June 5, 2017    6 minute read

The 2007 Financial Crisis: Did Banks Learn Their Lesson?

Tougher Regulations?    June 5, 2017    6 minute read

The 2007 Financial Crisis: Did Banks Learn Their Lesson?

The excessive risk-taking culture of banks is often blamed for the 2007-2008 financial crisis. Since it is widely believed that this risk culture that led to the financial crisis has not altered, calls for change in the financial industry are widely heard. Could tighter regulation of bank’s business models and practices help to prevent another crisis?

A Brief History of Financial Crises

During the last 200 years, financial crises had been more common than most people believe. In the first 60 years of the nineteenth century, the world experienced a financial crisis approximately every ten years.

From 1870 onwards, crises occurred less regularly, and there were only four worldwide crises between then and 1970. Also, contrary to popular belief, the financial system has been globally connected from early on. Many of the crises of the nineteenth century were international in scope. For example, the financial crisis of 1873 affected the U.S., Germany, Austria and several emerging economies such as Argentina.

The period from 1945 to 1971 was unusually calm. A growing world economy and the Bretton Woods system led banking crisis to virtually disappear. Under Bretton Woods, governments prevented banks from taking on much risk by either tightly regulating bank’s balance sheets or directly owning them to achieve the same goal. There had been currency crises during that period though. However, these currency crises were mostly the result of poor macroeconomic policy.

After Bretton Woods was abolished and banking regulation loosened, financial crises made their reappearance on the world stage in the early 1970s. For the period from 1970 until 2007 the International Monetary Fund counts a total of 42 systemic banking crises, national and international in scope.

Most articles discussing the 2007 financial crisis devote at least one chapter to the question “Can it happen again?”. From a historical perspective, as depressing as this may sound, the answer most certainly is: yes, it can and it eventually will.

Are Some Banks Prone to Crises?

The historic view shows that financial crises come in cycles and if governments are not willing to return to the tight regulations of the Bretton Woods era – and there are good reasons not go back to those – the next crisis will eventually come.

So, are some banks more prone to crisis than others? This precise question was investigated in a 2013 study published in the Journal of Finance. The authors of the study tested whether a poor stock market performance of a bank during the crisis of 1998 could predict a poor stock market performance during the crisis of 2007.

And the astonishing answer to the question is: yes, some banks are more prone to crisis than others. For each percentage point of loss in a bank’s equity during the 1998 crisis, the same bank lost an annualised 66 basis points during the crisis period from July 2007 to December 2008.

But it does not stop there. The authors also find that banks which performed poorly in 1998 had a 67% higher probability of defaulting during the 2007 crisis than the average bank. Both are sizeable effects, important for investors and regulators alike

Is Excessive Risk Culture to Blame?

An organisational culture of excessive risk taking is often blamed for both the 1998 and the 2007 financial crises. Thus, the question occurs: why are banks not adapting their culture or business models?

Lehman’s CEO – who headed the company both in 1998 and 2007 – is quoted as having said “We learned a tonne in ’98.”, while one Goldman Sachs executive said to “[…] never silenced that desire to do something about the next 1998, […]”.

So, while bank executives claimed to have learned their lesson after the 1998 crash, as they do since 2007, the study’s results indicate the contrary. It seems like banks which performed poorly during 1998 did not learn their lesson and did not adapt their culture regarding risk-taking or their business model to become less prone to crisis and thus performed poorly again in 2007.

Indeed, the author could show that banks which performed poorly in 1998 did not change fundamental aspects of their business strategy in response to the crisis, such as leverage, reliance on short-term funding, or aggressive asset growth.

The conclusion seems obvious. Banks – or at least many of them – are unwilling or unable to learn from their mistakes. The only way to prevent futures crises is to roll back the liberalisation of the financial sector and return to the tight regulations and government control of the Bretton Woods period, an era that was free of banking crisis after all.

Governments on both sides of the Atlantic followed such a conclusion in the aftermath of the 2007-crisis. The Dodd-Frank Act, the Volcker rule, and the Foreign Account Tax Compliance Act (Fatca) in the U.S. And the Mifid II, Emir, Mifir, and Basel III accords in the EU were introduced. Today financial markets are again heavily regulated.

Compared to earlier regulations the Senior Managers Regime, Certification Regime and Conduct Rules are also increasing the individual liability of senior bank managers.

Is Heavy Regulation Really the Best Answer?

The authors of the Journal of Finance study mention two caveats of their results. First, financial crises are necessarily unexpected. Banks which performed poorly in 1998 might indeed have shifted the asset side of their balance sheet towards less risky assets which then unexpectedly turned out to perform poorly in the 2007-crisis.

Second, the authors find that leverage, short-term funding and aggressive asset growth are proxies for a bank’s business model and risk culture but do not fully explain why the poor performance of a bank in the 1998-crisis predicts a poor performance in 2007-crisis.

Hence, a focus on the observable and quantifiable aspects of risk culture might not be sufficient. As Bob Graves, co-chair of Jones Day’s banking practice, said in a 2015 Forbes interview: “[…] regulators are realising that rules alone won’t go all the way in changing individual or institutional behaviour.

Rather, something more fundamental, a change in organisational culture, seems to be necessary”. And such change might slowly be underway as recent reports on changes in risk culture in the financial services sectors indicates.

Elimination of financial crises during the 1945-1971 period also came at a cost. Due to the large extension of regulation and government control financial markets stopped to perform their most important task: allocating investments.

This led to huge inefficiencies which led to calls for deregulation in the first place.  The current surge in regulation already begins to take its toll on the financial services sector. Talent is drawn away from banking towards lesser regulated areas of business. There is a fine line between stabilising the sector and strangling it.

Lastly, another topic is usually omitted from the discussions around financial crises and their prevention: the social benefits of free capital flows. Hence, a more nuanced approached to banking regulation might be the better course for the future.

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