Gold Investor, February 2019

What caused the Great Financial Crisis (GFC) of 2007– 2009? Many fingers have been pointed at the global banking system, which had got out of control, and failures in regulation. That is true to a large extent, but in my view the root causes go much deeper and are to be found in well-meaning, but ultimately misguided, policy actions by various authorities around the world.

The United States is often considered to be the home of free markets, but there is a surprising degree of intervention by the authorities, some of which can be market distorting. The Community Reinvestment Act 1977, for example, encouraged – and in some cases directed – the US financial system to lend money to people in poor districts. Subprime lending took that encouragement to extremes – arranging mortgages for people who could not really afford them, but who could gain enough equity in their homes to support their loans, as long as house prices continued to rise. And after all, house prices had historically never fallen across the whole of the US, had they? So there was no real risk, was there?

Also relevant was the contribution of the US Federal Housing Agency and related bodies, such as Fannie Mae and Freddie Mac. Although not formally supposed to be financially backstopped by the authorities, the market traded these bodies’ debt as if they were – an assumption which proved to be justified in September 2008, when Fannie Mae and Freddie Mac were taken into official ‘conservatorship.’ These institutions did not create subprime assets but, with cheap funding sources, they were able to buy up ‘conforming’ mortgages, and effectively make mortgages cheaper and more accessible than market forces alone would warrant, helping to increase home ownership and house prices.

The United States is often considered to be the home of free markets, but there is a surprising degree of intervention by the authorities, some of which can be market distorting.

US imports

Meanwhile in Asia, many authorities had been burned by their own crises in 1997, which witnessed massive outflows of foreign capital and (to them) unpalatable remedies prescribed by the International Monetary Fund. Such countries adopted a new economic model of being export led, with exchange rates either linked to, or generally suppressed against, the US dollar to help make their exports more competitive.

Low US short-term interest rates were thus imported around the world. And with high savings needs in Asia, especially by the ageing populations of China and Japan, and a shortage of real-economy investment opportunities elsewhere, the result was low real interest rates globally.

The various consequences of that strategy choice in Asia have been huge: large trade surpluses in the region, with the (arithmetic) corollary of exporting capital, in some cases to richer economies, in a complete reversal of the usual model of economic development (Chart 2). Those capital flows out of Asia helped to fund a huge current account deficit in the US (6% of GDP in 2006) – and collectively they helped fund the issuance of dollar financial assets, including those backed by US mortgage loans, especially subprime.

Prior to 2007, the financial system appeared to be in robust health. But when things are going well and risks are not crystallising, it is human nature to relax – which of coursehelps cause an unexpected crisis. Modern methods of risk management went badly astray, partly from extrapolating the low volatility observed in markets or simply from misestimating tail risks. Financial regulation looks to have been asleep at the wheel: many regulators thought that new financial instruments had successfully dispersed risk around the system. But the largest intermediaries were holding too little liquidity and capital. Furthermore, of these, a number seemed to be run by charismatic and egocentric chief executives seeking to drive up returns competitively.

Financial regulation looks to have been asleep at the wheel: many regulators thought that new financial instruments had successfully dispersed risk around the system.

Liquidity regulations were generally weak and were not always applied. The risk-weighted Basel system of capital weights relying on internal models was being quietly exploited by some banks to minimise capital requirements. Also, many of the capital-raising securities that were issued to meet those requirements turned out not to be loss absorbing.

All-round failure

It is easy to blame the regulators but it is noticeable that banks in many different regulatory regimes failed, despite big differences in national approaches: intrusive vs nonintrusive; dynamic vs static provisioning; principles-based vs rules-based. The dominos all toppled regardless. Interestingly, the most prominent developed economies where banks did not crash seemed to be commodity producers such as Australia, Norway and, to some extent, Canada.

In Europe, subtle forces were at work. In searching for yield, European investors were buying US assets, especially securitisations based on subprime mortgages with misleadingly high credit ratings. One of the first firms to fail because of this was Germany’s IKB DeutscheIndustriebank, back in July 2007. When the subprime assets it was responsible for turned out to be far riskier than the bank had realised, IKB was sunk. But the issues went much deeper than a misjudgement of credit risk.

