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How Uncontrolled Risk Created the Global Financial Crisis

Author(s):
Erlend Nier, and Gregg Forte
Published Date:
April 2016
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The global financial crisis of 2007–09 brought much of the world economy to its knees.

  • What caused the crisis?
  • What should have prevented the crisis?
  • Why did banking regulation fail in 2007?
  • What were the implications of the return of systemic risk?

What Caused the Crisis?

The financial crisis that began in 2007 brought much of the global economy to its knees and nearly triggered another Great Depression. The financial storm gradually died down in 2009, at least in the United States, but even six years after that, much of the world had yet to fully recover from the enormous economic damage caused by the crisis.

This short essay describes what happened and outlines a new approach to financial regulation—macroprudential policy—that aims to prevent such crises from happening again.

The global financial crisis started in 2007, after house prices in the United States began to move down following years of increases that had been fueled by ever-rising indebtedness. Defaults on home mortgages and on bonds backed by those mortgages began to rise. Investors started to dump these assets, and major banks and other financial institutions—such as Bear Stearns, Lehman Brothers, and AIG—took heavy losses. Financial firms stopped lending to each other, and credit to the rest of the economy gradually dried up, too, aggravating the boom-bust cycle.

The United States wasn’t the only country where financial risk was allowed to get out of hand. A number of other countries—including Iceland, Ireland, Spain, and the United Kingdom—also suffered from homegrown imbalances in their financial systems (see Box 1). Just as it had in the United States, lending in Ireland, Spain, and the United Kingdom helped simultaneously push up both house prices and mortgage debt. With the financial system overexposed to real estate, the eventual drop in real estate prices led to banking crises. In Iceland, foreign investment in banks drove up the exchange rate and fueled consumer borrowing, until the exchange rate collapsed—and the banking system along with it.

In its early days, the global financial crunch looked in some ways like the banking meltdown of the early 1930s, a type of crisis many thought could never happen again. Until it did.

In September 2008 the financial system nearly came to a standstill, inevitably bringing, as in the 1930s, wider economic destruction. The shortage of credit strangled business activity, forcing cutbacks or outright failure for many firms in the real (that is, nonfinancial) economy—construction companies, factories, stores, restaurants, and so on.

Business loans began to go into default along with real estate loans, and bank failures soared. As credit tightened further, millions of private sector workers lost their jobs. Hundreds of thousands of people in the public sector also lost their jobs as tax receipts plunged, forcing layoffs of firefighters, police officers, and teachers and the cancellation of government contracts. The value of cross-border trade plummeted, dragging even more countries into economic recession.

Concerns about the soundness of financial institutions also caused global liquidity and cross-border credit to shrink dramatically. The pattern of upheaval thus spread to many countries along the pathways of global trade and economic activity.

What had gone wrong? In short: systemic risk had returned to the global economy in new and unforeseen ways.

What Should have Prevented the Crisis?

In 1930, as the Great Depression was taking hold, the failure of some banks sparked a wave of runs on other banks. Depositors lost confidence and lined up to withdraw their money, even from banks that were still solvent. This led to a further restriction of credit and caused yet more bank closures. The result was the virtual cessation of lending.

The solution put in place to prevent such bank runs was twofold:

  • Create a system of deposit insurance funded by the banking industry and backed by taxpayers.
  • Regulate banks to keep each one—and the new deposit insurance fund—safe and sound.

The global financial crisis started in 2007, when house prices in the United States began to move down after years of increases that had been fueled by ever-rising indebtedness.

(Chris Strach/KRT/Newscom)

Box 1.Four National Cases of Systemic Risk Unbound

Iceland

In the 1990s, a few Icelandic banks sought to play a more global financial role. They were subject to minimal domestic regulatory oversight and operated as complex financial institutions, combining traditional banking with investment banking and hedge fund trading. Limited by the small deposit base of the home country, the banks began aggressively amassing retail and wholesale deposits from abroad by offering attractive rates. By the time the global financial crisis hit, the assets of Iceland’s banking sector amounted to about 10 times the country’s gross domestic product. According to a 2008 report by a foreign investment bank, Iceland’s banks were characterized by excessive debt underpinned by a highly volatile, opaque interconnectedness with other financial firms. The massive influx of funds during those years drove up the exchange value of Iceland’s currency, thereby sharply increasing the buying power and perceived wealth of its citizens. Local debt soared along with the foreign debt of the banks. (See Jónsson 2009.)

Ireland

Creation of the euro eliminated exchange rate risk between the countries that adopted the new currency and also led to a decrease in nominal and real interest rates. As investors searched for higher yields, Irish credit institutions gained easy access to cheap wholesale funding from abroad. Likewise, foreign institutions could easily expand their operations in Ireland. Foreign banks gained a significant market share in Ireland by lowering their lending standards. Irish banks faced diminishing domestic market share—and as a result, lower share prices and possible takeover—unless they continued to lower their own lending standards and product prices. Housing prices boomed as banks began making mortgage loans with no down payment required, even to risky borrowers. In this highly competitive environment, credit expanded rapidly, lending standards deteriorated, and bank balance sheets became weaker. (Adapted from IMF 2013b.)

