The great majority of New Zealanders – indeed the great majority of people in most countries – think they know the answer to this question. Greedy and unscrupulous bankers caused the Global Financial Crisis (GFC), and most of them should be serving long prison sentences instead of living in the luxury financed by their ill-gotten gains.
But this Hollywood view of the GFC is fundamentally wrong. I’m certainly not going to suggest that all bankers behaved prudently and responsibly: some bankers took outrageously large risks gambling with other people’s money, confident that, if things worked out well, they would make themselves and their shareholders very wealthy, while if things didn’t quite go to plan, they would at a minimum secure large farewell bonuses while the taxpayer bailed out their bank’s creditors.
Despite that, I believe that the fundamental causes of the GFC were policy failures, largely although not exclusively in the United States, not greedy bankers.
The immediate cause of the GFC was a crisis related to the US housing market when financial institutions all over the world suddenly found that the securities they held, which purported to be backed by good quality mortgages over US homes, were worth a great deal less than they had been led to believe. Government policy had contributed to this situation in at least three ways.
First, there had been on-going political pressure on US banks to lend to marginally creditworthy borrowers since at least the early nineties. In an effort to increase home ownership, particularly by minorities and low income families, virtually every branch of the US government pushed banks to ease their lending criteria. Writing in early 2009, one writer referred to the “utter debasement” of lending standards, and noted that the US central bank had “for years distributed a booklet to mortgage lenders – Closing the Gap: A Guide to Equal Opportunity Lending – which includes sidebar reminders that fines and jail terms await those found to be deficient in fighting ‘discrimination’ by [not] lending to the less-than-creditworthy. The booklet, still distributed today, derides as ‘arbitrary and unreasonable’ such traditional credit standards as a 20 percent down payment…, an above-par credit score, a history of paying one’s bills on time, and a steady job yielding an income sufficient to make monthly mortgage payments.”[1]
By the end of 2007, just before the GFC broke, Fannie Mae and Freddie Mac (the US government-sponsored housing agencies) had guaranteed or lent a sum equal to the entire US federal debt – and for every $100 they had guaranteed or lent they had just $1.20 of equity capital, even though a substantial fraction of the mortgages guaranteed were subprime or so-called Alt-A loans – often referred to as “liar loans”.
A second factor leading to the crisis in the US housing market was the practice in many urban areas of tightly regulating the supply of residential land, so that once demand for residential property started to go up there was little or no scope for an increase in supply to meet that demand, and house prices started to rise strongly. While house prices hardly rose at all in large and fast-growing cities like Dallas and Houston where restrictions on the supply of residential land were almost non-existent, they rose very strongly indeed in places like Los Angeles and San Francisco. Sixty percent of all mortgage defaults in the US were concentrated in just five states, primarily those where the supply of residential land was subject to tight restriction.
And third, more and more intensive supervision of banks – the very reverse of too little regulation – created the strong impression that the creditors of major banks would never lose money. Not since the failure of Continental Illinois Bank in 1984 – when all creditors, insured and uninsured, were protected from loss by the authorities – have the creditors of any significant bank incurred losses in the US. As a consequence, bank creditors paid less and less attention to the financial position of the banks they lent money to, and bank directors felt able to progressively increase their gearing – reduce their equity capital relative to their total assets. When supervision was minimal or non-existent little more than a century ago, the ratio of bank capital to total assets was very much higher than it is now – over 15% on average in the UK and nearly 25% on average in the US. When the GFC broke, many major banks had a ratio of capital to total assets of less than 4%, partly because, although the internationally accepted minimum for capital was 4%, that was 4% of risk-weighted assets. In other words, it was the direct consequence of creating the impression that bank supervisors had everything under control that enabled banks to live more and more dangerously, with progressively less capital relative to their assets.
I think there was an additional factor at play creating a dangerous environment prior to the GFC, and that was China’s policy of holding its currency at an artificially low exchange rate for a number of years. This had the beneficial effect from China’s point of view of leading to a huge increase in Chinese exports, thus helping to employ the tens of millions of people who left the countryside for higher incomes in Chinese cities. From the American point of view, this avalanche of inexpensive imports from China helped to keep inflation low in the US, justifying low central bank interest rates, while the huge increase in Chinese foreign exchange reserves, largely invested in US Treasury bonds, kept US long-term interest rates low as well. Low US interest rates undoubtedly contributed to the bubble in US property prices which bankers were only too happy to encourage.
Given the widespread public view that the GFC was a result of irresponsible bankers and insufficiently stringent regulation of the banking sector, the risk we face now is a further intensification of banking regulation. We’ve certainly seen a marked increase in the regulation of banks in New Zealand in recent years. In a 2012 paper, two Bank of England economists warned about the grave risk in the increasing complexity of bank regulation:
The single most important legislative response to the Great Depression was the Glass-Steagall Act of 1933… It ran to a mere 37 pages.
The legislative response to this time’s crisis, culminating in the Dodd-Frank Act of 2010, could not have been more different. On its own, the Act runs to 848 pages… [But] that is just the starting point. For implementation, Dodd-Frank requires an additional almost 400 pieces of detailed rule-making by a variety of US regulatory agencies. As of July [2012], two years after the enactment of Dodd-Frank, a third of the required rules had been finalised. Those completed have added a further 8,843 pages to the rulebook. At this rate, once completed Dodd-Frank could comprise 30,000 pages of rulemaking.
In 1980, there was one UK regulator for roughly every 11,000 people employed in the UK financial sector. By 2011, there was one regulator for every 300 people employed in finance.[2]
It is not at all clear to me that more and more intensive regulation of banks will actually reduce the risk of the next financial crisis. Indeed, by creating the perception that banks are riskless, intensive regulation may actually increase the likelihood of the next crisis.
Copyright © 2024 Don Brash.