The financial industry’s new-year resolutions

This year marked the tenth anniversary of the devastating financial crisis of ’08 that hit the financial industry and rippled into the lives of millions of people across the world. Heading into the next year, it is now time to ask ourselves a pertinent question: What have we, and the banks, learnt from it? To understand this, let’s go back to what actually caused the crisis in the first place.

With a decade’s hindsight now, it is clear the crisis had multiple causes that were all intertwined. Firstly, banks created too much money too quickly. Commercial banks, like Barclays or Santander, take money deposits from you, the account holder, and use that to invest in the market for a return so they can simultaneously lend more to loan-seekers. Every time a bank issues a loan, it creates money in the market – banks went from creating around £881 billion in 2000 to £2,213 billion in 2010 – one of the steepest increases in the history of banking.

When banks don’t get sufficient money from the loans back at the same time as the account-holders wanting to withdraw funds, the bank is unable to give them the money and thus causing a banking crisis

In the US, a lot of these loans were issued to potential homeowners in the form of mortgages, boosted by Bill Clinton’s ‘affordable housing for all’ initiative. The years before the crisis saw a flood of irresponsible mortgage lending in America – loans were issued to ‘subprime’ borrowers, a term for individuals with poor credit histories. Starting in 2006, America started suffering a nationwide house-price slump, which should’ve been an early indicator; with the creation of too much money in the market, especially the property market, the Federal Reserve (USA’s central bank) decided to tackle inflation concerns by increasing interest rates. Soon subprime borrowers were defaulting on their loans, because the increased interest rates meant that borrowers now had to pay higher installments. In such circumstances, when banks don’t get sufficient money from the loans back at the same time as the account-holders wanting to withdraw funds, the bank is unable to give them the money and thus causing a banking crisis.

This probably makes you wonder whether banks are even allowed to do that? Wasn’t anyone keeping a watch on them? In anticipation of situations like this, central banks do regulate commercial banks by asking them to set aside sufficient reserve money, however in a wave of deregulations from the late ‘90s, the Fed lowered its reserve requirements and the senate passed a regulation that let banks use deposits to invest in derivatives.

The banking crisis became an economic crisis, as … the failures of systemically-important created a seismic shock to the entire global financial system

This brings us to the second, and more prominent, cause of the crisis: derivatives. Derivatives are risky financial contracts that derive their ultimate value from an underlying asset, for example a notorious type of derivative is the mortgage-backed security (MBS), the cause of the crisis, whose value was based on the promised repayment of mortgage loans. If loans aren’t paid, the value goes down and the investors holding MBSs don’t receive a return. Investors had a lot of faith in these because they trusted the triple-A credit ratings assigned by reliable agencies such as Moody’s and Standard & Poor’s – this was a grave mistake – the investors didn’t know that these agencies were actually paid for those generous ratings by the banks who created the MBSs. When the housing market collapsed, due to default mortgages, so did the value of the MBSs – and you can see how that’d be a problem as lots of banks had invested their deposits in MBSs and they essentially lost billions of dollars as a result.

Banks that issued risky mortgages were affected as well as banks that decided to indirectly invest in them. When America’s housing market bubble burst, a chain reaction started exposing fragilities in the financial system. The banking crisis became an economic crisis, as banks like Lehman Brothers went bankrupt and the failures of systemically-important financial institutions, like Northern Rock, created a seismic shock to the entire global financial system.

Such institutions then had to be bailed out by central banks and the government, and the scale of the required response by the government had significant political consequences. The people were enraged by the size of support for the banks, which was made more infuriating by the fact that hundreds of millions of ordinary people suffered by losing their homes and jobs; many were also enraged that so few senior individuals were charged by the law. The trust that must exist in any democracy between elites and everybody else collapsed. There was also a systematic loss of trust amongst financiers in the solvency and reliability of each other’s institutions, making cooperation difficult.

Regulators now assert that the safety of the financial system is in a considerably better state

Fingers of blame were pointed in all directions: At subprime mortgage companies for selling loans inappropriately, at borrowers for taking on too much debt and at investment bankers for creating and marketing irresponsible products. Despite flaws of the financial system being the core of the crash, bankers were not the only people to blame, central bankers and other regulators bore responsibility too for mishandling the crisis, for failing to keep economic imbalances in check and for failing to exercise proper oversight of financial institutions. After better knowledge of all this, and learning lessons from it, are the conditions of the financial system any better today?

Regulators now assert that the safety of the financial system is in a considerably better state, with the imposition of higher reserve ratios and lower loan-to-deposit ratios, stress tests for all banks are regularly conducted by authorities, and there has been a complete restructuring of debt in the banks. This may or may not be enough, as there are always several other factors at play.

Some analysts looking at the current economic conditions fear that stimuli from the economy is also in precarious conditions, whether it’s the excessive consumer debt in China – where the total debt-to-GDP ratio has soared above 300 per cent – or European politics with Brexit and Italy at the center, or even trade tensions between China and the USA with the possibility of it escalating into a full global trade war. Another concern is the rise of populist leaders in nations over the globe, especially Donald Trump who criticizes the Fed for taking inflation precautions and aims to deregulate high finance on Wall Street.

Future conditions are perceived bleak, the next crisis may already be brewing, hence we must be better informed and ready to act when it strikes

Prominent economists have also commented on the “toxic culture” at banks and bankers attitude to risk-taking. A decade before the 2008 crisis, in 1997, Tokyo entered a banking crisis, sparked by $1tn of bad loans left by Japan’s 1980s real estate market. Japanese central banker, Hiroshi Nakaso, drew a parallel between the Japanese banking crisis and the Financial Crisis of ‘08 by observing that the “pre-crisis period in both was marked by hubris, greed, opacity — and a tunnel vision among financiers that makes it impossible for them to assess risks”. Has this changed? The crisis is used as a cautionary tale by the industry, and there is definitely a significant observable difference in the bank’s attitude to regulations and compliance, however rampant corruption still brews. In the past quarter itself, we’ve seen how senior-level officials from Goldman Sachs were involved in Malaysia’s $4.5 billion embezzlement scandal ‘1MDB’, and revelations in the European Parliament on ‘€200bn of dirty money passing through the Estonian branch of Danske Bank between 2007 and 2015’, two prime examples that are nudging banks to introspect and prioritize making changes in its culture.

Future conditions are perceived bleak, the next crisis may already be brewing, hence we must be better informed and ready to act when it strikes.