Preventing the Next Financial Crisis

Victor A. Beker

• Verlag: Routledge
• Jahr: 2021
• ISBN:
  9781000375299
• Auflage: 1
• Thema: Business
• Thema: Finance

The collapse of Lehman Brothers, the oldest and fourth-largest US investment bank, in September 2008 precipitated the global financial crisis. This deepened the contraction in economic activity that had already started in December 2007 and has become known as the Great Recession. Following a sluggish and uneven period of recovery, levels of private debt have recently been on the rise again making another financial crisis almost inevitable. This book answers the key question: can anything be done to prevent a new financial crisis or minimize its impact?

The book opens with an analysis of the main elements responsible for the 2007/2009 financial crisis and assesses the extent to which they are still present in today´s financial system. The responses to the financial crises - particularly the Dodd-Frank Act, the establishment of the Financial Stability Board, and attempts to regulate shadow banking – are evaluated for their effectiveness. It is found that there is a high risk of a new bubble developing, there remains a lack of transparency in the financial industry, and risk-taking continues to be incentivised among bankers and investors. Proposals are put forward to ameliorate the risks, arguing for the need for an international lender of last resort, recalling Keynes' idea for an International Clearing Union.

This book will be of significant interest to scholars and students of financial crises, financial stability, and alternative approaches to finance and economics.

1 Introduction

On September 15, 2008 Lehman Brothers filed for Chapter 11 bankruptcy protection in what has been the largest bankruptcy filing in US history, far surpassing previous giant bankrupts as WorldCom or Enron. As a matter of fact, it was the largest bank failure ever as well as the largest bankruptcy ever.

The collapse of Lehman, which was the fourth-largest US investment bank, was followed by a global financial crisis. This deepened the contraction in economic activity that had already started in December 2007 and has been known as the Great Recession. The world economy was brought to the brink of collapse.

Between December 2007 and June 2009 US GDP fell 4.3% while unemployment increased from 5.0% to 9.5%, peaking at 10.0% in October 2009. Most advanced economies followed suit. In the United States, the stock market plummeted, wiping out nearly $8 trillion in value between late 2007 and 2009.

The main issue addressed in this book is whether a new financial crisis can be avoided. In this respect, the former US Federal Reserve Chair J. Yellen, in a lecture at The British Academy on June 2017, gave an optimistic point of view: “I do think we’re much safer and I hope that it (another financial crisis) will not be in our lifetimes and I don’t believe it will be.”

However, contrary to Janet Yellen’s hopeful assertion, Blanchard and Summers (2019: 12) claim that “financial crises will probably happen again.” Steve Keen (2017), one of the very few economists who anticipated the last financial crisis, warns that ever-rising levels of private debt make another financial crisis almost inevitable. The key issue is what can be done to try to prevent a new financial crisis or minimize its consequences. As the Vice-President of the Deutsche Bundesbank Claudia Buch (2017) stated, “reducing excessive risk-taking, making crises less likely and reducing their costs should be the ambition of policymakers.”

However, it seems that these goals are far from being attained. Adrian et al. (2018) warn that the $1.3 trillion global market for so-called leveraged loans may be approaching a threatening level.¹ These authors remark that “yield-hungry investors are tolerating ever-higher levels of risk and betting on financial instruments that, in less speculative times, they might sensibly shun.” Even worse, underwriting standards and credit quality have worsened.

This year (for 2018), so-called covenant-lite loans account for up 80% of new loans arranged for nonbank lenders (so-called “institutional investors”), up from about 30% in 2007. Not only the number, but also the quality of covenants has deteriorated.

(Adrian et al., 2018)

Moreover, according to a report by the Financial Stability Board, assets of collective investment vehicles with features that make them susceptible to runs have grown by around 13% a year since end-2011 (FSB, 2018: 3). It goes on to warn that greater attention is needed on collecting liabilities data to better assess funding vulnerabilities although it admits that some progress has already been made (FSB, 2018: 5).

The October 2019 IMF’s Global Financial Stability Report warns that “vul-nerabilities among nonbank financial institutions are now elevated in 80% of economies with systemically important financial sectors (by GDP). This share is similar to that at the height of the global financial crisis” (IMF, 2019).

Already, in July 2013, Governor Daniel Tarullo, Member of the Board of Governors of the Federal Reserve System, warned that “a major source of unaddressed risk emanates from the large volume of short-term securities financing transactions in our financial system, including repos, reverse repos, securities borrowing, and lending transactions” (Tarullo, 2013).

Then, the key question is to what an extent the financial system is prepared to avoid systemic risk i.e. the spreading of losses, illiquidity and/or other forms of financial distress across financial institutions with serious consequences for the economy as a whole as we witnessed in 2007/2009.

The subject of financial crisis has deserved very little attention in the economic literature during the last 50 years. Minsky (1992) together with Kindleberger (1978) were lonely voices during the years of the so-called Great Moderation when the possibility of a financial crisis had been discarded and its study considered just a waste of time, at least in developed countries.

