Systemic risk was the real culprit in the 2008 financial crisis and, with banks continuing to borrow huge amounts, the dangers are still there
Why did nobody see it coming? Queen Elizabeth famously asked this question when visiting the London School of Economics in 2008. Along with Allan McConnell at the University of Sydney, I’ve been thinking about the best way of answering this question for the last few years. But, in doing so, I think I may have been looking at the wrong part of the question.
We started with an article just published by Political Studies, which looked at the ‘why’. Our argument here was that, prior to 2008, market traders, bank executives and regulators alike were being driven by a mixture of groupthink, irrational exuberance and herding effects. At the time, this felt like a moderately contentious argument. But there has emerged a new orthodoxy here. At a recent SPERI symposium the former Director of Financial Stability at the Bank of England, Sir John Gieve, centred his presentation around the pernicious effects of ‘groupthink’. What’s more, the same set of cognitive suspects has been now been picked out of a line-up by no less a figure than Alan Greenspan in his new book The Map and the Territory. It now seems that financial markets are not powered by rational utility-maximisers.
In a forthcoming article in the Journal of Public Policy we then went on to look a bit more at the ‘nobody’ bit of the Queen’s question. Was it really the case that nobody saw it coming? Who saw what, where, when and how, and what positions did these people occupy within the financial system? After trawling through years of newspaper editorials, regulators’ reports, Parliamentary questions and Treasury select committee inquiries, we found there were actually plenty of prophets. A number of people (some of them now very wealthy hedge-fund managers) did publicly predict a crisis. But these sceptics were hugely outnumbered by others who argued that risk had been calibrated and distributed, that the economy would continue to grow, and that all would be well. In short, there were warning signals, but they stand out only with the benefit of hindsight.
But there is one part of the Queen’s question we did not look at closely enough- ‘it’. What is the ‘it’ which nobody saw coming? A number of people saw that the US housing market was bubbling and might one day crash. Plenty of people saw the dangers in the liar loans and teaser rates which we now know were propping up the subprime market. But subprime is not ‘it’.
The eventual losses in the US subprime market were around US$500bn. This is not loose change. But, as Ben Bernanke noted in a speech in 2012, neither is it a huge sum when compared with the total balance sheets of the largest banks. So why did the subprime losses trigger a global financial meltdown when the larger losses incurred during the bursting of the dot.com bubble in 2000 did little long-term damage? The answer, as both Bernanke and the Bank of England’s Andy Haldane have argued, is systemic risk, which thus leaves systemic risk is the best candidate to be the ‘it’ in the Queen’s question.
In other words, subprime losses led to a financial crisis in 2008 because the banks were more highly leveraged relative to their capital and also, crucially, more dependent upon short-term funding markets. The 2008 financial crisis was, above all else, a crisis in and of the wholesale funding markets which arose when institutional investors stopped lending to any banks at any price in the knowledge that some of those banks (they did not know which) had incurred losses in the subprime market that would be enough to wipe out their inadequate capital buffers.
Why does this matter? It matters because, five years on from the onset of the crisis, the banks, although more tightly regulated and less leveraged, still require massive amounts of wholesale funding to sustain their balance sheets. In 2006 JP Morgan recorded commercial paper debts of US$18,000m on the liability side of its balance sheet, together with US$133,000m in long-term debt. By 2012 these figures had risen to, respectively, US$55,000m and US$249,000m. Nor is this a one-off story. In 2006 Barclays recorded £177,000m in repurchase agreements and cash collateral on securities lent on the liability side of its balance sheet. By 2012 – after several years of seeking to reengineer its balance sheet away from investment banking – this sum was still £176,000m. Investors in these funding markets are under no obligation to continue lending to these or other banks if and when losses are sustained in housing markets, corporate lending or financial trading. Indeed, institutional investors have good reason not to take any chances when it comes to rolling-over loans to any bank they think might even be close to being nearly in trouble.
In a speech on 24th October, the new Governor of the Bank of England, Mark Carney, pointed to new capital and liquidity regulations, as well as new cross-border arrangements for bank resolution, and promised that, in the event of any future crisis, the Bank of England would stand ready to exchange cash and collateral in return for assets. The message was, in one sense, a reassuring one. The largest UK banks will not be allowed to go bankrupt. The Bank of England will cover private sector losses and make good on any future freeze in funding markets. Yet the fact that this still needed to be said is of itself a worrying sign of how, in other respects, very little has changed since 2008. Banks continue to borrow huge sums. This borrowing creates a systemic risk and this systemic risk is backstopped not by the banks, but by public authorities, representing us.