The rally in global banking stocks is underpinned by expectations that the new US administration will reduce the new regulations imposed in the wake of the 2008/2009 financial crisis. However, the dangers posed by a large financial sector have, in fact, not gone away. In the US and globally, the combination of too big to fail plus a relaxation in measures designed to modest reduce financial sector make be laying the foundation for another financial crisis.
In the lead up to 2008, parallel to increasing debt levels, the size of banks rose sharply, especially relative to the size of certain economies. By 2007, bank assets in many developed countries had reached in excess of 100 per cent of gross domestic product (“GDP”).
In 2007, bank assets in the US were around 78 per cent of GDP. In Japan it was around 160 per cent. In Germany, it was around 270 per cent. In Italy and Spain, it was 213 per cent and 269 per cent respectively. Ireland’s bank assets were over 700 per cent of GDP. Iceland’s bank assets were nearly 900 per cent of GDP. Bank assets to GDO was over 500 per cent in the UK and over 600 per cent in Switzerland, reflecting in part the role of these nations as major financial centres channelling capital flows between third countries.
The banks feed domestic credit, financing asset purchases, investment and consumption as well as cross border lending. As banking became more international, cross border capital flows peaked in 2007 at around US$ 12 trillion, a rise from US$500 billion in 1980 reflecting an annual increase of around 12 per cent.
In the US, at its peak, the finance industry generated 40 per cent of corporate profits and represented 30 per cent of the market value of stocks.
A large banking system is not necessarily problematic. For example, in the UK, reflecting the status of London as a major global financial centre, financial services contribute significantly to economic activity. Financial and insurance services contributed £125.4 billion in gross value added (GVA) to the UK economy or 9.4 per cent of the UK’s total GVA, around 46 per cent from London alone. Trade in financial services contributes significantly to the UK’s trade surplus in services. The sector’s provides 3.6 per cent of UK jobs is around 3.6 per cent and contributed £21.0 billion to UK tax receipts in 2010-11.
But a large banking system creates a number of issues.
First, the role of banks expands beyond support for the real economy, facilitating payments, capital formation and deployment and risk transfer. Economic activity becomes inordinately dependent on trading financial instruments and channelling rapid capital movements, which are largely zero-sum games or relatively low economic value-added functions.
Second, the commercial drive for growth and higher profitability leads to increased risk taking. For example, the need to grow loan volumes may require lowering lending standards or taking other risks. This is what happened in the led up to the 2008 financial crisis, exemplified by the sub-prime loans in the US.
Third, there are complex linkages between banks and financial entities, both within countries and internationally, reflecting the mobility of capital and cross-border transactions. In 2008, the dangers of these connections were exposed as the globalised financial system's intricate linkages became a conduit for transmitting contagion. It led to a sharp fall in cross-border capital flows, which remain well below the pre-crisis levels.
Fourth, frequently (untested) financial innovations create new risks, both for individual institution and systemically. It also allows rent seeking by banks and financiers, who exploit the asymmetry of information between sellers and buyers of complex products. It also creates control issues as managers, directors and regulators are unable to keep up with new developments. During the 2007/ 2008 crisis, the problems of higher risk mortgages, CDOs and the shadow banking system populated by off-balance sheet vehicles illustrate these risks.
Fifth, the identified problems are amplified by the leverage of financial firms. In the last 20 years, capital ratios and liquidity reserves of banks have fallen sharply. Leverage is increasingly used to drive higher and more volatile returns on equity. During the GFC, the high leverage, both on and off-balance sheet, accentuated the problems.
Sixth, the increase in size of the banking system, risk and complexity is implicitly underwritten by the state, a fact which is recognised by rating agencies. It typically takes the form of deposit insurance, liquidity insurance and implied capital support. Given the central role of banks in payments and credit provisions, it is difficult for governments to allow banks to fail.
The Bank of England’s Andrew Haldane wrote about “a progressive rise in banking risk and an accompanying widening and deepening of the state safety net”. He referred to this as the “Red Queen’s race”, where the system is running to stand still with governments racing to make finance safer whilst bankers creating more risk.
Following the crisis, governments in the US, UK, Ireland and Europe were forced to step in and support their banks. Many other governments indirectly supported their banks by increasing the scope of deposit guarantees.
In the years since, banks have not grown smaller, with size and concentration increasing.
In the US, since the crisis, the six largest US banks now control nearly 70 per cent of all the assets in the US financial system, having increased around 40 per cent (against overall asset growth of only 8 per cent). JP Morgan, the largest US bank, has over $2.4 trillion in assets, larger than most countries.
The growth and increased concentration is the result of forced consolidation (‘shotgun’ mergers) and the effect of new capital and liquidity regulations which favour larger banks. A flight to the perceived safety of TBTF (Too Big Too Fail) banks combined with contraction of alternative funding sources, such as securitisation, has reduced competition from smaller entities. Governments and regulators have also favoured larger banks which are national champions which are internationally competitive and theoretically easier to regulate.
The increased importance of banks also reflects their role in now financing beleaguered states by increasing their holding of government bonds, often financed by the central banks. Italian, Spanish and German banks now hold around 24 per cent (over Euro 400 billion) of all government bonds, 41 per cent (around Euro 300 billion) and 15 per cent (around Euro 240 billion).
The banking system has also gained from such policies such as quantitative easing (“QE”). Liquidity fuelled asset price rises has also encouraged a return of dubious banking practices.
In a 2013 study McKinsey found that in the US between 2007 and 2012, lower interest rates resulted in a net transfer from households, pension funds, insurers and foreign investors to the government, non-financial business and banks of around US$1.36 trillion. The benefit to US banks was around $150 billion from an increase in effective net interest margins and a cumulative increase in net interest income.
In Europe and the UK, loose monetary policy and low rates benefited governments and non-financial business but banks lost through lower net interest income. Banks also lost as a result of having to shed assets and buy government bonds, which made them even more dependent on governments.
The confluence of government support (which protects depositors and creditors), limited liability (which protects shareholders), profit maximisation and incentive pay for financiers encourages a culture of “rational carelessness”. Rather than dismantle the financial doomsday machine, governments and regulators have perpetuated a large financial system, which increases the risks for the economy in the future. In June 2013, then Bank of England governor Sir Mervyn King stated that: “It is not in our national interest to have banks that are too big to fail, too big to jail, or simply too big.”
Approached to provide government aid to a company that claimed it was too big to fail, George Schultz, Secretary of Treasury under President Nixon advised: “get smaller!” Policy makers would do well to heed Schutlz’s advice.
Satyajit Das is a former banker. His latest book is The Age of Stagnation (published internationally as 'A Banquet of Consequences' ). He is also the author of Extreme Money and Traders, Guns & Money.