This week in 2008, US investment bank Lehman Brothers was allowed to collapse, triggering a global financial heart attack and ushering in the worst slump in the world economy since the 1930s. And not much has changed since then. There is still “a vast amount of work” to be done, says Gillian Tett in the Financial Times, “before we have a financial world that looks both sane and safe”.
Banks are still too big to fail
The world’s banks have topped up their capital levels so that they have more money to withstand losses, says Hugo Dixon on Reuters. However, the amount of capital a bank must hold depends on the riskiness of its assets. The problem is that banks still “have too much freedom to decide for themselves how risky a loan is”. This allows them to “engage in monkey business” and increases the danger to the system.
And despite shrinking credit in recent years, Britain’s big banks still have balance sheets five times bigger than the economy, with leverage levels of 33 times, says Liam Halligan in The Sunday Telegraph. So they hold just £1 of reserve capital for every £33 on loan. “That is insane.”
Meanwhile, the “too big to fail” problem has yet to be properly addressed, as Jeremy Warner points out in The Daily Telegraph. Regulators have started work on how to unwind a huge, complex, transnational bank such as Lehman safely, but as this has to be an international effort it’s taking time. The bottom line is that “we are still a million miles away from a world in which banks can be allowed to fail safely”.
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Economies in a slump
When Lehman collapsed and the recession deepened, governments bailed out banks, applied fiscal stimulus and “hosed down the system with printed money”, says Warner. But while this unprecedented activism may have averted another depression, it hasn’t led to a vigorous recovery. Indeed, Western economies remain in a state of emergency.
Scarcely anyone would have believed when interest rates were slashed to zero that they’d still be there five years later, and will stay there for another three years, according to the Bank of England. Britain’s GDP, for instance, has yet to recover to pre-crisis levels. All this has vindicated research suggesting that recessions following credit bubbles and financial crises are far nastier, and the recoveries from them much slower, than traditional postwar downturns caused by central banks stopping booms and inflation by jacking up interest rates.
After a credit bubble bursts, the sheer debt load hampers growth as firms, consumers and governments pay off borrowing rather than spend. And now Western populations are ageing fast, putting further pressure on public finances and making it harder to pay down the debt. Welcome to the ‘new normal’.
Markets hooked on liquidity
The grim fundamentals have not, however, prevented stock markets from reaching pre-crisis highs. That’s because they “have become mesmerised by promises, hopes or fears of further monetary largesse” from central banks, as MoneyWeek’s Tim Price points out in his PFP Wealth Management letter. The S&P 500’s movements in recent years have correlated closely with the US Federal Reserve’s injections of printed money into the economy.
The big question now is whether central bankers can safely mop up all the printed money that economies and markets have become used to, says Economist.com’s Buttonwood blog. “Even the threat of tapering… has caused a big wobble” in markets. And there are fears that higher mortgage rates, priced off Treasury yields, are undermining the American housing recovery. Since so little Western debt has been unwound, a sharp rise in long-term interest rates – borrowing costs – “would have a very negative effect on consumers and businesses”. Five years on, the crisis is far from over.