GFC: lessons learnt

October 10, 2009 at 2:00 am Leave a comment

RestI attended a talk this week on the US banking and regulatory system. The dude who spoke is a lawyer in California who’s worked at pretty high levels in the US Government (he must have been over 70 years old but he sure was sharp and spritely). What was really interesting was the report he referred us to. I’ve now had a squizz of the paper, known as the De Larosière Report.

The European Commission mandated a bunch of high level dudes to get together and figure out what the hell went wrong that led to the GFC and provide advice on the future of European financial regulation and supervision. There’s 80+ pages so unless you’re really keen, I’ll give you the juicy bits.

I was particularly interested in chapter 1, which examined in detail the causes of the GFC and the section in Chapter 3, Lessons From the Crisis: What Went Wrong? Here’s what they think:

  • ample liquidity and low interest rates have been the major underlying factor behind the present crisis;
  • strong macro-economic growth since the mid-1990s gave the illusion that permanent and sustainable high levels of growth were not only possible, but likely;
  • excess liquidity showed up in rapidly rising asset prices;
  • central banks – particularly in the US – felt no need to tighten monetary policy;
  • very low US interest rates helped create a widespread housing bubble. This was fuelled by unregulated, or insufficiently regulated, mortgage lending and complex securitization financing techniques;
  • in the US, personal savings fell from 7% as a percentage of disposable income in 1990, to below zero in 2005 and 2006;
  • consumer credit and mortgages expanded rapidly. In particular, subprime mortgage lending in the US rose significantly from $180 billion in 2001 to $625 billion in 2005.

So everyone became greedy; investors sought higher and higher yields; the US became trapped in the dream of everyone owning their own home (especially low income earners); risk became mis-priced. Banks became way too clever for themselves – in an effort to improve yield, they developed complex (and often risky) instruments such as mortgage or asset backed securities. They thought risk was spread but there were fundamental failures in the assessment of risk, both by financial institutions and by those who regulated and supervised them. It all blew up in our faces. The report also talked of the role played by the “shadow banking system”, which I’ve heard a lot about recently. The shadow banking system refers to non-bank financial institutions that lend money.

The lawyer dude spoke about the failure of the Basel I framework -a document written in 1988 by the Basel Committee on Banking Supervision, which recommends certain standards and regulations for banks (and is now considered outdated). And he laid blame squarely at the feet of the explosive growth of Over-The-Counter credit derivatives markets, which were supposed to mitigate risk, but in fact added to it.

So what are the lessons learnt? The speaker wasn’t encouraging. He felt that the entire banking system and capitalism needs to be chucked out (I’d agree with this) and he warned that the 80 year period of prosperity we’ve enjoyed since the Great Depression is….well..never going to happen again. The report highlights a number of lessons. Although EU-specific, they point to what went wrong:

  • lack of adequate macro-prudential supervision, including supervision of non-banks;
  • ineffective early warning mechanisms – although individual risks might have been identified, at the macro level they were not or no action was taken;
  • different types of failures in supervision – supervisory behaviour was not always to an adequate standard. This lesson is really talking about competencies as well as referring to a lack of cooperation between supervisors and a lack of consistent supervisory powers;
  • failures to challenge supervisory practices on a cross-border basis. So when a financial institution spread its activities into countries other than its home country, host countries were reluctant to challenge the decisions of the home regulator.

On another note, what was really frightening was the slide showing the US banking system – I’ll see if I can get hold of it. Scary.

One thing I don’t think should happen is the creation of a super-Regulator in the US, which the Senate is talking about. The Americans have long been suspicious of the aggregation of power and a super-Regulator would be a concentration of power that would probably be of benefit to large banks but not community or small banks. Anyway, read the report. I think you’ll find it illuminating.


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