Spain

In 1999, when Spain adopted the euro, domestic bank lending there was funded essentially entirely by domestic deposits. By 2008, half of bank lending in Spain was funded by foreign loans to Spanish banks. As in Ireland, global liquidity and the international search for yield combined with the seeming stability of the euro to generate huge inflows of borrowed money. And competition for those funds and for market share fueled a credit boom that was largely focused on residential real estate. (See Aziz and Shin 2013.)

United Kingdom

The run-up to the crisis in the United Kingdom was also characterized by a booming housing market and increases in wholesale funding. Indeed, the provision of credit within the financial system—one bank lending to another—outstripped even the rise in credit to the real economy, thereby creating a dangerous web of exposures between institutions. In addition, the precrisis period was characterized by fierce competition for market share, as well as mergers and takeovers between financial institutions. Funded by debt, rather than equity, such mergers increased both the likelihood and the impact of failure of the new institution. (See Financial Services Authority 2009.)

The regulation of individual banks is known as prudential regulation, although in this context the word “prudential” has a unique meaning. Industrial regulation generally involves protecting companies’ workers and customers through rules designed to keep workers safe from accidents or hazardous conditions and to keep products safe for use by the public.

In contrast, prudential regulation protects the business itself. Thus, prudential regulation ensures that a business follows established standards to protect its own financial soundness and to prevent it from taking excessive risks in search of profit, thereby protecting the deposits in each individual bank.

In the wake of the Great Depression, policies were enacted to protect the banking system by forestalling two types of risk. Prudential regulation was enacted to keep risks or poor management at individual banks—known as idiosyncratic risk—from exposing all banks to the systemic risk of cascading bank failures arising from the collapse of some weak or excessively risky banks.

With a watchful regulatory eye on each bank, any bad luck or bad management would usually be caught in time to allow the struggling bank to take remedial action, or for it—and its deposits—to be taken over by a stronger bank.

A deposit insurance fund is meant to reassure depositors and prevent them from lining up to withdraw their money. The fund would not need to be large enough to cover all insured depositors; it would only need to protect deposits at weak or struggling banks until they could be successfully resolved or taken over by stronger banks. Therefore, taxpayers would not usually have to directly support or rescue the deposit insurance system.

For decades, this two-pronged Depression-era solution—deposit insurance and microprudential supervision of individual banks—worked pretty well in stabilizing the financial sector and the flow of credit to the wider economy. By building public confidence in banks, it stabilized their main sources of funds, which were checking and savings deposits of businesses and individuals (“retail” deposits). By stabilizing individual banks, the regulatory system stabilized overall economic activity because banks were the main source of credit for firms in the rest of the economy.

Why did Banking Regulation Fail in 2007?

Banking regulation was insufficient to protect financial firms from “aggregate” (economywide) shocks, which would hit all banks at the same time. It did not recognize the procyclical (self-reinforcing) feedback between asset prices and credit—each pushing the other up, or down—so it was essentially blind to the dangerous vulnerability of the whole system to a sharp reversal of asset prices. And it did not respond to changes in the structure of the financial system that was generating a growing web of interconnections among banks and nonbank financial institutions. More particularly:

  • A light-touch approach to banking regulation increasingly allowed banks to use their own mathematical models to assess the riskiness of their loans. During the boom, and as prices rose, these models did not capture the risk that asset prices, including house prices and exchange rates, could fall.Instead, with markets calm and asset prices on the rise, the banks’ models pointed to lower risk even as imbalances grew under the surface. Encouraged by the apparent calm in financial markets, financial firms increased their risk profiles by taking on ever higher levels of debt, leaving the system less resilient to the eventual downturn.
  • Prudential regulators did not catch the increased risk to the system.Individual firms looked financially healthy. Also, the debt owed by banks was no longer predominantly in the form of the retail bank deposits that regulators wanted to protect. Instead the debt was increasingly “wholesale funding” from sophisticated investors placing large amounts of money.Regulators believed that wholesale investors would look after their own interests and so did not see the need for interference. Although—as the 2007–09 crisis showed—wholesale funding could be as susceptible to runs as retail deposits, prudential regulation did not detect the increasing fragility of the system.
  • In a number of countries, mortgage credit and the price of houses rose in tandem ahead of the crisis.In this upward phase of the procyclical process, rising house prices allowed borrowers to take out larger loans regardless of their underlying creditworthiness, and the abundant credit in turn helped push up prices even further.Banks increased their volume of mortgage lending, and hence their interest and fee income, by lowering lending standards to reach less-qualified (“subprime”) borrowers. This procyclical process contributed to the rising overexposure of the financial system to a single sector—the real estate market. But the regulatory system did not recognize the potential problem because the focus of regulation was on individual banks, which generally appeared to be doing very well.
  • In a number of countries, including the United States, credit to the economy was increasingly provided by nonbank financial institutions.Nonbanks provide credit but do not issue deposits and were therefore entirely outside the purview of traditional banking regulation. As a result, these “shadow banks” had even weaker defenses against an aggregate shock. And they were funded in wholesale markets to a degree far exceeding even that of banks.
  • Wholesale funding in turn created an intricate web of interconnections among banks and nonbanks.For instance, mutual funds, a type of nonbank, were often the main source of wholesale funding to banks. Nonbank financial firms also include investment banks, finance companies, and providers of insurance on credit instruments (specifically, the providers were sellers of credit default swaps, which would pay off if credit instruments insured by the swap defaulted).Interconnections in the regulatory shadows meant that regulators could not adequately protect the financial system from internal shocks, such as the failure of a dominant financial firm. At the same time, even depository institutions had taken on risks that were no longer closely monitored by prudential regulation. These financial linkages among banks and nonbanks posed new, uncontrolled risks to the credit system.

