A lot of leveraged finance has moved from the traditional banking sector to investment banks, private equity funds and the so-called shadow banking system that are less regulated, and borrow from classical banks.
Time flies. The fall of Lehman brothers and the start of largest financial crisis since the great depression is already 10 years behind us. When future historians will write the history of the early 21st century, two big events will come to mind: the attack on the Twin Towers on September 11, 2001 and the financial crisis of 2008-2009.
Countless books, papers and articles have been written about the origins and the consequences of the crisis. My goal is not to enlarge this mountain of words, but just reflect on two questions: How does today’s financial system compare to that of 10 years ago and, more importantly, could a similar shock, or worse, happen again?
Better but not perfect
Let’s start with the good news. Banks’ capital and liquidity positions are way better than they were 10 years ago. Off-balance sheet activities have been greatly reduced and brought under the supervision of regulators. Leverage in the banking system is also lower. Sub-prime mortgages have all but disappeared. And finally, a lot of over-the-counter options are now being cleared which increases the transparency and reduces the risks.
But all this does not mean that things are perfect. A recent study by three Federal Reserve Bank of New York economists indicates that a lot of leveraged finance has moved from the traditional banking sector to investment banks, private equity funds and the so-called shadow banking system that are less regulated, and borrow from classical banks. Consequently, risks have moved but not disappeared. Financial innovations are also happening more and more in the realm of shadow banking.
The inevitable black swans
In order to save the financial system and the world economy from a ‘new great depression’ governments of advanced economies have increased their total level of debt by about 30 percent (compared to GDP). The total worldwide debt mountain (of governments, households and companies) now stands at $233 trillion, quite a bit larger than it was in 2008. One could say that governments have ‘bought off’ the crisis by increasing debt. This is without a glimmer of doubt the proverbial elephant in the room.
But it was not only governments that went all-in. The world’s largest central banks reduced short-term interest rates to zero. When that proved to be insufficient, they embarked on an unprecedented quantitative easing spree in order to suppress long-term interest rates, quite a bit of which went into negative territory. Because yield became scarce, this provoked a tsunami of liquidity that found (and is still finding) its way to risky assets, such as equities and real estate creating bubbles all across the globe. Reducing this large amount of liquidity without wreaking havoc on financial markets and the world economy remains both the top priority and the biggest challenge for central bankers.
As Hyman Minsky writes in Financial Instability Hypothesis: Stability breeds instability. One just has to look at market history to realise that crises and crashes are quite common in our market system. The longer the period of relative calm, the closer we inevitably get to the next one. At the moment that everyone feels safe, typically the next one hits. And typically it is one of Nicolas Taleb’s blacks swans (events that nobody predicted ex-ante, but everyone finds logical and predictable ex-poste) that set the whole process in motion once again.
That we are today reminded of the crisis that took place a decade ago probably means that we have not yet reached the complacency phase. We must also not forget that we are still looking at the most hated bull market in financial history (because so much investors missed it). This will hopefully give governments and central banks some more time to gradually normalise policy.
Diversity can help, some Schumpeter as well
Talking about Taleb, his book Antifragility points out that as systems grow, crises become less common. But when they finally hit, the impact is much larger and less controllable. This is certainly the case for our globalised world that has not only increased prosperity but also inter-connectedness. The same goes for the global banking system. Banks, on average, have become larger thanks to mergers and take-overs during and immediately after the crisis. The problem of ‘too big to fail’ and moral hazard that goes with it has thus also become larger.
This beckons a philosophical question: should governments and central banks avoid recessions at all cost?
Governments are still strongly influenced by Keynesian thinking, which states that governments should spend when the economy heads south, thereby cushioning the blow. (Unfortunately they often forget the part that they should reduce debt when the economy is booming). Central banks, on the other hand, use the works of Milton Friedman as their monetary bible. If inflation is too low, monetary conditions have to be loosened, and vice-versa.
But both often forget the works of Joseph Schumpeter, the father of the concept of creative destruction. The concept states that recessions from time to time are healthy to clear the system of excesses. This process is often painful, and in our populist world very unpopular, but very healthy in the long run.Unfortunately, the system has become so large and so integrated, the mountain of debt so large, that even a simple recession could lead to a systemic crisis. This makes clearing the excesses a Herculean task.
Perhaps, we could take comfort in the words of Christine Lagarde of the IMF that if Lehman Brothers had been Lehman Sisters, the world would have looked totally different. Diversity and more women at key financial positions could reduce group think and the risk in the system. A rational conclusion that might originate from such a system with less testosterone, less ego and more common sense could be that up until now financial crises have always proved to be great long-term buying opportunities. Rendezvous in 10 years!(The writer is chief strategy officer at BNP Paribas Fortis. Views are personal.)