Many European investors were holding dollar-denominated assets, which required an equal supply of dollar funding. To secure that funding, European banks and related financial institutions were selling large quantities of shortterm, dollar-denominated paper to US money market funds (MMFs). According to a BIS estimate,¹ in mid-2008, European banks relied on US MMFs for around US$1 trillion of funding – an eighth of their total dollar funding needs. And for US MMFs, over 40% of their assets were those same debt instruments of European banks. For the banks this was a classic borrow short, lend long strategy, backed by as little capital as investors could get away with, and with assets sometimes held in special purpose vehicles of various types (such as IKB’s conduit, Rhineland Funding, which was the cause of its problems).

Moving on

Considerable progress has been made since the GFC. The capital regime for banks has been significantly strengthened and a new liquidity regime is in place. Banks are now subject to coordinated stress tests in the US, Europe and the UK.

In the UK we went further, restructuring the entire regulatory system, creating a new Financial Policy Committee, and establishing a ‘twin peaks’ regulatory model of separate prudential and conduct regulators (the Prudential Regulation Authority and Financial Conduct Authority) to correct a mistake in the architecture dating back to the 1990s. The Bank of England has created a new set of wide-ranging liquidity-support operations. The UK has also introduced a new Senior Managers Regime to make sure that senior bankers take their responsibilities seriously (and can be held to account for their actions if not).

Will all these changes be enough? Probably not. The financial sector is good at lobbying, chipping away at the various measures that have been put in place. We still don’t have all the answers for banks operating globally, with foreign currency needs that can’t be met directly by the local central bank. And many regulators are worried about their banking system being dominated by branches run from other countries – a particular problem now being highlighted within the EU.

There will be another crisis – most likely when the generation that dealt with the GFC have all retired. The banking system should be more robust to the kinds of shocks we experienced in 2007–2008. But financial crises never repeat themselves exactly. The next crisis could come from a completely different source: cyber hacking perhaps, or maybe disintermediation of the banking system by new technology companies. Or perhaps from climate change, which could wreck the whole of the global economy, not just the financial system. Nevertheless, it is important that we remember and record the root causes of the GFC so that those who deal with the next crisis are better informed and better prepared.

When US MMFs started to appreciate the doubtful credit position of European banks, they bought much less of their debt – leaving those banks both with a credit headache in their assets and desperately short of dollar funding in their liabilities, at the same time and at relatively short notice. Dollars also became expensive or dried up in other funding markets. In fact, most public bank funding markets in Europe closed partially or completely as no one firm could be sure who was at risk of failure.

Spare me a dime

In 2008, I was the Head of the Foreign Exchange Division at the Bank of England (and Markets Director from March 2009). Until September 2008 we had not seen any significant shortage of dollar funding in London. The European Central Bank (ECB) had seen such pressures earlier and had started to lend dollars to European banks in December 2007.

On 15 September 2008, Lehman Brothers filed for bankruptcy. Then AIG went bust, the Reserve Primary Fund broke the buck and the financial system broke comprehensively. Banks in Europe became desperate for dollars. Overnight dollar interest rates in Europe became extremely volatile – soaring to over 10% in the morning when no one had spare dollars to lend and then crashing down to near zero in the afternoon, once the Fed was open.

Within a week, the central banks of the then five major global currencies (the Fed, ECB, Bank of England, Bank of Japan and Swiss National Bank) were undertaking new operations, borrowing dollars from the Fed and lending them overnight, every night, in an operation which was as much about US monetary stability as anything else. But it quickly became clear that the underlying problems were European, structural and long-lasting. We got as high as lending US$86 billion in total in London. By late 2009, the dollar shortage had abated in London, although by that time some of the most famous names in global banking had failed, as well as some lesser-known entities.

The structural issue of continental European demand for dollar funding took longer to ease and is still not completely resolved. It remains evident in several places, including the cost of swapping euros for dollars in foreign exchange markets – the so-called basis swap – and in the ECB dollar lending operations which are still drawn upon occasionally, particularly at year-end or other reporting dates.

There will be another crisis – most likely when the generation that dealt with the GFC have all retired. The banking system should be more robust. But financial crises never repeat themselves exactly.