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The financial crisis began because of dangerous features within the financial system itself. Massively leveraged investment banks engaged in socially useless trading of huge volumes of complex credit securities and derivatives. New forms of secured funding left the system vulnerable to self-reinforcing runs if confidence ever cracked. Banks operated with absurdly low equity ratios, so that when the market crash came, counterparties doubted their solvency. Within two weeks of Lehman’s collapse the global interbank money market had frozen, creating real danger of economic collapse.
The excessive risk-taking was allowed by bad regulation justified by flawed economic theory. Authoritative experts such as the IMF explained how increased securitisation and trading activity made the financial system more efficient and less risky. Global bank capital reforms sought to make it easier for banks to fund rapid credit growth.
The first priority in autumn 2008 was to use central bank and Treasury money to prevent the crisis turning into a 1930s-style Great Depression. The subsequent challenge for international regulators was to make future financial crises less likely.
The most crucial change was a dramatic increase in bank capital ratios. Changes to the definition of what counts as bank capital and to how risk weighted assets are calculated, together with higher regulatory ratios, have effectively forced big banks to hold three to five times as much capital as before.
But the probability of a crisis developing rapidly within the guts of the financial system itself is now far lower than before 2008.
A more robust financial system is no ground for complacency. A deep economic recession, made worse by a large debt overhang, could occur even if not a single big bank went bankrupt or needed to be rescued with public money.
The fundamental question is why economic growth has become so debt dependent. Rising inequality is probably one answer, with poorer people trying to use debt to compensate for stagnant real wages. The increasing role of real estate in modern economies is also crucial.
The priority is to understand these and other causes and to design an appropriate policy response. By contrast, worrying about a repeat of 2008 is planning for the last war.
Full article on Financial Times (subscription required)