The prime cause of the bust was excess leverage that had built up in the banking system, aided and abetted by some irresponsible activity by banks and lax oversight by the regulatory authorities. Thanks to an unprecedented degree of monetary easing, the fallout from the crisis proved to be far less disruptive than the Great Depression of the 1930s but it nonetheless exposed the limits of the pre-2008 financial system. Despite all the hype suggesting that risk had been tamed, the opposite was true. Instead banks merely learned to hide risk using off-balance sheet vehicles, and when banks ceased to trust each other because they were not sure how much balance sheet risk their counterparties were exposed to, financial markets seized up.
It was evident during the meltdown that the motto of the London Stock Exchange “my word is my bond” counted for nothing. Trust evaporated faster than an ice cube in a heatwave. Whilst banks were clearly the catalyst of the crisis, I hold the view I expressed at the time that the whole episode reflected a systemic collapse in which regulators, central banks, governments and indeed private households all played a part. I was also initially puzzled as to why the authorities allowed Lehman’s to go to the wall when the Fed brokered a deal with JP Morgan after a similar fate befell Bear Stearns in March 2008. I rationalised it by suggesting that having acted as a backstop for the US financial system to that point, the authorities took the view that they could not continue to bail out failed institutions and thereby continue to promote risk taking. Which was fine, but a couple of days later they stepped in to bail out AIG.
It was nonetheless obvious on 15 September 2008, the day markets reopened after the Lehman’s announcement, that the risks to the economy had significantly risen. I noted on the day that “On previous occasions when the US financial industry has suffered major shocks, the authorities have responded by implementing major legislative changes … We might expect a similar legislative backlash in future with any legislation likely to focus on improving the transparency of banks' risk positions.” That proved to be an understatement. The Basel III legislation, unveiled in 2010, was a comprehensive overhaul of the financial sector which changed the way in which banks operated. The first element of this policy required banks to hold much more loss-absorbing capital, with a required minimum capital buffer of 7%-8.5% compared to an effective pre-crisis buffer of 4%. A second element of the legislation focused on enhancing the consistency and comparability of banks’ risk weighted, assets to impose a much greater degree of uniformity thus enhancing transparency.
Although we will never fully know how successful the new legislation proves to be until it is tested in a crisis, regulators’ regular stress tests give grounds for optimism. Balance sheets have changed significantly in the past decade with a higher proportion of the asset base comprised of loans at the expense of trading securities whilst deposits make up a larger share of liabilities. But as the BIS has pointed out, a crucial area of banking resilience is profitability since this determines the extent to which banks can recover from losses. Although much progress has been made to weather-proof bank balance sheets, profitability – particularly in Europe – has not recovered. Admittedly, pre-2008 profit levels may be an inappropriate benchmark given the significant degree of risk required to generate them, but market pricing based on metrics such as price-to-book ratios suggest that investors are not very optimistic with regard to a profit recovery.
From an economic standpoint, economic prosperity is clearly growing more slowly than before the great recession. In the ten years to 2007, UK real household incomes grew at an annual average rate of 3%; over the period 2008 to 2017 the rate slowed to 0.8%. The experience across the euro zone has been similar, with average annual growth of 1.9% in the seven years prior to the crash but 0.2% in the decade thereafter.
A perception that living standards are not improving at the same pace as pre-2008 has resulted in a backlash against globalisation – a view that has been fuelled by the rise of China, which is viewed in some quarters as getting rich at the west’s expense. Rising economic nationalism has placed limits on the EU’s ambition and although the single currency has survived intact, it survived a near-death experience in the wake of the Greek debt crisis and highlighted that a fixed exchange rate system needs much more than a single monetary policy to survive. Arguably, the problems in the EU coupled with a backlash against immigration gave rise to Brexit, whilst mounting concerns about the rise of China was the catalyst for the rise of Trump.
Just as many lessons were learned from the crash of 1929, so economic historians will have a field day with the Lehman’s bust. Perhaps the biggest lesson was that self-regulation does not work. The idea prevailing in the preceding 20 years that aligning incentives would ensure optimal market outcomes proved to be hopelessly naïve (as indeed many of us said all along). Few bankers are fans of the enhanced regulatory regime subsequently introduced but it is a necessary price to pay to ensure that 2008-style outcomes are not repeated. After all, the imposition of Glass-Steagall legislation in the US in 1933 successfully prevented banking crises until after it was repealed in 1999.
But one lesson has remained unlearned. Many believed that the Keynesian policy prescriptions which worked well in the 1930s, coupled with massive monetary easing, would help economies to recover relatively quickly. Although we got the monetary easing, governments have conducted a prolonged period of fiscal austerity after a brief stimulus. The economy has thus struggled to recover and financial markets are less dependent on the economic pickup than on the cheap liquidity provided by central banks. In that respect perhaps we will only know the extent to which we have fully recovered from the crash of 2008 when we see how markets and the economy cope with monetary tightening. The US seems to be doing fine on this front but Europe remains a long way behind.
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