Fifteen Eighty Four

One issue which needs to be eliminated from the table straight away is the sovereign budget and debt crisis. Politicians needing to shift the blame for their own errors are purposely confusing causes and effects, the old “post hoc ergo propter hoc” argument being used to good effect. Certainly, the current global debt crisis exploded after the financial crisis, but it was not caused by it. This may have been the case in a very few number of countries, where the financial sector had been allowed by politicians, by supervisors and by the central bank to grow to several multiples of GDP (Iceland, Ireland, Latvia, perhaps the U.K.) but it was not a general phenomenon. Remember that U.S. banks have already repaid every cent that they received from the government (through the TARP program), and with a good return on the taxpayers’ money. Recall as well that some countries now facing severe budgetary problems did not experience a financial crisis in recent years, such as Italy and France.

The budget crisis did not originate with profligate bankers but with profligate politicians. It started already back in the 1970’s, when many countries tried to compensate the loss of purchasing power induced by quadrupled oil prices with increased domestic demand. The consequences for inflation and for the public purse were disastrous. The advanced countries in this world have not run a budget surplus since; consequently, their debt levels have, on average, risen from some 40 per cent of the Gross Domestic Product in 1975 to over 100 per cent and risk rising even further unless drastic resolutions are implemented. This leads to our first lesson: Fixing the debt crisis is imperative but it has little to do with past or future financial crises.

Fixing what went wrong the last time in the financial sector is encumbered by an unholy coalition of bankers and conservative politicians in the U.S. and elsewhere, who have succeeded in blocking most of the changes necessary to prevent yet another financial crisis that may turn out to be just as virulent. Overall, actions actually taken have been directed at popular causes such as hedge and private equity funds or executive pay, but in reality, neither caused the recent crisis in any way. Rather, they serve as convenient scapegoats.

Some steps have indeed been taken in the right direction. Capital adequacy requirements have been raised and the quality of capital improved. However, the required ratio of equity to risk-adjusted assets is still way too low except in a few countries bold enough to go their own way (Switzerland, Sweden and maybe the U.K.).The leverage multiple (total assets over capital) is finally being restricted in Europe, although the maximum should have been set at 20 (as in the U.S.) rather than 33. In the recent crisis, some major European banks (UBS, Deutsche Bank) had assets over 70 times their capital base! Liquidity requirements will (hopefully) be implemented, although banks are screaming bloody murder. Better information and better analysis of information will perhaps result with the European Systemic Risk Board and its U.S. counterpart, the Financial Stability Oversight Council. An independent and strong U.S. Consumer Financial Protection Bureau might make a difference in the next crisis.

Yet, virtually nothing is being done about the major problem – the “too-big-to-fail”- syndrome in financial as well as non-financial institutions. Concentration in banking is rising in most countries, especially in the U.S. Capital ratios are still set at levels too low to enable banks to survive a major crisis on their own. Even worse is the fact that the Dodd-Frank Act has shifted some of the banks’ most risky business such as proprietary trading onto the “shadow banking system”, where it is much more difficult to spot, evaluate, supervise and regulate. On top of this comes the incentive aspect. All of this results in the second major lesson from the crash: Bailing out GM, Chrysler and the professional counterparties of AIG’s derivative business will probably be seen as one of the major mistakes of government intervention in the past crisis. In the future, similar business organizations will think – rightly or wrongly – that the government is always able and willing to provide any amount of help they might require.

Finally, will we be able to spot where the next crisis is going to hit? Apart from a few professional pessimists, nobody saw the last crisis coming. It was obvious that the housing market in some countries, mostly Anglo-Saxon, were in need of a significant correction. What we did not know was that the risks involved had in many cases been shifted by derivative instruments such as CDO’s (Collateralized Debt Obligations) and CDS’s (Credit Default Swaps) to countries such as Germany which in itself had had no house-price hysteria. However, that this would lead to a situation where banks globally would lose over half of their initial capital base was not obvious. Ultimately, will the next crisis be easier to predict? Can we spot where the new risks are? If we have learnt anything from the recent crash, the answer is: most probably not.