The financial crisis turns 15: have lessons been learned?

One of most cataclysmic times of my professional career was watching the slow immolation of the UK banking system between the first profit warning from HSBC (HSBA) on US sub-prime mortgages in early 2007, to seeing the lines of customers queueing up outside the Moorgate branch of Northern Rock in September 2007 before the final twilight of RBS in October 2008. The fall of RBS continues to be a traumatic and hurtful memory, so much so that the name itself has disappeared as the official brand of a revived NatWest (NWB).

There were disturbing, if faint, echoes of that time after a recent cautious trading update from NatWest caused a double-digit share price fall. The biggest difference, which is maybe a sign of basic progress, is that this time around nobody was questioning the bank’s basic solvency. In other words, NatWest’s high capital buffers, ringfenced structure and generally simplified business model have the confidence of its depositors and counterparties, which means the actions of the share price are related purely to its performance in the context of market and economic conditions.

However, the lessons learned from the crisis have acquired a new urgency as the government rolls out the last pieces of the so-called Edinburgh reforms, which aim to set up the post-Brexit financial services regulatory system. Most of the proposals have drawn little comment outside of specialist industry circles – if insurance companies and pension funds want to invest more in infrastructure, then no one is really going to stop them on moral or financial grounds. On the other hand, the proposed scrapping of the bonus cap for bankers touched a very raw nerve and had a succession of commentators and grandees lining up to attack the proposal. Some have argued, including Chris Dillow, former Investors' Chronicle economist, that the move to lift the bonus cap is really an attempt to restore some of the finance industry’s “rent” that it charges the rest of society.

The implication here is that rewarding risk-taking, which in the period 2002-07 had reached excessive levels, is now considered to be inherently dangerous when it comes to finance. But it is not unique to how previous crises have played out. As is so often the case, Walter Bagehot, the third editor of The Economist, wrote presciently in his book Lombard Street: A Description of the Money Market that “the mania of 1825 and the mania of 1866 were striking examples of… the delirium of ancient gambling co-operated with the milder madness of modern overtrading”. This is as good a summary of the root causes of the 2008 crisis as you’ll find.

However, a more interesting argument in the context of the macroeconomic figures, is whether financial services actually need a lift? The sector still contributes hugely to tax revenues – the government says £76bn in total, which is enough to fund the education system and the police – but judging by current share price volatility and lack of earnings growth, there is a marked contrast with the early 2000s. This is mirrored in the sector’s share of the UK’s gross domestic product, which reached a peak of 9.1 per cent in 2009 but has since shrunk by a whole percentage point. In other words, finance is both less profitable and less productive to the wider economy.

Strangely, this is also mirrored at the government level. In the early 2000s, it had taken 300 years to accumulate a national debt of around £500bn, whereas post the financial crisis this had risen to over a trillion, with the specific cost of the crisis alone in terms of government bailouts for banks, large-scale financial guarantees and lost tax revenues estimated at £450bn. It bears painful contemplation to think what the interest payments associated with that higher debt could have bought in terms of infrastructure and public services instead.     

However, it is still undeniable that financial companies and banks are taking relatively fewer risks; for instance, the average bank balance sheet has shrunk by 70 per cent compared with the peak in 2007. That means lower profits and naturally lower bonuses, whatever the cap may be. It also adds to the impression, given that fewer graduates than ever before are considering finance as a career, that the sector’s best days are behind it, which is a possible reason for the government’s attempt through the regulatory system to return it to a semblance of growth. It may be the only lever it has.

The risk of imported risk

One of the criticisms of the reforms, and possibly a key lesson from 2008, is that no financial company exists in isolation and outside events can have just as big an impact as a home-grown crisis. If we translate America’s deposit withdrawal crisis at Silicon Valley Bank back to 2008, then the risks of contagion are just as likely. In SVB’s case, the Bank of England acted quickly to wind down SVB’s subsidiary and prevent any deposit flight from taking hold at domestic institutions.

The other point to make is that reforms aimed at making banks safer are still largely irrelevant when it comes to a major crisis. For instance, the ring-fencing of the deposit of Credit Suisse (may it rest in peace) did little to restore confidence in the bank once depositors had decided to withdraw their money.  

Ultimately, finance is a trick performed by a bad conjuror. We lend our savings to banks who then lend it themselves, in the hope that we do not all demand our money back at once. Most times it works; occasionally and disastrously, everyone sees through the illusion.