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A blog by Leon Oudejans

After the crisis, the banks are safer but debt is a danger (FT)

23 September 2018


“It is said that generals often plan to fight the last war. Ten years on from the collapse of Lehman Brothers, many experts fear a new financial crisis. In fact, the global financial system is much more robust than before 2008, but the global economy is still threatened by excessive debt.

 The financial crisis began because of dangerous features within the financial system itself. Massively leveraged investment banks engaged in socially useless trading of huge volumes of complex credit securities and derivatives. New forms of secured funding left the system vulnerable to self-reinforcing runs if confidence ever cracked. Banks operated with absurdly low equity ratios, so that when the market crash came, counterparties doubted their solvency. Within two weeks of Lehman’s collapse the global interbank money market had frozen, creating real danger of economic collapse. 

The excessive risk-taking was allowed by bad regulation justified by flawed economic theory. Authoritative experts such as the IMF explained how increased securitisation and trading activity made the financial system more efficient and less risky. Global bank capital reforms sought to make it easier for banks to fund rapid credit growth.

The first priority in autumn 2008 was to use central bank and Treasury money to prevent the crisis turning into a 1930s-style Great Depression. The subsequent challenge for international regulators was to make future financial crises less likely, and I believe we succeeded.

The most crucial change was a dramatic increase in bank capital ratios. Changes to the definition of what counts as bank capital and to how risk weighted assets are calculated, together with higher regulatory ratios, have effectively forced big banks to hold three to five times as much capital as before.

As a strong hawk on bank capital I wish we had done still more: ideally banks should run with 15 to 20 per cent equity ratios. But the probability of a crisis developing rapidly within the guts of the financial system itself is now far lower than before 2008.

But economic growth has been anaemic despite massive policy stimulus. This has produced not the overheating which economic theory might have predicted, but a decade of sluggish growth and inflation averaging well below target. True, over the past year the global economy has begun to perform better, but only because of large and growing fiscal deficits in both the US and China.

That poor performance reflects factors more fundamental than unnecessary financial innovations and inadequate capital regulation. The crisis reflected faults within the financial system which had grown over a decade, but the post-crisis recovery was so weak because of a massive growth in leverage — both household and corporate debt — over the previous half-century.

Since the crisis, that debt burden has not gone away, but simply shifted around the world economy from private to public sectors within developed economies and from developed economies to China, whose debt to gross domestic product soared from 150 per cent in 2008 to 250 per cent by 2016. Total global debt as a percentage of GDP — public, household and corporate together — is now higher than ever. [Note: bold markings by LO]

That debt overhang leaves the global economy dangerously vulnerable to shocks. Ultra-low interest rates have made even huge debts affordable, but only small rises in dollar interest rates and resulting dollar appreciation are already causing severe stress in emerging markets.

China’s debt boom helped keep the global economy going between 2009 and 2016, but Beijing’s efforts to control it could cause a significant slowdown. Italian government debt is almost certainly unsustainable. And with interest rates still low in the US and zero in the eurozone and Japan, there is far less potential than in 2008 to offset a big slowdown with rate cuts.

A more robust financial system is no ground for complacency. A deep economic recession, made worse by a large debt overhang, could occur even if not a single big bank went bankrupt or needed to be rescued with public money.

The fundamental question is why economic growth has become so debt dependent. Rising inequality is probably one answer, with poorer people trying to use debt to compensate for stagnant real wages. The increasing role of real estate in modern economies is also crucial.

The priority is to understand these and other causes and to design an appropriate policy response. By contrast, worrying about a repeat of 2008 is planning for the last war.”

The writer [Adair Turner] was chair of the UK Financial Services Authority from 2008-13 and chair of the regulatory committee of the international Financial Stability Board



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