The Global Financial Crisis: Lessons Learned from History.

Until the early 1980’s, finance was sticking to an ‘originate and hold’ model. Due to a small and lumpy market, America’s government-sponsored mortgage giants started the process of securitisation, in which mortgages, credit card receivables and other financial assets were transformed into more marketable securities. In order to maximize profits, banks decided to switch to a ‘originate and  distribute’ model, which spawned a range of structured products that promised huge gains at a cost that was only becoming clear when the loans  grew to unsustainable levels and borrowers started to default in the lead up to the GFC. As a result the causes of the GFC need to be analysed in the light of this ‘new model’, its hidden features during the credit bubble, as well as its advantages and deficiencies.

Generally, financial innovation can be good as it reduces the cost of borrowing for all consumers, giving everyone more investment choices, and thus facilitating economic growth. Its three most important deficiencies, however, were its complexity and confusion, a fragmentation of responsibility and the gaming of the regulatory financial system.

Both the GFC and the Great Depression led to widespread losses to market participants and lenders, a great loss of confidence into financial markets and among market participants, bank failures, frozen credit markets, and a sharp overall decline in consumption and investment.

The financial response to the Great Depression differed dramatically to that of the GFC.  Franklin D. Roosevelt remarked famously at his inauguration during a bank panic in 1933:

     “The only thing we have to fear is fear itself.”

The newly elected Roosevelt administration responded to the crisis with the New Deal Legislation that was defined by the idea of revamping of the financial system in order to regain investors’ confidence. By passing the Emergency Banking Act, Roosevelt increased Americans confidence in the banks, and the subsequent Glass-Steagall Act banned improper banking activity by restricting overzealous commercial banks from participating in non-bank activities. As part of the extension of the regulatory framework, they also created the Federal Deposit Insurance Corporation. This removed the problem of bank runs. 

In summary, the Roosevelt administration was trying to redesign the U.S. financial system with the following three objectives in mind:

1. to inhibit similar excesses as seen in the 1920s;
2. to reduce the likelihood of a future systematic crisis; and
3. to create a financial system that supports economic growth, and controls speculation.

Turning now to the response to the GFC, the current system of regulations evolved out of the 1929 crash and the 1930s depression. The financial and economic environment, however, changed completely as driven by three main factors: globalization, technology and complexity. 

There have been two key deregulation events in the US that shaped the decade for the GFC and arguably set the stage for it.

Firstly, there were the Reigle-Neil Branching Laws of 1993. This law allowed interstate banking and branching across state borders. It was aimed at increasing bank efficiency, economies of scale and improved bank access to growth areas. This act also allowed banks to take on unlimited deposits.

Secondly, the Gramm-Leach-Bliley Act 1999 repealed the Glass-Steagall Act allowing banks to form Financial Holding companies (FHCs). The result was a conflict of interest between security analysis and lending.

Other legislation such as The Community Reinvestment Act 1977 encouraged lending to urban areas that were considered to be of sub-optimal credit quality making use of innovative products that resulted in lower lending standards in the form of securitised loans.

Last but not least Credit Rating Agencies such as Moody’s and Standard and Poor evaluated these pools of securitised mortgages. The process called rating shopping encouraged the rating agencies to rate the securities higher for fear of lost income. Later it has been suggested that one key failure was that the securitisers paid the rating agencies.

In summary, as it is often the case with financial crises, many of the underlying drivers that led to the GFC arose from responses to previous crisis. While the GFC and the Great Depression share some similarities, their main differences stem from the complexities of globalisation and newly introduced legislation as a response to previous crises.

The Asian Financial Crisis (AFC) of 1997-1998 and Basel II

The AFC is said to be a fundamental cause of the global financial crisis as Asian countries and other emerging market countries in the aftermath of the AFC decided to follow an export-led growth strategy which entailed investment and consumption of undervalued currencies and the accumulation of foreign exchange reserves (FER). 

Export led growth opportunities were primarily seen in the US as investment of high amounts of FER kept US interest rates at very low levels and thus supported consumer lending.

Basel II was another legislation that was a result of the Asian financial crisis, which provided significant incentives to the excessive behaviour of banks that took place in the final years preceding GFC. The following changes introduced by Basel II were the main underlying causes for the GFC. It entailed higher emphasis on quantitative risk modelling, reliance on credit ratings, and the regulatory recognition of credit risk mitigation techniques. 

A contemporary view and future outlook as envisioned by Robert Shiller

Yale Professor Robert Shiller knows that history of finance is the history of bubbles. In his current book titled ‘Irrational Exuberance’, Shiller studied the GFC with a special focus on the U.S. stock market. In order to do this, he examined historical data.

Shiller believes that every speculative bubble coexisted with a widespread consensus that high valuations were a result of the market’s special conditions. It was popular consensus rather than a specific event or news releases that seem to have led every large market correction. Shiller argues that bear and bull markets grew beyond their means in a quite irrational manner. As a result, he challenges the efficient market theory by utilising a historical analysis of price-earnings ratios and dividends.

He concludes that the current U.S stock market fulfils all criteria of a speculative bubble of the past and as such is in need of correction.

Summary

To conclude, the events of past crises have highlighted many causes underlying the GFC in both private sector risk management and the public sector’s control mechanisms of the financial system. Clearly, the design and evolution of the US regulatory system combined with the financial industry’s mindset from Wall Street exercising a greedy and purely profit maximizing behaviour were the main drivers.

This article showed that many of the underlying factors leading to the GFC arose from responses to previous crises.  It does not only leave us with the question of whether the United States of America will eventually be utilising the crisis as an opportunity to restructure the entire banking industry in order to prevent new financial crisis to occur in years to come, it also asks the question if the U.S  can find a way out of the crisis that does not lay the foundation of new one. A more regulated environment such as the one that would be created through the implementation of the ‘Volcker Rule’, which is currently under review by U.S regulators, and which would curb speculators seems to be a first step into the right direction.

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