Can the world handle another financial crisis?
The global financial system is bound to face another severe test some time soon, but is it ready? Ian Fraser investigates in the first of a three-part series.
The phenomenon of “boom and bust” is endemic to capitalism, but as the booms get bigger and the world becomes ever more connected, the risk of a truly catastrophic crisis is never too far away. Ten years after the last major test for the system, what have we learned? Who, and which investments, will be best placed to survive the next challenge when it comes?
Has enough been done to prevent another crisis?
As the dust settled on the global financial crisis of 2008, just after many of the world’s largest banks and financial institutions narrowly avoided collapse thanks to generous taxpayer-funded bailouts, many commentators believed the global financial system was going to be totally rethought.
Speaking in October 2008, the Nobel Prize-winning economist Joseph Stiglitz said “the fall of Wall Street is for market fundamentalism what the fall of the Berlin Wall was for communism – it tells the world that this way of economic organisation turns out to be unsustainable”.
Among reformers and campaigners, optimism was in the air. Ideas for change included the total rewiring of the global financial system, reforming the incentives in the finance sector to ensure they drove greater personal responsibility, breaking up “too big to fail” banks and prosecuting high level bankers who had committed fraud.
Sadly, however, policymakers were so focused on shoring up the existing system, none of this materialised. In the process, they arguably entrenched bad habits.
...the banks have been allowed to remain too big to fail. Virtually everything they do is guaranteed by the state, by taxpayers
Kevin Dowd, Professor of Finance and Economics at Durham University, believes that the financial reforms that have been brought in since 2009 are inadequate, untested or counterproductive.
He says the Basel III capital regime, which requires banks to maintain capital equivalent to at least 8% of their risk-weighted assets, as well as the central banks’ “stress tests” for banks, fall into the “counterproductive” category.
He added that ring-fencing, which will force UK-based banks to split their retail banking activities from their investment banking activities from next year, fails to address the underlying causes of the crisis. He is also highly critical of the macroprudential approach to systemic issues which was adopted by the UK’s Prudential Regulation Authority, part of the Bank of England, from April 2013. He says this “unwisely presumes that policymakers have the incentive and the ability to time the economic cycle”.
Kevin adds: “Many of these responses create new hidden systemic risks. They fail to address the root causes of excessive risk-taking which requires a combination of much tougher personal liability on the part of senior bankers and much higher capital standards.”
The result is that British banks are even more vulnerable to collapse than they were in 2007-8, he says.
The failure to tackle the opacity of banks’ balance sheets has also stored up danger. As the Financial Times City Editor Jonathan Ford recently made clear, post-crisis tweaks to accounting rules have done little to bring bank balance sheets and capital ratios into line with reality, ensuring that behind the confident façades presented by bank directors, auditors and regulators, the sector is still an impenetrable black box.
“Accounting is supposed to paint a picture that allows investors to assess the current valuation of a company,” says Jonathan. “But in the topsy-turvy world of banks, it can conceal more than it reveals about economic reality.”
Ann Pettifor, economist and author of The Coming First World Debt Crisis, warns that post-crisis reforms have only scratched the surface. She says: “A few positive changes have been made, but the international financial architecture – the framework in which the banking system and financial institutions operate – has remained largely untouched.
That includes the mobility of capital, the dollar’s status as global reserve currency, and the power of the US Federal Reserve. It is this systemic architecture that produces, with increasing regularity, financial crises, and it desperately needs to be transformed.”
They’ve been relatively tough on the banks, but far too soft on shadow banking. If it quacks like a duck, it is a duck. If it creates credit, it needs to be regulated
Ann laments the fact banks have continued to funnel about 80% of their lending into the property sector (which she dubs “existing assets”), inflating asset price bubbles, while lending very little to productive industries and innovative businesses which might boost productivity (“the creation of new assets”).
“To make matters worse, the banks have been allowed to remain too big to fail. Virtually everything they do is guaranteed by the state, by taxpayers.”
She accepts that the Bank of England’s quantitative easing (QE) programme – by which the central bank created some £435bn of new digital money to buy assets such as government bonds or corporate bonds from banks and other financial institutions in the hope they would use the extra funds to boost lending to households and businesses – as necessary.
But she said it was “wrong that banks and financial institutions have had access to that massive taxpayer-backed resource without any conditionality”.
Illuminating the shadows
For Stephany Griffith-Jones, Financial Markets Director at the Initiative for Policy Dialogue at Columbia University, New York, the main problem is that policymakers and regulators have ignored shadow banking, which basically includes the provision of credit by entities other than banks.
She argues: “They’ve been relatively tough on the banks, but far too soft on shadow banking. If it quacks like a duck, it is a duck. If it creates credit, it needs to be regulated.”
Russell Napier, Co-founder of online investment analysis portal ERIC, and a Non-executive Director of the Scottish Investment Trust, sees regulators’ reluctance to rein in shadow banking as a major failure, and one that is likely to drive the next crisis. As he puts it: “Banks are only a small part of the problem.”
One reason that the shadow banking sector – which includes players such as hedge funds, investment banks and asset managers – has escaped scrutiny is because its senior players are so connected politically and do not stint on their political donations and lobbying.
The austerity imposed by George Osborne as Chancellor was particularly misguided, foolish and counterproductive
That may be why policymakers and regulators are turning a blind eye as US-based hedge funds such as Fortress Investment Group quietly revive the junk bond CDO – a collateralised debt obligation packed with junk bonds acquired with borrowed cash that yields in the region of 20%.
CDOs are the hugely opaque financial instruments that enabled Wall Street to dupe investors about the quality of large bundles of subprime US mortgages, and they were at the heart of the 2007-8 crisis.
Stephany believes the post-crisis austerity policies adopted by the UK and European governments after 2010 did nothing to improve the stability of the system.
She says: “The austerity imposed by George Osborne as Chancellor was particularly misguided, foolish and counterproductive: it stifled growth at a time when the UK could have borrowed more at relatively low interest rates, particularly for investment. In the US the economy recovered more quickly partly because they continued the fiscal stimulus for longer.”
Steve Keen, Professor of Economics at Kingston University London, warns that the post-2008 reforms are bound to fail because the policymakers, regulators and economists who drew them up “fundamentally misunderstand the role of credit in an economy”.
He believes they still erroneously equate credit with the “lubricating oil inside an engine” and they invariably regarded the crisis as “the engine seizing up because it ran out of lubricant”.
In fact, says Steve, they should be viewing credit as fuel, in which case they would recognise sudden increases or decreases in supply prove disastrous. That is a fundamental misunderstanding that has driven deeply flawed remedies, he says.