Banking: The Rebirth Rationale

From the point of view of economic historians, in an era of instant communications and rapid globalization, policymakers have at best deemed irrelevant and at worst blatantly ignored lessons from the past. What they view as a rather cavalier approach to fiscal policy and market deregulation was graphically illustrated during a 2003 Bush administration photo-op in which representatives from various agencies involved in banking oversight used pruning shears and a chainsaw to demonstrably cut up stacks of regulations.

There is an interesting correlation between the activities of trusts that emerged at the turn of the 20th Century, largely causing the Panic of 1907 and the role played by investment banks in the run-up to the current crisis. Neither of these entities fit the mold of traditional commercial banks, and as such they were not subject to the same regulations. Another characteristic shared by trusts and their contemporary investment versions is lower operating costs, allowing them to offer clients a better return. Collectively, these institutions have been referred to as the “parallel” or “shadow” banking system.

The Federal Reserve System and the Glass-Steagall Act

Following the Panic of 1907, the US national banking system was replaced with the Federal Reserve System. Through standardization it required all deposit-taking institutions to hold adequate reserves and facilitate inspection by regulators. However, this did not stop bank runs, the worst of which evolved from a crisis of confidence into recession and then what became known as the Great Depression.

In response, the Glass-Steagall Act (1933) separated banks into two kinds: commercial banks, which accepted deposits, and investment banks, which did not. In return for heavy restrictions, commercial banks were given ready access to credit, and most importantly, all of their deposits were insured by the Federal Government – a mechanism specifically designed to institutionalize confidence.

In 1999, the Glass-Steagall Act was repealed, and the process of convolution between mandate and responsibility became blurred as commercial banks were allowed to enter into investment banking, taking on more risk and increasingly subject to less regulation.

The years from 2002 to 2006 witnessed an unprecedented boom in the value of housing prices across Europe, North America and beyond. People were literally making money out of their ability to obtain credit, and as the housing price bubble grew, it seemed that the more mortgages people had, the wealthier they became. Deregulation and artificially low interest rates encouraged banks to tear up the rule book on lending criteria, particularly in the US. Risk was marooned on a desert island as what became known as ninja loans to the sub-prime market proliferated.

For financial institutions, experts agree that the credit crunch began on 9 August 2007 when French bank BNP Paribas suspended withdrawals from three of its funds, triggering a sharp rise in the cost of credit. The default of sub-prime mortgage payments due to companies like New Century Financial in turn caused them and other companies to default on payments to other banks and investors to whom they had sold risky sub-prime debts.

One problem, as Nobel Laureate Paul Krugman external pagenotescall_made, is that when foreclosures take place on peoples homes, the banks usually only ever get back about half of the original loan amount (due to degradation associated with homes being vacant for prolonged periods). One possible solution would have been to restructure loan payments and keep people in their homes (maintaining as much residual value as possible and a source of income to creditors). But due to the complexity of the financial engineering involved, and the fact that most sub-prime mortgages were made by loan originators (rather than banks), they had neither the human resources to carry out such a task nor the incentive to do so.

One might expect problems within a single sector of the financial market to be easily contained; and indeed they would have been were it not for prolific and systemic financial alchemy, now interpreted as highly questionable practices.

The risks from sub-prime loans were disguised by financial institutions, hedge fund managers and other investors by mixing them with other loans, bonds and assets, which were then bundled into portfolios known as collateralized debt obligations (CDOs) and structured investment vehicles (SIVs) and sold on globally. The problem with these financial products was that they failed to properly assess and quantify the risks associated with them. The architecture of CDOs encouraged risky lending because the fees were collected when they were issued. And in the case of SIVs, the originator was able not only to sell the SIVs on to other institutional investors (transferring the risk), but they were structurally encouraged to do so because increased volume meant greater commissions.

Credit default swaps (CDSs) were another mechanism designed to minimize the risk of taking on CDO and SIV exposure between parties. In simple terms, CDSs can be understood as a kind of insurance policy whereby the buyer pays a premium and the seller guarantees the credit worthiness of the product. In other words, the risk of default is transferred from the holder to the seller. One problem was that CDS providers were not properly regulated. Another was with risk rating agencies, which failed to assess all of the individual clients in terms of their financial exposure; they only monitored the last link in the chain, thereby increasing overall systemic risk.

Still, investors believed that these innovative financial products had led to the securitization of risk. However, as banks repackaged loans in order to create liquidity and extend new loans (which would then be securitized again), this in effect created an unchecked credit multiplier that was supported by a perception of moral hazard. Investors who were counterparties to assets held by Bear Stearns (those to whom it owed money or with whom it had made financial deals) were protected when the US Treasury moved in to assist them.

This widespread understanding was shattered when similar treatment expected by counterparties to Lehman Brothers did not materialize. Such inconsistent behavior sent confusing messages to the market as it seems the Treasury made a calculation that some financial institutions were too big to fail.

In September 2008, due to its exposure to the CDS market, the Federal Reserve was forced to take an 80 percent stake in AIG in order to save it from collapse. Investor anxiety quickly became a crisis of confidence as asset prices fell and the few remaining lines of credit dried up.

Transatlantic contagion

Across the Atlantic in the United Kingdom, growing anxiety caused the first run on a bank in over 100 years. This is when public perceptions changed as the BBC’s business editor Robert Preston observed “the fact that Northern Rock has had to go cap in hand to the Bank of England is the most tangible sign that the crisis in financial markets is spilling over into businesses that touch most of our lives.”

The queues of people outside its branches brought home the seriousness of the situation for many ordinary citizens, and people began talking about the possibility of recession. This began to look increasingly likely after 21 January 2008, when global stock exchanges suffered their biggest single-day losses since 9/11. The FTSE sustained US$149 billion in losses, with other markets suffering similarly:

According to the International Labor Organization, 51 million jobs worldwide could be lost this year, with global unemployment increasing from 5.7 percent in 2007 to 7.1percent in 2009. The figures for 2008 show the variation by region:

Worst (2008): 

North Africa 10.3%
Middle East 9.4%
Central and Southeast Europe 8.8%
Sub-Saharan Africa 7.9%
United States 7.2%
Latin America 7.3%

Best (2008):

East Asia 3.8%
South Asia 5.4%
Southeast Asia and Pacific 5.7%

On 1 December 2008, the National Bureau of Economic Research announced that the US economy had begun to contract, and by January 2009, Britain entered recession, with a 1.5 percent fall in GDP (compared with the previous three months).

Data published in The Economist external pagedemonstratescall_made the relationship between consumer spending and falling exports. China saw a reduction of 2.8 percent in December 2008 from the same month of the previous year. To put that figure in context, some 20 million migrant workers have lost their jobs and headed back to their native towns and villages. Latest figures from Japan indicate the extent of the economic downturn. Between January 2008 and 2009, exports to the US fell by 53 percent, to Europe by 47 percent and to China by 45 percent. And Japanese car exports have fallen by 69 percent.

At the international level, governments have responded by implementing some of the prescriptions of economist John Maynard Keynes, including increased spending on infrastructure and public works. Some commentators fear that these stimulus packages could lead to an increased risk of economic nationalism (the urge to keep jobs and capital at home) reminiscent of protectionist measures introduced in the wake of the 1929 financial crash. It is a rationale understood by policymakers.

But faced with the prospect of national elections it is hard to see how the political expediency of domestic politicians can be overcome and public opinion informed to understand that the economic fate of citizens in Hungary or Slovakia is inextricably linked to those of Britain, France and Germany.