Think - AT LONDON BUSINESS SCHOOL

A financial crisis foreshadowed

Professor Richard Portes is concerned by warning signs

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David Solomon Chairman and CEO of Goldman Sachs and Jamie Dimon Chairman and CEO of JP Morgan argue that the financial world is “substantially safer” and “fundamentally sounder” than before the financial crisis of 2008. And the Financial Stability Board has declared shadow banking no longer a risk to stability. But the markets think that banks are weak, especially in Europe. The ratio of European banks’ market value to book value is around 0.5 to 0.6 and their return on equity is negligible.

This could be a warning sign of another financial crisis. A crisis, like the 2008 crash, that made the financial sector seize up, required massive taxpayer-funded bailouts, and took large shares of GDP. After 2008, unemployment rose over 10% in the US and 25% in Greece and Spain. Public debt issued by governments, soared from 40% in the UK and US to 80-90% of GDP, where it remains today.

Types


Richard Portes
, Professor of Economics at London Business School, has built a distinguished career studying the causes and consequences of crises, and he is concerned. Although he won’t be drawn on predictions, he has identified three types of crisis.

One is a systemic banking crisis, which is what happened in 2008. It started with Lehman Brothers and spread rapidly, to economies both large and small. As a result Iceland lost a whopping 40% of GDP.

The second is an exchange rate crash. That didn’t quite happen to Sterling after the UK referendum on EU membership. It lost 15% of its value against a basket of currencies. However, when the Indonesian Rupiah lost 75% of its value in 1997, many Indonesian companies with revenue in Rupiah but debt in US Dollars went bust.

The third is a debt default. A sovereign debt default in Greece 2012 saw private sector holders of Greek government debt lose 75% of their value. Italy came close to default in late 2011.

Shadow banks


In an early paper, ‘The Anatomy of a Financial Crisis', Professor Portes explored the links between these types of financial crash. He has also studied shadow banks, a wide range of organisations that take deposits or make loans but aren’t banks. These include anything from asset managers like BlackRock to hedge funds and pension funds. The difference is that they don’t guarantee deposits and there is no lender of last resort, like a central bank, to step in to bail them out. If a shadow bank fails, depositors and creditors are left with nothing.

“There will always be crises. That is the nature of the capitalist system, the forces which make it work, what makes it productive.”

In research with central bank officials, Professor Portes has found that European bank exposure to shadow banking is “huge”, with 60% of that to shadow banks domiciled outside the EU and outside the scope of its regulation and protections.

Origin


A crisis could start from outside or from within and spread through contagion. External risks include political uncertainties like Turkey, Italy, Argentina, Brazil and potentially even China. Trade wars could be a “considerable danger” if Donald Trump were to escalate, says Professor Portes. He is also concerned about cyber security, a risk that is hard to quantify but where attacks could be immensely disruptive in the financial system, with grave consequences for the real economy.

From within financial systems, a crisis can become deeper through a ‘doom loop’ mechanism. Today low interest rates have led to a buildup of debt because it’s cheap to borrow. Corporate debt is at historic highs, creating considerable concern for UK and US officials. Household debt is also high. High sovereign debt could also bring down already weak banks if their exposure to the debt loses value, forcing governments to bail out the banks. This would create more sovereign debt, leading to downgrading of the sovereign debt held by the banks, which in turn makes the bank balance sheets look worse and triggers further bail outs. Each step in turn sends institutions spiraling down.

Low rates have also pushed asset managers, who have historically offered 8% yields on pensions and savings, to look further afield for riskier investments to meet their obligations. This search for yield leads to more risk-taking.

“There is a big bank problem in Europe, some of them are in clear danger.”


Over the past decade, complex financial products, like synthetic Credit Default Obligations, explained by Selena Gomez and Richard Thaler in the film version of Michael Lewis’s The Big Short, have made a comeback.

“There is a lot of speculating out there among hedge funds,” says Professor Portes. “Less so among asset managers like BlackRock, Vanguard or Fidelity but they too are subject to the possibility of runs. If people want some of the $6 trillion of assets that BlackRock manages, that could force asset sales, driving down prices, with negative effects on balance sheets throughout the system.”

Through his work with the EU Non-banking Financial Intermediation Monitor, Professor Portes has found that fully half of shadow bank assets cannot be fully traced or easily categorised, like a security. It is a systemic problem, says Professor Portes.

He maintains that banks in Europe are still weak. Non-performing loans are being kept on balance sheets to avoid the banks from taking a hit. Distressed loan specialists won’t touch some of them. “There is a big bank problem in Europe,” says Professor Portes. “Some of them are in clear danger.”

A new threat


A little understood new threat to financial stability are the central counterparties, according to Professor Portes. After the crisis the authorities insisted that central counterparties take the risk between agreement and implementation.

“So the idea was to put deals through central counter parties. The trouble is these institutions are absolutely enormous. The London Central Clearing House transacts trillions. If one of these institutions failed we would be in big trouble.”

Despite this risk, Professor Portes believes the biggest threat to stability comes from a sudden rise in interest rates, bringing a major repricing of financial assets. Ultimately the risk, however high, is something we must all learn to live with.

“There will always be crises. That is the nature of the capitalist system, the forces which make it work, what makes it productive,” says Professor Portes. “People take risks, they innovate, invest. Some of those risks go bad. If a lot of them go bad at the same time, you have a crisis. Historically, there have been dozens and dozens over the centuries. And they are often very costly. Too much risk-taking, that search for yield, raises the likelihood of a crisis. But the specific mechanisms and when it happens, we can’t predict.”

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