I do not believe we are on the edge of another financial implosion. New rules which require banks to hold more capital; more vigilant regulators; reforms to the bonus system; and swingeing corporate fines and misconduct costs – more than £60 million for the top three British banks alone – should see to that. But what has not changed is a fundamental belief that it’s okay to have banks bigger than the economy that they serve and that it’s okay for banks to lend out much more capital than they have. Add to that a lack of contrition and an enduring sense of self-belief from the bankers themselves and you have a recipe for the next disaster.
Before we unpack this, let’s remind ourselves what happened 10 years ago. Gordon Brown had taken over as Prime Minister in June 2007 after a decade as Chancellor of the Exchequer. The economic cycle had apparently been conquered, the British economy was outperforming international competitors and the City was a poster child. “Britain needs more of the vigour, ingenuity and aspiration that you already demonstrate,” Brown told an audience of bankers in one of his last speeches as Chancellor.
A decade of austerity has followed. It is the defining story of our age, a spectacular and disastrous unwinding of the Great Moderation and a debunking of economic theory. It must never happen again – but history tells us that, of course, it will
These were the years – the final years, if we had but known it – of the Great Moderation, a period of steady growth, low inflation and rising real wages. There was a consensus amongst global policy makers that the ‘boom and bust’ economic cycle had been tamed.
But having waited so long for the prize, no sooner had Brown become Prime Minister than the rock on which his reputation was built crumbled. Northern Rock, which collapsed in September 2007, was not just a badly run bank, it was symptomatic of a deeply flawed financial system that was, in fact, every bit as unstable as its predecessors. Even so, commentators and politicians were slow to pick this up.
Like all modern banks, Northern Rock practised a type of banking known as ‘originate and distribute’. Whereas old-school banks lent out only the money they took as deposits, ‘originate and distribute’ involved borrowing money short-term from other financial institutions and then lending it out long-term. That was never a problem while confidence was high in the 2000s, as the banks which originated the loans did not hold them for long. They sold them on using a technique known as ‘securitisation’ which involved parcelling up thousands of loans, putting them all into a separate entity and then selling shares in that entity to investors.
With global interest rates low and investors eager for income, financiers looked for debt to securitise. They alighted on the US housing market. In the late 1990s and 2000s, commission-hungry real estate brokers waived requirements for borrowers to show an earnings history or even to have a job. Home ownership soared and mortgage-based securities became every investors’ go-to product. Between 2000 and 2005, sub-prime mortgages in the US grew from $130 billion to $625 billion as millions of Americans became first-time home owners. Apparently armour-plated from risk and desperate to get income in a low interest world, investors gobbled up slices of US mortgage debt that the investment banks fed them and the technique of securitisation became the driving force of the global economy.
A new generation now sits at the top of the leading banks but they are of the same provenance as their predecessors, self-confidently proclaiming shareholder value above all other objectives
Back in Britain, Northern Rock and other banks used the technique to offload the loans they made to homeowners and recycled the proceeds as new loans. In Britain, lending standards remained under control but leverage – lending borrowed money – did not. In 2000, the British banks lent out about the same amount as they took in deposits; by 2007, loans exceeded savings by £500 billion. The big banks were borrowing more than 20 times their capital base; a five per cent fall in asset prices would wipe them out.
That fall began in the US in 2005. Sub-prime borrowers in the US could not repay the interest on their new mortgages and house prices collapsed. In 2007, banks began writing off the loans they had unwisely made, fund managers marked down the value of mortgage-based assets, some funds closed and banks became wary of lending to each other. Markets thrive on confidence and trust and when that disappeared in the summer of 2007, Northern Rock could not fund its business. The Bank of England stepped in, Chancellor Alistair Darling guaranteed customer deposits, and although Northern Rock itself had to be nationalised, the immediate panic was over.
But in September 2008, the US investment bank Lehman fell and the causes were just as already outlined: over-leverage on a thin capital base and over-confidence in the alchemy of financial engineering. The US authorities allowed it to go under on September 15, setting off a domino effect that would see a whole series of US financial institutions bailed out by their government and the part nationalisation in the UK of RBS and Lloyds.
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A decade of austerity has followed. It is the defining story of our age, a spectacular and disastrous unwinding of the Great Moderation and a debunking of economic theory. It must never happen again – but history tells us that, of course, it will.
What has been done since the crash of 2008 to make the world a financially safer place?
International banking regulators, including the Bank of England, have certainly imposed tougher rules on the banks. In the UK, the amount of capital they have to hold has trebled. Leverage levels are much reduced. Regulators require the banks to run stress tests to model their performance in nasty scenarios such as stock market and housing crashes.
The top three British banks have combined balance sheets that exceed the size of the national economy. The buffer is big, but is it enough?
Starting from January 2019, banks in the UK will have to separate their retail banking businesses from the riskier investment banking operations. ‘Take the money and run’ bonus payments, which were incentives to reckless risk-taking, have been phased out in favour of deferred payments that can be clawed back in the event of problems emerging. Banks are required to have ‘living wills’, detailed plans for how to wind themselves down in the event of a crisis.
All of these things reduce the risk of another imminent crisis and improve our chances of containing the damage, if one occurs. But although the banks themselves are safer now, the banking model they operate is merely a mildly-reformed version of what went on before, heavily reliant on vigilant regulation and responsible management. Neither should be taken for granted.
The UK financial services sector is 10 times the size of GDP and set to double in size, according to Bank of England Governor Mark Carney. The top three British banks have combined balance sheets that exceed the size of the national economy. The buffer is big, but is it enough? Not according to Sir John Vickers, the distinguished economist who chaired the government’s 2010 commission on banking and who challenges the Bank of England’s view that the banks are adequately capitalised. The fact is that a sector so large and so dependent on borrowed money can never be safe and the authorities must remain sceptical. Therein lies the danger.
The sector’s economic importance – financial services accounts for more than six per cent of UK national output, provides more than a million jobs and contributes 11 per cent of tax receipts – gives it a hold over government. In the US, which sets the tone for global banking, the powerfulindustry lobby is pressing hard for the rollback of post-crisis regulation. The deregulatory Trump administration looks ready to listen. Look out for further easing of the capital requirements placed on US banks and watering down of the so-called ‘Volcker Rule’ which, in a fit of post-crisis reforming zeal, banned banks from trading the markets for profit on their own account. Do not be surprised if the British banking lobby is equally successful in reversing post-crisis regulation, especially if it is a loser under Brexit.
That danger is particularly severe because, despite the failure of free market economics, competing theories have yet to get traction. A new generation now sits at the top of the leading banks but they are of the same provenance as their predecessors, self-confidently proclaiming shareholder value above all other objectives.
There is no pushback from government. Protest votes – Brexit, Trump, Europe – produce unexpected results, dispersed over a wide political spectrum but the market model remains unchallenged. Until that changes, I, for one, am going to stay on my guard.
The Bank That Lived a Little:Barclays in the Age of the Very Free Market by Philip Augar is out now