Posts Tagged ‘Global Financial Crisis’

Spotting a Financial Crisis

November 30, 2017 Leave a comment

Below is another great video from PunkFT. Financial crises start with significant increases in asset prices followed by a severe correction and a collapse. But with more debt and more credit the market is unstable and although they have never been higher the yields have never been lower.

Thanks to more and more debt driving yet more and more credit, making everything more and more unstable. Today, for example, markets have never been higher. Yields have never been lower.

The early warning signs
These economic crises are easy to spot and they follow a familiar pattern. The warning signs are:

1. A bank grows very quickly and issues poor quality loans against nominal yields. It uses leverage to do this and fails to be aside reserves for possible future losses.

2. Normally the share price of these banks would plummet but in fact the opposite happens – the share price is driven up. As the bank takes more and more risk to generate more return, the market gets giddy, and they drive up the share price.

3. We don’t learn from our mistakes. The Global Financial Crisis suggests that the economy is following the contours of typical recession but that it is more severe. Subsequently forecasters who have tried to make resemblance to post-war US recessions are “barking up the wrong tree” and are of the belief that conventional tools like expansionary fiscal policy, quantitative easing and bailouts are way to go. The real problem is that the global economy is badly leveraged and there is no quick fix without a transfer of wealth from creditors to debtors. Ken Rogoff (co-author of ‘This Time is Different’) suggests that the ‘Second Great Contraction’ is a more realistic description of the current crisis in the global economy. The “First Great Contraction” was the Great Depression of 1929 but the contraction applies not only to output and employment, as in a normal recession, but to debt and credit, and the deleveraging that typically takes many years to complete.

If everybody else is doing it and getting rich, why, the CEO asked himself, shouldn’t I? The real cause of banking failures and systemic collapse lies with ethics at the top. And human nature tells us that bad ethics drive out good ethics.


PBS: Mervyn King and the future of global finance.

October 18, 2016 Leave a comment

Another good video from Paul Solman of PBS ‘Making Sense of Financial News’.

In his new book, “The End of Alchemy,” Mervyn King still worries that the world banking system hasn’t reformed itself, eight years after its excesses led to collapse. He states that it’s easy with hindsight to look back and say that regulations turned out to be inadequate as mortgage lending was riskier than was thought. Furthermore, you are of the belief that the system works and it takes an event like the GFC to discover that it actually doesn’t.

Paul Solman asks the question that a large part of the problem that caused the GFC was the Bank of England and the US Fed were not able to keep up with the financial innovation that was going on in both of these countries. King refutes this by saying that there were two issues that were prevalent before the GFC:

  1. Low interest rates around the world led to rising asset prices and trading looked very profitable.
  2. Leverage of the banking system rose very sharply – Leverage, meaning the ratio of the bank’s own money to the money it borrows in the form deposits or short-term loans.

Central banks exist to be lenders of last resort. Problem: Too big to fail. And that’s what began happening in England, just like America, in the ’80s and ’90s. There needs to be something much more robust and much more simple to prevent the same problem from happening again. King makes two proposals:

  1. Banks insure themselves against catastrophe by making enough safe, secure loans so they have assets of real value to pledge to the Central Bank if they need a cash infusion in a hurry.
  2. Force the banks to keep enough cash on hand to cover loans gone bad as during the crisis banks didn’t have enough equity finance to absorb losses without defaulting on the loans which banks have taken out, whether from other bits of the financial sector or from you and I as depositors.

He finally states that the Brexit vote doesn’t make any significant difference to the risks facing the global banking system. There were and are significant risks in that system because of the potential fragility of our banks, and because of the state of the world economy.

Chart – Debt before and after GFC

January 18, 2015 Leave a comment

Here is a chart that I use to explain how mainstream economists before the GFC tended to view debt – loss to creditors but gains to debtors = a zero sum game. However this has been shown to be fundamentally wrong since the GFC.

Debt post GFC

Banking culture and cheating.

December 14, 2014 Leave a comment

FX RoomSince 2008 the financial sector has been the target for a lot of criticism especially when you think the sub-prime mortgage crisis, the bailing out of banks and the recent manipulation of interest rates and currency rates. The Journal entitled Nature had an interesting piece of research on the banking culture and how it primes people to cheat

Individual bankers behave honestly — except when they think about their jobs.

A study of investment managers and traders at a major international bank suggests that the financial industry’s culture encourages dishonest behaviour, but that the individuals themselves are not inherently dishonest.

In the latest study, published online by Nature magazine, researchers enlisted the help of 128 employees from a large international bank. At the start of the tests, half the participants were quizzed about their jobs and their company, to prompt them to think of their identity as bank employees. The other half answered questions about their hobbies.

