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Author: Alan Shipman

Risk will return

Updated Friday, 10th May 2013

Is it too much to expect that the new financial system will be fundamentally less accident-prone than the old?

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Several internationally interrelated causes for the 2008 crisis have been identified. The subsequent reforms have been implemented at national level, by separate regulators. It is therefore unlikely that a comparable crisis will not recur; and it’s a hope rather than a promise that the next will not be on such a spectacular scale.

Excessive lending by commercial banks, especially in mortgage and unsecured loans to consumers, fuelled the property price bubble whose bursting left several large banking groups in need of state-financed rescue.

Banks will be expected to exercise more caution in future. But as the excess of credit (especially for home-buying) gave way to a drought, which has slowed the recovery of house prices and investment, governments are wary of making it too hard for households and businesses to borrow.

The UK is even, through its help-to-buy scheme, committing public funds towards private home purchase, in a market-supporting way not dissimilar to the one that fuelled the  US real-estate boom before 2008. 

One major cause of higher household borrowing and mortgage equity withdrawal – which left many families over-extended when house prices fell – was the stagnation of average real incomes from the early 2000s.

This has not been tackled. On the contrary, pay freezes and  ‘flexible’ labour-market reforms have been extended during the recession. So households’ reliance on credit, and risks of default, have risen further across much of Europe, including the UK.

Excessive borrowing by banks helped them to push up pre-crisis lending, and this has been tackled internationally by new capital-adequacy and liquidity ratios to be enforced (under the Basel accords) by 2019.

But the new discipline has been weakened, and the timetable kept long, by governments’ need to get banks lending more in the short term to finance recovery.

And the ‘shadow banks’, which borrow short and lend long but fall outside the Basel process, are likely to expand (from a size already comparable to the banking sector) as a result of new regulation.

Investment banks, including those attached to high-street lenders, were accused of making casino-like gambles on their own account before 2008 which put depositors’ funds at risk.

If visible to the public, any such risk can cause a run on the bank that takes it, causing liquidity problems which quickly spread through the system even if affected banks remain fundamentally solvent.

If risks don’t pay off and banks’ assets take a dive in value, their lending may be staunched, and the whole economy can be hit by an investment-sapping ‘debt deflation.’

To guard against this, the UK has set a timetable for ‘ring-fencing’ commercial (high street) from investment banking operations, so that the deposit guarantees given to the first no longer under-write any gambling indulged in by the second.

But the ring-fence stops well short of the outright separation forced on US banks after the 1929 financial crash (until 1999). Some seasoned City-watchers suspect that banking groups which still (legally) combine high-street with trading-room operations will quickly find ways through it, just as they find loopholes in the present taxation rules.

And whereas future banks collapses should (in principle) wipe out the shareholders and bondholders before they can harm depositors, that’s difficult to do when (increasingly) those shareholders are ordinary people’s pension funds, not a riche elite. 

‘Moral hazard’ is often cited as a reason why big banks took excessive risks, both in the loans they extended and the investment strategies they followed.

They pursued high returns by taking excessively high risks, knowing that governments would bail them out if they failed, because of the cost to the economy of letting a major bank collapse.

The fact that all overstretched banks except Lehman Brothers were rescued – and the phenomenal cost of letting Lehmans collapse – hardly dispelled this inadvertent assurance in 2008.

Governments of smaller economies (including the UK) have tackled it by trying to create smaller, more numerous banks so that none is too big to fail (or, as Ireland and Cyprus found, too big to bail).

But the fixed costs of running a bank – especially with raised post-crisis capital requirements – makes it very hard to increase their number. In the UK, recent deals to sell Lloyds and RBS branches have fallen through, and newly found banks are only growing at a snail’s pace.

Outside the US, few banks are small enough not to cause systemic problems if they collapse, so the moral hazard is unlikely to have gone away.

Competitive gamble

Increasing the number of smaller banks is designed to promote competition among them. But competition may have been another cause of the financial crisis, which subsequent reforms have therefore amplified.

Commercial banks expanded their mortgage (and unsecured) lending to households, moving into the building societies’ traditional territory, because competition from investment banks (for their larger corporate clients) and financial markets (which started to attract higher-net-worth depositors) had eroded their traditional profit source.

In general, competition erodes banks’ traditional, safe sources of revenue (the premium of borrowers’ over savers’ interest rates, transaction charges, commissions) and propels them into riskier lines of business. It is not clear that this aspect of reforms has pushed the system in the right direction.

Deregulated financial markets helped the banks to expand their borrowing and lending unsustainably – notably through the repackaging and re-sale of mortgages and other previously non-transferable loans, and other derivatives on which they could place leveraged bets to raise their profit rates.

New regulations will bring these over-the-counter derivatives trades back onto organised exchanges, allowing regulators to monitor their (previously massive and undetected) growth and better identify financial institutions that have taken on too much risk.

But these reforms seek only to control, not to outlaw, the use of derivatives for speculation (which multiplies risks through the financial system) rather than hedging (which efficiently transfers it). 

The use of derivative contracts to gamble on financial asset price movements – effectively banned until the early 1990s, because of financial crashes in the 19th Century – is still permitted.

In fact it is still growing (through, for example, the growth of spread betting, synthetic exchange-traded funds, and speculative trades in carbon quotas), and receiving government support (for example through the UK government’s use of contracts-for-difference to promote private sector financing of new nuclear power stations). 

Here, as in the case of needing banks to lend more (for short-term recovery) while lending more wisely (to avoid another crisis), governments’ response is necessarily contradictory.

It’s too much to expect that the new financial system will be fundamentally less accident-prone than the old.

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