Customers line up outside a Northern Rock branch to withdraw their money, 2008.

(Jon Enoch/Newscom)

What were the Implications of the Return of Systemic Risk?

By 2007, regulators in advanced economies were no longer covering all the important sources of credit because they were not covering the shadow banks. And they were not covering all the important financial risks, which were instead now supposedly controlled more by the banks themselves and by the discipline imposed by investors. In the 1930s, a bank run involved hordes of depositors lining up at the doors to physically withdraw their money. In the 2000s, a bank run could occur swiftly and pervasively—by means of a series of computer mouse clicks, wholesale lenders could instantly pull their money out of the system simply by declining to roll over their short-term loans.

Uncontrolled systemic risk—risks that threaten the system as a whole—had thus returned to the financial system. Massive systemic risks were lurking and growing beneath the surface of a booming financial sector. Regulation would have to cast a wider net to capture systemwide conditions.

How can a Big-Picture Approach to Prudential Regulation help Contain Systemic Risk?

Regulators need a broader mandate and new tools to detect and contain systemic risks before they grow large enough to be destabilizing. In the wake of the global financial crisis, regulators and experts have been gradually developing and implementing such new policies and the mechanisms to implement them.

The new policies are still prudential—focused on safety and stability—but they are aimed at the systemwide (“macro”) picture, not the firm-level (“micro”) picture. Hence, they are called macroprudential policies, designed to protect the broad financial system and thereby to ensure a stable supply of credit to the real economy.

Governments are taking the new approach by establishing new entities or granting new mandates and powers to existing agencies. Because the problem of systemic risk is global, national policies are being coordinated and supported by international organizations, including the IMF, the Basel Committee on Banking Supervision, and the Financial Stability Board.

What is the Goal of Macroprudential Policy?

The goal of macroprudential policy is to reduce systemic financial risks. Macroprudential policy is designed to counter threats to financial stability in three ways:

  • Strengthen the resilience of the financial system to aggregate shocks. Strengthen the finances of banks (and shadow banks) by increasing the proportion of their assets funded by equity rather than debt, increasing the amount of their liquid assets relative to their cash obligations, and raising the proportion of long-term funding relative to assets.
  • Tame the procyclical interaction between credit and asset prices. Cyclically adjust required levels of equity in financial institutions—pushing them up in good times and letting them decline to cushion losses in bad times—and cyclically adjust loan terms, such as the size of minimum required down payments and debt-to-income ratios.
  • Address risks from interconnections among financial institutions. Limit institutions’ exposures to each other and increase the financial resilience of institutions that are “too interconnected to fail,” thereby limiting taxpayer liability.

Suggestions for further reading

Ouarda Merrouche and Erlend Nier, What Caused the Global Financial Crisis? Evidence on the Driver of Financial Imbalances 1999–2007.

IMF, Key Aspects of Macroprudential Policy.

Highlights

  • In the 1930s, the primary “systemic” risk threatening the financial sector was the spontaneous spread of bank runs, or cascading bank failures. The Depression-era solution was to combine deposit insurance with prudential regulation geared to preventing failures of individual banks.
  • The years leading up to the global financial crisis brought the return of unchecked systemic risk in new forms. Increases in asset prices went hand in hand with an unprecedented increase in credit. Banks were increasingly allowed to judge for themselves how much debt they could safely take on in search of profits. Much of the lending was conducted by shadow banks—financial institutions outside the bank regulatory system but connected to banks.
  • Macroprudential policy—“macro” because its object is the whole financial system rather than individual firms; “prudential” because it employs tools to make the financial system safer—is oriented to addressing the types of systemic weakness that grew in the years preceding the global financial crisis.
  • Macroprudential policy aims to contain systemic risk in three ways: (1) Increasing the resilience of banks and shadow banks to aggregate shocks. This can be done by building up equity and liquidity that can be drawn down in periods of heavy losses and by more closely matching the maturities of assets and liabilities. (2) Counteracting the positive feedback loop between credit and asset prices in the real economy. (3) Limiting interconnectedness and reducing the potential of highly interconnected firms to destabilize the financial system if they reach the point of failure.

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