In the lead-up to the crisis, banks started leveraging themselves up to the hilt. As they sought external funds, their capital became a tiny proportion of their total assets. That was fine when things were going well, but with the credit crunch and the great financial crisis (GFC), the sources of funds dried up.
Banks pretended that risk would go down simply because instruments such as collateralised debt obligations (CDOs) were tradeable. They had blind faith in “the market”. Since then, banks have been prevented from expanding too far and engaging in the sort of folly that meant that firms such as the Royal Bank of Scotland would spend years in the red.
That’s fine as far as it goes – but I’m worried about what will happen in the next downturn. And I firmly believe that there will be another downturn; we are due for contraction any time now.
The credit environment will be different. Regulators are much more aggressive about pushing the banks to offload low-quality debt, which means they will no longer be able to hold loans with companies in trouble, so now we have a new generation of potential players who will be involved in the secondary market for those loans.
That fundamentally changes the environment for companies who are struggling – how are they going to get fixed? We won’t see the results of what we have created until tougher times are upon us.
And when might that be? The huge monetary intervention by central banks means we are supporting things that might otherwise not be so healthy. Remember, central banks are holding 15% of outstanding bonds on their balance sheets – that’s unprecedented. Central banks are providing enormous support to the capital markets.
'I worry that, as a result of low interest rates, some of the fundamental problems that led to the crisis have returned'
Interest rates are so low that problems that would have come to light because of cyclical pressures have been kept at bay. But we haven’t yet tested what would happen under the new regime. We have asked banks for copious notes on what would happen if they hit trouble. But the real test will be when we see an historically indicated increase in signs of distress as well as an increase in interest rates.
My concern is that the next financial crisis will come from that part of the financial services industry that has been allowed to work relatively unsupervised: intermediaries that are now involved in things that in the past would have been in the hands of systemically important national institutions. Some of the capital market intermediaries might get into trouble.
In the meantime, I worry that, as a result of low interest rates, some of the fundamental problems that led to the crisis have returned – it’s just that we haven’t seen the consequences yet.
Look at some of the loans that are currently being granted to corporates. In too many cases, loans are being offered with little documentation and with covenants that aren’t especially onerous. One consequence is an inﬂation in the prices of private equity deals, leading to an increased likelihood that some of those could go sour.
In the wake of the crisis, we cut interest rates to zero and central banks started buying financial instruments. That meant there was too much liquidity looking for limited uses. As a result, we are now in a position where loans are being agreed on too generous terms or without adequate safeguards. That never ends happily.
You give a patient a hard drug and they become addicted. I think reliance on monetary policy may have created dependencies that people did not fully anticipate.
Finally, look at the role of ratings agencies. When the crisis erupted they were understandably castigated for awarding high credit ratings to financial instruments that were clearly risky. Since then, the agencies have tried to become less blatantly ineﬃcient – but it is still the case that they have little incentive to be effective and impartial. They are meant to be guarantors of financial security, but they are competing for the business of the people they are guaranteeing.
Here’s an analogy. Imagine that in the US, instead of a single Food and Drug Administration, there were three of them. A company trying to get approval for a new drug would shop around for the agency that would give the “right” result and say the new formulation was fi ne. So the agency that is prepared to paint the most attractive picture would get the work: there is no incentive for an agency to show rigour and objectivity.
Similarly, we should still be concerned about the financial ratings agencies. They don’t have an incentive to behave in the way we would hope and expect them to.
The financial system is considerably more robust than it was 10 years ago. Banks have built up their capital bases. There is better ring-fencing – both within countries and between countries, so we see ring-fencing that divides retail banking from wholesale banking. And across borders, we have tried to minimise the likely repercussions overseas when something goes awry at home: banks operating outside their home territory have been forced to incorporate overseas operations as subsidiaries with their own capital base rather than simply as branches.
Also, look at the progress that has been made in reducing non-performing loans. In the US, they have come way down. In Europe, there are clearly still problems in some countries, such as Italy, Greece and Cyprus. But in Europe as a whole, some progress has been made.
Worries? Well, there are clearly still vulnerabilities. The involvement of the shadow banking sector – hedge funds, private equity, money market funds and suchlike – has declined somewhat in the US. But that’s not the case in Europe.
And over the past decade, there has been considerable growth in exchange-traded funds (ETFs). We’re not yet sure what effect that could have on markets. The concern stems from the likelihood of herd behaviour: with passive investments such as these, if a shock hits, everyone does the same thing – they all rush for the exit at the same time.
However, even if there is a sell-off in equity markets, I don’t think we need to worry too much about the effect on the economy. Look at history: in virtually all cases where there has been a market crash, the economic effect has been pretty minor.
Of course, that may be true with equities and ETFs. But bonds are a different story because of the relationship between the bond market and interest rates. If, let’s say, we had a crash in the price of US Treasury bonds, that could have a real effect on the economy. Arguably, that’s where the ETF effect could kick in: a substantial decline in US government bond prices could snowball.
One further niggling thought: some insurance companies and pension funds have big problems. If they came to a head, it could affect a lot of people. But there’s not much risk of contagion, so there wouldn’t be a systemic crisis.
Where I disagree with many others is that I don’t believe we are “due” a new recession. The theory is that, after a long period where things have been going well, people start taking unwise risks and build up exposures that make them vulnerable. Stability sows the seeds of instability to come. Well, that story certainly fits the years leading up to the crisis of 2008 and 2009. But I don’t see that the experience proves the theory more generally: it is not inevitable that we are going to have another recession. In both Europe and the US, there have been long periods which have seen some expansion followed by some deceleration – but recessions are mercifully rare. No, in my view the greatest threats are political. It seems that the threat to expansion has receded in Spain – but, unfortunately, not in Italy, where there is a big debt overhang in the public sector and the burden of non-performing loans is still very high. The rest of Europe seems pretty robust, as does the US economy, and I don’t see much likelihood of runaway inﬂation there.
'Even is there is a sell-off in equity markets, I don't think we need to worry too much about the effect on the economy'
China will be fine and India seems to be growing very fast – although its banking system has problems that could come to light in the next couple of years.
Taken in the round, I feel pretty optimistic. We learnt some harsh lessons in 2008-09. Those lessons should mean we avoid a repeat.