The participants were then asked to toss a coin ten times, unwatched by the researchers, and to report the outcome. They could earn money if they reported flipping more heads than tails — and up to US$200 if they reported flipping all heads or all trails.

The first group reported flipping heads 58.2% of the time — significantly higher than would be expected by chance alone. The control group reported tossing 51.6% heads.

The team tried to replicate the pattern in other groups of people — for example, priming students to think about banking. But they did not see the same effect on the participants’ honesty levels. The results show that this banking-related priming effect seems to be specific to people who work as bank employees, suggesting that the culture of the banking sector is to blame.

Stress Test – not enough to bolster the real economy

November 16, 2014 Leave a comment

Paul Krugman in the ‘New York Review of Books’ wrote a very informative review of Tim Geithner’s book “Stress Test: Reflections on Financial Crises”. Although I have not read the book Krugman does put across a strong view that the stimulus to end the US economy’s free fall was too small and too short-lived given the depth of the slump.

We can think of the economy as a patient who was rushed to the emergency room with a life-threatening condition. Thanks to the urgent efforts of the doctors present, the patient’s life was saved. But while the doctors kept him alive, they failed to cure his underlying illness, so he emerged from the procedure partly crippled, and never fully recovered.

Something went very wrong with the US economy in 2008. But what?

Quite early on, two somewhat different stories emerged about the economic crisis.

1. A classic bank run of enormous proportions. And there certainly was a very frightening panic in 2008–2009.
2. The large overhang of private debt, in particular household debt.

What’s the difference? A financial panic is above all about confidence, or rather the lack thereof, and the overriding task of policy is to restore confidence. However confidence will not overcome the problem of debt overhang. It needs policies like sustained fiscal stimulus and debt relief for families.

Financial panics arise institutions promise their creditors ready access to their funds but are unable to pay them. This is because they invest in assets that are relatively illiquid, and this works only when a small fraction of a bank’s depositors try to pull their money out on any given day. When this does happen the bank is forced to sell assets – usually at fire sale prices – in order to raise cash – and this can break the bank. And this in turn means that when investors fear that a bank may fail, their actions can produce the very failure they fear: depositors will rush to pull their money out if they believe that other depositors will do the same, and the bank collapses.

The point is that a financial panic is very much a case of self-fulfilling prophecy. And it needs a “lender of last resort,” providing banks facing a run with cash, so that they don’t need to engage in desperate fire sales.

So why was it so hard to organise an effective response to the 2008–2009 panic? One answer is that the Fed was set up to deal with conventional banks, and had neither a clear legal mandate for nor much experience in bailing out shadow banks. Fear of bank losses led to 3 ideas that needed to be debated.

1. Some who warned of “moral hazard”—that bailing out banks would reward bad actors, and encourage future irresponsibility.

2. Some who were in favour of nationalization argued that the banks needed to be bailed out. The idea was that the government, in return for taking on big risks, should temporarily acquire ownership of the most troubled banks, so that taxpayers would profit if things went well.

3. Some thought that the financial crisis should be treated more or less as an ordinary lender-of-last-resort problem—that temporary nationalization would hurt confidence and was unnecessary, that once the panic subsided banks would be OK.

Stress TestWhatever the reasons, however, the stress test pretty much marked the end of the panic. The graph below shows several key measures of financial disruption—the TED spread, an indicator of perceived risks in lending to banks, the commercial paper spread, a similar indicator for businesses, and the Baa spread, indicating perceptions of corporate risk. All fell sharply over the first half of 2009, returning to more or less normal levels. By the end of 2009 one could reasonably declare the financial crisis over.

But a funny thing happened next: banks and markets recovered, but the real economy, and the job market in particular, didn’t. It’s still very hard to find a full-time job—both the number of long-term unemployed workers and the number of people unable to find full-time jobs remain far above pre-crisis levels.

Balance Sheet Recession

The best working hypothesis seems to be that the financial crisis was only one manifestation of a broader problem of excessive debt—that it was a so-called “balance sheet recession.” This is where households have taken on high levels of debt and at some point face pressure from creditors to ‘deleverage’, reducing their spending in an effort to pay down debt. But by doing this they reduce consumer spending in the economy and this can turn into a self-reinforcing spiral, as falling incomes make debt repayment even harder.

However a balance sheet recession cannot be cured by restoring confidence. Fiscal stimulus and debt relief are required by the government to reduce private debts and allow debtors to spend again. The private sector is not in a position to do so.

%d bloggers like this: