Welcome to the next financial crisis

Posted on September 5, 2014

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Until structural reform of the banking system starts being taken seriously, we should brace ourselves for the next financial crisis, and the one after that, and the one……

This article first appeared in The Huffington Post and in Het Finincieele Dagblad

In a recent speech Angela Merkel stated that “the danger of another financial crisis is already pre-scripted.”

She is right.

What was less convincing was what she claimed to be the driver of the next crisis. She used the speech once more to repeat her pet complaint – that France and Italy should stick to the arbitrary EU limits on budget deficits. Yet a whole gaggle of eminent economists and even the European Central Bank have now clearly come out in favour of allowing greater flexibility in the interpretation of the deficit rules.

Rather than government deficits, what is much more likely to drive the inevitable recurrence of the next financial crisis is Europe’s continued hesitancy in getting to grips with a broken banking system. The banking system was at the centre of the last financial crisis and will likely be at the centre of the next one. Yet, over the last six years the combined efforts of governments, regulators and the banking industry itself have done little to tackle the obvious fragility of the system.

Banking reform in Europe has, so far, focused on two main efforts: trying to insulate sovereign debt from bank failure and passing supervision of the large, systemically important banks from national regulators to the ECB.

The first of these is a chimera. There is little mileage in continuing to pretend that taxpayers can be fully insulated from the failure of large, interconnected, systemically important banks by a combination of building up sufficient reserves and the passing of the costs of failure from governments to the banks’ creditors and ordinary savers (the currently fashionable ‘bail-in’ approach). First of all, it all but inconceivable that Eurozone banks will be asked to raise the approximately €1 trillion necessary to make the system resilient to the next financial crash. It could also be argued that the more visible and reliable the backstop, the more risk taking it will encourage.

Nor is it a particularly socially or politically desirable if, as a consequence of bank failure, thousands of ordinary people have their savings wiped out. As the recent episode of Banco Espirito Santo has shown, the sovereign cannot be fully insulated if individual banks are allowed to remain large enough to be systemically important, are allowed to retain integrated operations and, as is inevitable, remain intimately interconnected within the system so that a failure of one threatens many.

As for the second – passing regulatory responsibility to the ECB – it is not clear why anyone should believe that this will be particularly effective. The rationale put forward is that this will remove the political influence that weakens national regulators. While there may be some truth to that, it ignores other effects. While it is true that, pre-crisis, national regulators did not cover themselves in glory, they remain much closer to their local banks and their senior management teams. They should be in a position to gain a better insight into the non-transparent human factors that drive behaviour and risk taking. It is these intangible, hard to measure human factors that are all important in determining risk.

If one thing has become clear over the last few years, it is that even chief executives of the larger banks find themselves unable to have full knowledge of what goes on in the deepest recesses of their complex organisations. The idea that auditors poring over their computers in Frankfurt can gain full insight into all the major banks across the Eurozone is not credible. Such an approach represents blind faith in ‘management by spreadsheet’ – the technocratic idea that everything can be reduced to rules and numbers. It reflects a mindset that takes an engineering approach to a system that is organic, fluid, dynamic, unpredictable and populated by human beings who will, as human beings do, tend to find ways of dodging around any set of rules.

While the proposed new system on paper retains co-operation between local regulators and the ECB, implementing this effectively will be difficult. All experience shows that central organisations largely tend towards centralising control in a false belief that those employed by the centre are somehow superior beings to those in the local markets. Add to this the now impossibly complex resolution mechanism and it would be foolish to put our faith in this new super-regulator as the answer to all the system’s problems.

Mrs Merkel is right that the next financial crisis is already pre-scripted. And it may be deeper and more severe than the last one. But the primary area of risk is a financial system that remains dominated by large, complex systemically important institutions that are both internally and externally interconnected. Such a system is, and will always remain, inherently fragile and susceptible to major collapse. While the issue remains a structural one, no mountain of rules and no amount of spreadsheet management will protect us from another meltdown with its terrible economic, social and political impact.

The only way to make the system less fragile it to deal with it at a structural level. This can either be done internally by the individual banks or externally through imposition by regulators and, if all else fails, by breaking up the systemically important banks.

A few months ago I was speaking to a highly experienced banking regulator. His comment was “Over the years we have tried everything. Nothing has worked.” He is right. Nothing has worked. But he is wrong that everything has been tried. Meaningful structural remedies are, so far, notable by their absence. It is too early to say whether the European Commission’s incipient plans for a programme of structural reform will be bold enough to do the job or whether the industry will be successful in emasculating it. KPMG, the accounting firm, has recently tried to undermine the programme by stating that structural reform should be abandoned as it would draw capital out of the system and further undermine lending to small businesses. That may or may not be true in the short term. But better that than maintaining a system where our whole society remains hostage to a handful of large financial institutions (many of which are, no doubt, lucrative KPMG clients).

It is reassuring that the Commission is exploring structural reform. Let us hope that the programme is not killed in the womb but is born and turns out to have teeth. Or, even better, that the banks themselves decide to undertake their own meaningful structural reform so as to make such a programme unnecessary. Failing either of those, we should all simply brace ourselves for repeated financial collapse in spite of all the regulators’ best efforts.