Have banks learned anything from the world financial crisis 10 years ago?
The best preparation against catastrophe is tough regulation, enforcement and equity protection. Markets may be self-correcting and clearing, but bad regulatory policies are not.
No respectable financial columnist should forget to commemorate the 10-year anniversary of the global financial crisis.
Although its memories have retreated into the sands of time, don’t forget that it nearly collapsed the international markets. What we learned or failed to learn from that historic event continues to determine our future.
Today, we can see that the financial crisis was a cyclical, secular and historical turning point that sparked the populist movement in America. The anger of the forgotten class spawned from the crisis allowed for the electoral victory of Donald Trump, an unconventional and reviled candidate who was outspent, out-organised, out-polled and demonised daily (even today).
In May 2007, ground zero for bank megalomania was in full swing, fuelled by low interest rates and a rising market.
“As long as the music is playing,” Charles Prince, then boss of Citigroup, told the Financial Times. “You’ve got to get up and dance.”
And for global banks, dancing meant empire building. By October 2007, Royal Bank of Scotland and its buyout group completed the banking industry’s biggest takeover, which began in May.
When ABN Amro was reorganised, RBS briefly celebrated being the world’s largest bank in term of assets.
American house prices, propelled by low interest rates and loose lending policies, led to the creation of a new homeowner class – subprime borrowers.
In February, 2007, HSBC Holdings surprised analysts by raising its bad-debt provisions to US$10.5 billion, US$1.8 billion more than analysts expected because of failing subprime mortgages. During that summer, two hedge funds run by Bear Stearns collapsed after losing money on soured subprime investments. Cracks in the system began to spread.
Banks began to worry about their exposure to subprime lending and their long chain of complicated and interconnected derivatives. Credit markets began to choke and liquidity began fading.
That caused BNP Paribas to suspend withdrawals from three funds in August. In the following month, Northern Rock, a British mortgage lender, asked the Bank of England for liquidity support. Worried depositors queued around the block to withdraw their deposits.
In November 2007, Citigroup provided for subprime-related write-downs of US$18.1 billion. And Prince resigned.
The debt-fuelled party came to an explosive halt with the Lehman Brothers implosion in September 2008. On September 18 that year, then US treasury secretary Hank Paulson told former president George W. Bush that because of Lehman’s mishandling of its balance sheet and its large role in the commercial paper business, it did not know how its holdings and models would affect the market.
The money market’s T. Rowe Price Prime Reserve Fund (now called Government Money Fund) “broke a buck” for the first time.
If you bought a unit for US$1,000, you could only sell it for US$900. What was supposed to be a safe, short-term investment in US Treasury bills was being priced for implied sovereign impairment.
So the Federal Reserve pumped US$900 billion of liquidity into the system within 24 hours. According to Congressional testimony, the Fed said it needed US$1 trillion immediately or the US system would freeze up in 72 hours and the world system in three weeks, followed by social and political chaos within a month.
The current state of the financial industry reminds me of the famous quote from John Kenneth Galbraith: “People of privilege will always risk their complete destruction rather than surrender any material part of their advantage.”
The banking merger mania, and its subsequent bust, laid bare a conflict between the interests of big banks against the public good of the economy. The financial establishment is still bereft of any governing principles, except in maximising bonuses and the abiding belief that it alone should be trusted to manage the “too-big-to-fail” dilemma.
Without supervision, big banks are likely to hold too little capital because they do not take into account the effect of a systemic crisis on other banks or on the economy.
The alternative is to require them to hold so much equity that they can fail without affecting the entire system even though their returns will be punished.
Ten years after the crisis, banks are seeking regulatory relaxation under a Trump administration. Jamie Dimon, head of JPMorgan Chase, argues that the banks have already passed the fail-safe point and are holding too much equity: “Essentially, too big to fail has been solved. Taxpayers will not pay if a bank fails.”
Is it possible for a bank to carry too much equity? Banks will never be completely safe entities. And it is impossible to derisk them. Risk – the opportunity to succeed or failure – is the foundation of capitalism.
The best preparation for catastrophe is tough regulation, enforcement, with equity protection that’s substantial and liquid.
Markets may be self-correcting and clearing, but bad regulatory policies are not. Instead, they eventually spawn a crisis.
Peter Guy is a financial writer and former international banker