Lessons from the new financial crisis
Contrary to all beliefs that the financial crisis was coming to an end, it managed to surprise us yet once again only three years later. Who are we going to blame this time?
Issue Date - 01/04/2012
The previous crisis of 2008 was blamed on greedy bankers, driven by bonuses tied to short term profits, trying to sell complicated products that people could not understand. Other culprits were the rating agencies that, also driven by greed and conflicts of interest, deliberately underestimated the risk of structured products so that their paymasters (the banks) could easily sell them to unsuspecting clients. Even business schools, and in particular finance professors, were blamed for teaching that companies should maximise shareholder value. In many cases these accusations were made by people who had never taken a finance course and did not understand the difference between shareholder value, the stock price and profits. The political left around the world had a field day, proclaiming the end of capitalism and the need for government control over the economy.
In response regulators cracked down on bankers’ bonuses, putting limits on the ratio of bonuses to fixed salary. Banks were told to invest in low risk liquid instruments and what could be more liquid and low risk than government bonds? Especially if the European banking regulators declared that all sovereign debt issued by members of the eurozone was risk-free. The SEC investigated credit rating agencies and the European Commission took steps to set up a new credit rating agency that would provide more reliable credit ratings than the US-based agencies. Business schools introduced mandatory ethics courses where shareholder value maximisation was attacked as a dangerous ideology. Some business schools even asked their MBA students to sign an oath, essentially asking them to maximise stakeholder value rather than shareholder value. Government intervention in the economy was heralded as the “new deal”, justifying massive government spending and borrowing to create “Keynesian stimulus”.
Who would ever have thought that, now, after all these efforts, and only three years later we would be in a new financial crisis? Who are we going to blame this time? And what did we learn? First of all, the main culprit here is obviously the introduction of the euro as a common currency, before fiscal integration. Without the euro Greece would not have been able to borrow at the same rate as Germany, and would have not been able to lever up its balance sheet to the same extent. European banks would not have been encouraged by regulators to buy Greek and other Club Med debt so there would have been no global banking crisis. Greece would have devalued the drachma, a more gentle approach to become competitive than trying to bring down wages and prices. The potentially disastrous consequences of introducing the euro were not taken seriously at the time, in spite of warnings from major economists such as Milton Friedman. Countries were allowed to enter the club if they met the Maastricht criteria, but these criteria were subsequently ignored as France and Germany ignored them. It was obvious that the euro was a politically driven project: starting with a common currency and then hoping for further political and fiscal integration later on to build a European super state. A cynic might conclude that deep inside the true Eurofans are quite happy with the current crisis: Europeans will now be coerced into giving up their political independence in order to avoid the unpredictable consequences of a break-up of the monetary union. As William Hague put it so eloquently: the eurozone is a burning house without exits.
The second, most fundamental cause, is the massive amount of growth in government spending and borrowing that we have witnessed during the last 30 years. In 1980 the government debt to GDP ratio of France was 20%, while today it is approaching 90%. In the same year there were 3 million people employed by the French government. Today there are 5 million “fonctionnaires”. France never balanced its budget since 1976. This growth in government spending and deficits is a direct result of the political process in which politicians buy votes by giving away goods and services for free and handing out government jobs. In order not to lose too many votes from taxpayers these expenses are financed with borrowing, shifting the burden to future generations who (currently) don’t vote. Today this Ponzi scheme is hitting a brick wall, as the current generation start realising that they have become the “future” generation. For the first time in history, voters start worrying about government finances. So if we watched the end of capitalism and the promoters of shareholder value in the previous crisis, this time it is clearly the crisis of socialism and its promoters: the stakeholder value maximising politicians. Turning back the clock is also likely to be a difficult process due to massive protests in countries where almost bankrupt governments try to turn back the welfare state.
Third, politicians and regulators did the same thing as rating agencies in the subprime crisis: deliberately underestimating the sovereign debt risk by giving it zero weight in capital ratios (i.e. the ratio of book value of equity to risk-weighted assets). Even in the middle of the crisis when Greek bonds were trading at massive discounts from face value stress tests performed by the EBA (European Banking Authority) in July 2011 assumed that all the Greek debt held on the bank’s “banking book” (80% of all Greek debt) was risk free. A bond is held on the banking bond if the bank plans to hold it until maturity. The idea that your intention to hold an asset longer makes the asset less risky is a new theory with which I must admit I am not familiar. With such a flawed methodology, it is not surprising that Dexia, the French-Belgian bank, passed the stress test with flying colours and then fell off the cliff a few months later. The manipulation was clearly driven by a desire to facilitate the relentless government borrowing and spending at low interest rates. Another obvious motivation is the preservation of the European project: that we are all one big family that will support each other. After watching the World Cup final between Italy and Brazil in a Club Med resort in the Caribbean many years ago, I have serious doubts about the assumption that we are all one family: except for the Italian vacationers, all the Europeans supported Brazil.
Finally, this new crisis illustrates the problem with depending on regulation to monitor banks. In many cases regulation is driven by good intentions with bad results. Take for example, the crackdown on bankers’ bonuses. In some countries regulators limit bonuses to a maximum percentage of fixed salaries. As a result fixed salaries increased dramatically, increasing the fixed costs (operating leverage) of banks. This increase in operating leverage has made banks more risky, going directly against the policy to reduce bank risk by increasing capital requirements. Regulators failed to appreciate that variable compensation is a risk management tool in a volatile business such as banking.
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