A new book by Stephen Bell and Andrew Hindmoor explores why banks failed during the financial crisis and how to prevent another crisi in the future. They write that the institutional and structural pressures that were to have such a devastating impact for banks were largely created prior to the crisis by bankers and supportive state elites through the process of liberalisation and increasing financialisation. A basic driver of bad outcomes, they argue, is market structure and levels of market competition.
The banking and financial crisis that peaked in 2008 and that engulfed many of the major US, UK and European commercial and investment banks in the key New York and London markets was as the former Chairman of the Financial Services Authority, Lord Turner, put it, ‘arguably the greatest crisis banking crisis in the history of financial capitalism’.
Very few bankers fully understood the scale and complexity of the new financial markets they had created, with their vulnerabilities and huge ‘systemic risks’ and their capacity to inflict economic carnage on a vast scale. Our book seeks to establish a clear account of what happened during the crisis, why it happened, and what can be done to prevent another crisis from occurring.
The origins of the banking crisis can be gleaned from answering an obvious but rarely-posed question: why did the financial and banking systems in the core economies of the US and UK implode, whilst the banking systems in other countries such as Australia and Canada, did not? Such comparisons provide a vital clue: banking crises, or their absence, are largely driven by the nature of the banking markets found in each country.
We provide a detailed comparative analysis showing how, even within an apparently globalised financial system, the behaviour of individual banks has been shaped by nationally specific market contexts. Banking markets with high levels of bank competition that produce strong profit pressures on firms as well as low returns from traditional lending encourage risky forms of bank trading activities and leverage that are prone to produce financial crises.
In the US and UK, highly competitive banking markets squeezed traditional lending and placed bankers under intense pressure to reengineer their balance sheets in the search for additional profits, largely in highly leveraged mortgage-backed securities trading. The origins of the financial crisis can be traced back to losses in these markets in the US. It was the collapse of these markets that triggered the banking crisis which began in 2007. Such market structures and pressures were pronounced and strong in the US and UK, but weaker in the Australian and Canadian markets. This is why the latter banking systems did not implode.
We also show that structural forces embodied in so-called ‘systemic risk’ within financial markets were central in driving the scale of the banking crisis. The crisis that peaked in 2008 and which decimated the banking sectors of the US, UK and a number of European countries stemmed from the collapse of the US mortgage market in 2007. This produced balance sheet loses especially in complex sub-prime securitised assets. Some banks in the UK also recorded losses in more traditional albeit highly leveraged lending.
In October 2008, the IMF estimated that the declared losses in the subprime securities markets to be around $500bn. These losses however were far lower than the $5 trillion in losses in US equity markets during the dot-com crash in the early 2000s and far lower than the assets of even a single large global bank such as JP Morgan, for example. Losses of $500bn nevertheless generated a full-blown financial crisis.
The financial boom and subsequent crash revealed that banks were operating in a new structural context of ‘systemic risk’. Banks are always structurally exposed because they borrow long and lend short, exposing them to a maturity mismatch – which is why the state has traditionally provided lender of last resort support in a liquidity crisis. By 2008, however, international banks were exposed to elevated forms of structural risk due largely to their huge leverage and associated dependence on short-term wholesale funding markets. In a context of complex asset and debt structures and opaque balance sheets, uncertainly, market panic and the subsequent freezing of global credit markets rapidly ensued. The structural context of systemic risk proved to be a situation in which relatively small perturbations could set off major chain reactions and cascading failures that brought down the entire financial systems in the core markets.
It is ironic that the institutional and structural pressures that were to have such a devastating impact were largely created prior to the crisis by bankers and supportive state elites in the core financial markets. The key changes were part of a wider process of liberalisation and the increasing financialisation of core economies. There was a revolution in banking that propelled bankers and financiers towards new wealth and power. It was a period in which they were widely seen as ‘Masters of the Universe’. Once the crisis was triggered however, bankers were quickly overwhelmed by forces they had not anticipated and could not control. They were thus revealed also as Slaves of the Markets; conditioned and then overwhelmed by forces they had helped create.
Our approach allows us to isolate key drivers of the origins and scale of the crisis from the long list of causal factors produced in many accounts. It is true that plentiful credit, imprudent mortgage lending, the collapse of the US housing market, and lax bank regulation were a part of the story. But these were not the primary factors that actually drove banks and the behaviour of bankers.
Regulation, for example, was largely permissive; it allowed but did not fundamentally drive bankers in the direction they took, especially in pursuing trading and massive leverage structures. Market dynamics were far more central in shaping what bankers did. Our analysis thus distinguishes between more fundamental causal factors such as market dynamics and those that were merely permissive. We point to the impacts of banking liberalisation and ‘financialisation’, especially the rise of intense market competition in recent decades, the associated decline in traditional banking as markets were squeezed, the rise of new attractive trading opportunities, and the build-up of debt and system complexity and risk in the core markets.