After the latest financial crisis, the issue became of public interest and several accounts of the crisis and its lessons were published, among them Paulson (2010), Bernanke (2015), Geithner (2014), Gorton and Metrick (2012), Mian and Sufi (2014), Pilkington (2013), Keen (2017) and Blanchard and Summers (2017). Most of them either focus on the events which led to the financial meltdown or deal with some particular issue such as the monetary or macroeconomic policies or the level of private debt. On the contrary, this book – after reviewing the main factors behind the 2007/2009 financial crisis – is focused on what has been done up to now to avoid a new one, to what an extent those measures have or have not removed the main factors which led to the last financial crisis and what should be done to avoid a new one.

The remainder of the book is structured as follows. In Chapter 2, the main elements which contributed to the 2007/2009 financial crisis are analyzed. Four main elements which led to the 2007/2009 financial crisis are identified: irrational expectations, securitization, the “shadow” banking system and the credit rating agencies. A brief explanation is given on how each of these four factors contributed to the financial crisis.

Chapter 3 summarizes the main reforms which took place after the crisis. The chapter starts with an analysis of the concept of moral hazard and its implications for the financial industry. It is argued that the negative externalities of bank failure and the economic and social costs associated with the chain reaction it may trigger weigh a lot more in policy decisions than the moral hazard argument. Then some of the key reforms in regulation and supervision since the crisis are examined.

The role played by the shadow banking system in the financial crisis and the regulatory reforms dealing with it are the subjects of Chapter 4. It is noticed that the Dodd-Frank Act fails to recognize that a significant part of the funding of the financial system is no longer in the form of insured deposits and fails to bring the shadow banking component of the financial system under the regulatory umbrella in a systematic way.

Systemic risk and run vulnerability are the contents of Chapter 5. The three different channels of transmission of a certain shock to the rest of the financial system – interconnectedness, contagion and panic – are analyzed.

In Chapter 6 it is argued that to prevent a new financial crisis the real issue is to avoid excessive concentration of loans in any one sector, region or kind of assets of the economy. Besides that, legislation should eliminate incentives for financial institutions to take risks that may be excessive from a social perspective. With respect to credit rating agencies (CRAs), it is argued that, with today’s technology, there is no obstacle to implement the investor-pay model in place of the present issuer-pay model and thus avoid a possible conflict of interest.

Micro- and macro-prudential regulation are examined in Chapter 7. The areas on which the regulation reform has focused are detailed. It is proposed that, as part of their macro-prudential policy, central banks should establish the acceptable limits of concentration risk and the mechanisms to monitor and control that the system behaves within them.

Chapter 8 is devoted to the need of reforming the international monetary system. It is argued that a new global monetary system is required to provide at least for an international lender of last resort and to remove the “exorbitant privilege” that allows the United States to run large external deficits while financing them with its own currency.

The treatment given by economic theory to economic and financial crises is the subject of Chapter 9. The analyses done by different authors, from Wicksell to Keynes to Minsky, are presented. The chapter concludes that economic crisis is one of the pathologies economics has yet to study in order to provide society with an answer about its deep causes and how to prevent their occurrence.

An Epilogue is devoted to the central banks’ and governments’ responses to the COVID-19 crisis. Some lessons the pandemic crisis taught are remarked upon.

A summary of the main conclusions arrived at in the book is detailed under the title of Conclusions.

An Appendix is devoted to the subject of financialization and the impact this process has had on the functioning of the economy; in particular, the fact that the production of goods has become for corporations just a by-product of their main activity focused on valorizing capital through mergers, acquisitions, takeovers and other financial instruments of the kind is remarked.

Box 1.1 Crises in economic history

Crises are a recurrent event in economic history. In their extensive review of economic crises, Reinhart and Rogoff refer to at least 250 episodes of sovereign external default episodes and at least 68 cases of default on domestic public debt between 1800 and 2009 (Reinhart and Rogoff, 2009: 34). The United Kingdom, the United States and France suffered 12, 13 and 15 banking crisis episodes, respectively. Virtually no country has escaped unscathed from economic crises of one form or another. Crises are white swans, not black swans.

The first financial crisis recorded in economic history took place in 33 AD. Not only Jesus was crucified that year but there was also a financial panic that struck the Roman Empire. The panic started in Rome and spread throughout the Empire.

In modern times, the tulip mania which peaked in 1637 is considered the first speculative bubble. The panic of 1792 is the first financial panic recorded in US economic history. It started with a run on the Bank of the United States, just created in 1791. The then Treasury Secretary Alexander Hamilton was in charge of maneuvering to contain the credit crisis. For this purpose, liquidity was injected to banks until normalcy was restored.

The Wall Street crash of 1929 signaled the beginning of the Great Depression which lasted until the late 1930s and is considered until now the most devastating economic downturn in economic history.

Source: Reinhart and Rogoff (2009)

Note

1 A leveraged loan is a type of loan that is extended to companies or individuals that already have considerable amounts of debt or poor credit history.

References

Adrian, T., Natalucci, F. and Piontek, T. (2018). Sounding the Alarm on Leveraged Lending. IMF Blog, November 15.

Bernanke, B. S. (2015). The Courage to Act: A Memoir of a Crisis and its Aftermath. New York: W. W. Norton & Company.

Blanchard, O. J. and Summers, L. H. (2017). Rethinking Stabilization Policy: Evolution or Revolution? National Bureau of Economic Research. Working Paper 24179 http:/­/www.n­ber.or­g/paper­s/w24179.

Blanchard, O. J. and Summers, L. (2019). Evolution or Revolution? Rethinking Macro-economic Policy after the Great Recession. Ca...