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Abu Dhabi, UAEMonday 24 September 2018

Nine lessons from the global financial crisis

Mohamed El Erian analyses the post-crisis achievements and failures

Bankers attend an emergency meeting at the London office of Lehman Brothers, in the financial district of Canary Wharf in London, Britain, September 11, 2008. Photo: Reuters
Bankers attend an emergency meeting at the London office of Lehman Brothers, in the financial district of Canary Wharf in London, Britain, September 11, 2008. Photo: Reuters

A lesson learned should lead to meaningful changes by individuals and institutions. That has largely been the case in the decade since the financial crisis almost tipped the global economy into a prolonged depression that would have devastated livelihoods for at least a generation. But there are also consequential lessons that haven’t been sufficiently internalised; and some that were not foreseen at the time of the crisis but are now urgent and important. Here’s a summary scorecard of post-crisis accomplishments, unfinished business and unintended consequences:

The accomplishments:

1. A safer banking system

Thanks to strengthened capital buffers, more responsible approaches to balance sheets and better liquidity management, the banks no longer present a major systemic risk in most advanced countries, and especially the US. That does not mean every country and every bank is safe; but the system as whole is no longer the Achilles’ heel of market-based economies.

2. A more robust payments and settlement system

The strengthening of the banking system has been part of a highly successful, broader effort to minimise the risk of “sudden stops” in the payments and settlement mechanisms at the core of the global economy - that is, a loss of trust in counterparts that freezes even the most basic financial transactions, paralysing economic interactions.

3. Smarter international cooperation

The crisis highlighted the importance of better approaches not just to crisis management, but also to prevention. At the top of the “to-do list” are steps such as improved harmonization of strengthened regulation and supervision, more timely and comprehensive information-sharing, and greater focus on the challenges of monitoring internationally active banks. Individual countries have been able to draw on a wider set of insights in bolstering both their macro- and micro-prudential efforts.

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The slippages:

4. Still-elusive inclusive growth

It took far too long for policy makers in advanced countries to realise that the great recession caused by the financial crisis had important structural and secular components. An excessively cyclical mindset initially impeded the design and implementation of the measures needed to generate high and inclusive growth. By the time mindsets evolved, the political window had narrowed. Even today, most advanced countries have yet to adopt measures to durably boost actual growth and stop the downward pressure on potential expansion.

5. Misaligned internal incentives

Judging from headline-grabbing incidents of inappropriate behaviour and processes in recent years, the sticks and carrots in place in some financial institutions need work. These institutions still contain pockets of improper risk-taking and other unsuitable conduct, as well as excessive short-termism in compensation payouts and managerial tolerance for actions that are too close to the line that separates permissible from non-permissible activities.

6. A scarcity of 'patient' balance sheets

Putting challenged and damaged securities in ring-fenced balance sheets was key to containing the huge financial disturbances. This involved reliance on large public balance sheets, though their use was increasingly met by social and political pushback. Concerns about distributional effects, including favouring corporate profits at the expense of wages, Wall Street at the expense of Main Street, and the rich at the expense of the poor, have added to what is now a reduced availability of these tools for use in future crises.

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The unintended consequences:

7. The big got bigger and the small got more complex

Although more progress has been made on what to do when a bank fails, especially when it is large, the market structure that emerged from the financial crisis involves significantly larger institutions, particularly US-based ones. The same phenomenon of the big having gotten bigger can be seen in asset management. It has come at the expense of a gradual hollowing out of the middle of the distribution of financial firms. Meanwhile, the other end of the size distribution consisting of small institutions has been increasingly populated by the proliferation of fintech activities that, for the most part, have not been tested through a cycle downturn.

8. Risk has morphed and migrated to underregulated areas

This change in market structure is connected to another phenomenon: the morphing and migration of risk to non-banks. This dynamic is particularly notable in the extent to which, benefitting from years of ample global liquidity and unusually low financial volatility, there has been an over-promising of liquidity provision and excessive volatility-selling in its many forms. And part of this has been embedded in the structure of the system through product proliferation, including the growing number of exchange traded funds that implicitly promise instantaneous liquidity in market segments that are structurally subject to repeated pockets of illiquidity.

9. Reduced policy flexibility

There is limited “dry powder” to rely on in the event of a crisis because interest rates are still floored at zero or below in much of the advanced world outside the US, central banks’ balance sheets are already large, and debt levels are significantly higher than before the global financial crisis. This suggests that, even if there is sufficient political will, the ability to crisis manage and recover may be diminished compared to 10 years ago.

Those of us who navigated the global financial crisis first-hand, managing assets and liabilities in the private sector during exceptional market turmoil, saw unprecedented unpredictability turn what had previously been unthinkable into reality with unsettling regularity. We readily recognise how much was done to prevent an awful situation from severely damaging current and future generations, and also the important steps taken to reduce the probability and severity of another global crisis.

But that does not mean all is well. Renewed efforts by both the public and private sectors are needed to deal with longstanding challenges that received inadequate attention in the aftermath of the crisis, and to understand and address some of the major unintended consequences of 10 years of crisis management and prevention. Fortunately, we know a lot more about both. The biggest challenge is to get the political process to address their importance when there is no actual or looming crisis in the advanced world to focus minds.

* Bloomberg

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