However, there is also a second important part of our explanation. We show that not all bankers, even in the US and UK, succumbed to these pressures. This is important because it shows that individual agency matters, even in the face of strong institutional pressures. Here, the particular character of agents and their ideas were central. We use interviews and an extensive analysis of public statements by bankers in the four countries we study to show how they read the situation and how they acted. Different agents and bank cultures can interpret the same context differently and act accordingly.
Those bankers who crashed were those who were largely sanguine about market developments and who joined the herd and rode the boom. The banks that crashed were also run by imperious CEOs and management teams that operated in a bubble at the top of steep corporate hierarchies in which upwards communication from lower ranks or from risk managers was limited. For example, Stan O’Neal, the CEO of Merrill Lynch, insisted that senior executives speak only to him about important matters and not to each other. He rarely asked for input when making decisions. As a Wall Street Journal profile concluded, ‘Mr O’Neal’s talent and steely drive came with a tragic flaw: He didn’t much engage in debate, kept his own counsel and had little use for the kind of strong-willed subordinates who might have helped him steer clear of the sub-prime troubles that brought him down’.
Yet not all bankers in the core markets became irrationally exuberant. A number of banks in the core markets largely avoided the meltdown. Banks such as HSBC and Lloyds TSB (prior to its take-over of HBOS) in the UK, and JP Morgan, Wells Fargo and Goldman Sachs in the US stepped back and avoided the worst of the carnage. They managed either to resist intense market pressures to copy the apparently successful strategies of their immediate rivals or, in the case of Goldman Sachs, having accumulated significant exposures, managed to reverse their positions.
What explains the other form of variation we observe? Why didn’t the large Australian and Canadian banks join the party and crash? We can show that the nature of banking markets and the intensity of competition between the largest banks were an important cause of the crisis because different types of market shaped different forms of banking behaviour across countries. This national variation is something that is often overlooked within existing accounts of the crisis.
Banks in Australia and Canada largely avoided trading in ‘toxic’ securities not because of tight prudential regulation or oversight in this arena but because they were operating in different kinds of markets, especially in relation to the level of competitive pressure and the nature of profit opportunities. These markets were structured by public policies that controlled competition and embedded an oligopoly that shielded the large banks from takeover pressure. These banks also mostly had a traditional rather than investment banking culture. In the markets they occupied, these bankers could make high profits through traditional lending practices. They thus avoided the fate of most of the bankers in the core US and UK markets.
The financial boom prior to 2008 bewitched most political and regulatory leaders in the core economies who saw financial sector growth as a valuable source of innovation, international competitiveness, taxes, and jobs and GDP growth. States provided subsidies that cheapened credit for the big banks, as well as low official interest rates and permissive forms of financial regulation.
Following the crisis, governments and policymakers have committed themselves to substantial reform efforts and are now grappling with a welter of new banking and financial regulation. Trading and systemic risk are often identified as causes of the crisis and these have been tackled through extremely voluminous and complex new rules around trading, systemic risk and capital levels. Yet a more basic driver of bad outcomes is market structure and levels of market competition. The problem however is that governments in the core economies persist in believing that highly competitive banking markets are a good thing, without recognising that competitive market pressures was one of the structural roots of the crisis.
Another problem is bankers and financiers remain powerful. Governments still appear to favour large, complex financial sectors. The centrality of finance in the core economies has produced a high degree of state dependence on finance, particularly as a source of jobs, tax revenue, and credit, as well as campaign contributions. In the UK, this has been distilled as the ‘British Dilemma’ by Chancellor George Osborne: the need to ‘preserve the stability and prosperity of the nation’s entire economy’, whilst also protecting London’s status as a ‘global financial centre that generates hundreds of thousands of jobs’.
Canada and Australia show what a sounder model of banking and finance looks like. There are lessons here about how to build more resilient banking systems, especially in terms of market structures that encourage more conservative and stable forms of banking. Charles Goodhart, formerly of the Bank of England, is one of the few commentators who have picked up on this important issue:
“How much competition within our banking systems do we actually want? Remember that the measures taken after the Great Depression in the United States were primarily and intentionally anti-competitive… one of the reasons why the Australian and Canadian banking systems have done so much better was… in part because the Australian and Canadian banking systems (at least domestically) were in some part protected from competition.”
Note: This article was first published in the April/May 2015 edition of The European Financial Review.
Stephen Bell is Professor in Political Economy at the School of Political Science and International Studies at the University of Queensland. Stephen is an elected Fellow of the Academy of Social Sciences in Australia.
Andrew Hindmoor is Professor of Politics at the University of Sheffield. Email address for correspondence: A.Hindmoor@sheffield.ac.uk.