mately po­lit­i­cal ques­tion.

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