What happened to the big banks and the global economy in 2007/8 and beyond?

‘Make Money and Do Good!’

Robert Frick,

Former Co-Chairman,

Bank of America.

Despite what the infamous Wall Street protagonist said; Greed is Not Good. But contrary to popular belief, money can lead to good. Because money means access to the possible. And considering what I have outlined thus far, the now impossible too. In the right hands, with right values, and with the right intent, money is good.

What is more, money may not be able to buy happiness. But try not having it. It is a guaranteed pisser! The street is the only opinion. A Street that has no Wall.

Bob Frick, quoted above, was one of the most successful merchant/investment bankers through the 1970s, 80s, and 90s. Anyone who knows him well, would not doubt his monetary values and intent. And as the records show, the legacy that Bob left at B&A enable the giant bank to be one of the few to navigate through the 2008 collapse on top.

So What Blew the Fuse in 2008?

To most, it is still a mystery. The answers are, or moreover can be, complicated only because we make them complicated. And it is the same for the solutions. We may read in the daily news that the financial institutes, thinktanks, and policy makers are at somewhat of a loss for solutions. Again, the solutions they offer are complex in their structure and takes time for them to come to flourish.

But time is not only at the essence, it is the essential quanta. Because banking – and there are a great many kinds – is and always will be about the future. Bank capitalisation is raised on speculation about the future. Investments and loans again are about speculating a good return on the future. And the macroeconomy that banks help create and support is all about a decent future.

A good and successful future is a great many things of course. And that many things comes down to how and what your measure. For a Tibetan Monk that will be a completely different set of metrics to a New York Investment Banker. So in the context of this post’s main theme, the bottom line here is a GigaMarket return on investment over the longer-term. When all is said and done, that is what it boils down to here. Reasonable? We will come to that below.

What are Banks For?

At its roots, banking has a formidable role in monetary and fiscal application, leverage, and innovation in (1) creating new economic spaces, (2) make possible economic expansion, (3) enable the creation and introduction of new products and services, and (4) provide on the street ‘real’ economic functionality and mechanics. Without these four kernels, there would of course be no economy, and no society and technology, at least as we know it today. Thus, financial potential, kinetics and innovation are fundamental.

However, given the latent design of so-called collateralised debt obligations or credit default swaps, and the many other new-fangled fiscal leverage and repackaging gadgets, financial innovation has earned a wayward reputation. But as you will see below, further and even continuous innovation is needed if we are to create and realise the new economic horizons of the future. Because in fact the role of the wicked reputation innovations were in fact merely out crops of a financial collapse caused by deeper means.

And there are two fundamental questions that need to be asked here: ‘Why did we not see the 2007/8 financial meltdown coming?’ and ‘And for that matter, what where the fundamental mechanics that caused the long depression?’

You would think that with such a massive financial tsunami heading our away, some bellwether Davey Crochet financial wizards might have yelled out that something was afoot. But in fact there were indicators, only in the huge hazy noise of the financial world, they went mostly unnoticed. The banking liability emergency exposed a number of defects in both the design and monitoring of such financial systems.

 First, there was no-bailout clause in any of the financial systems; and as a result of this absence there was no monitoring system and cumulative record in place to metricise the interest rate differentials to provide a clear signasl about the build-up of imbalances.

And second, bank regulations treated sovereign debt essentially as risk-free, implicitly assuming that there would always be bailout.

The latter assumption induced banks to take on excessive exposure to their own sovereign credit risk. This led to a ‘diabolic’ loop whereby sovereign risk and bank weakness reinforced each other – in countries where sovereign debt was perceived be riskier, bank stocks plunged, leading to expectations of a public bailout, further increasing the perceived credit risk in government bonds, as illustrated in the following figure.

Current design of the Eurozone promoted excessive capital flows across borders, followed by massive self-fulfilling flight to safety when confidence in a given country’s debt is lost. At times of turbulence, investors run from some countries, such as Italy, to park their investment in safe havens, such as German bunds.

The pressing matter of tacking sovereign-debt and the risk of neo-classic contagions; the full extent to which banking-risk and sovereign-risk are so dangerously intertwined that no EU bank is secure from the latent impact of holding government debt.

A more joined-up approach in regulatory restructuring and stronger worldwide regulatory frameworks in tune with resolution authority for systemically important financial institutions (SIFIs).

The essential role of banks in terms of their vital contribution to the real economy and the pivotal role they play as lenders to SMEs in support of economic growth at local and regional levels.

So rather than moving from privatising profits and nationalising losses and dept to nationalising both, I would advocate privatising both. An old idea that has not really been popular among policy makers these past years in the industrialised world.

For this to happen, the sovereign debt and banking crises that are intertwined have to be addressed with separate policy tools.

The current plan is for banks to seek fresh capital from the markets, with EFSF resources as a backstop. Conclusion 2 is that this plan will not work.

The only feasible solution is to guarantee all public debts, thus avoiding both stigma and lack of credibility. Finland, Estonia and Luxembourg would do the Eurozone an historical service by requesting to be part of a debt guarantee scheme. What kind of guarantee scheme is needed? An example is provided in Wyplosz (2011). In a nutshell, all sovereign debts must be partially guaranteed (eg up to 60% of each country’s GDP, or up to 50% of the nominal value). The scheme would backstop debt prices by setting a floor on potential losses. It would lead to less panicky debt pricing by the markets. In turn these market prices would serve as a guide to debt renegotiation

Who can offer such a guarantee, which is effectively a price guarantee? A price guarantee only operates if markets know beyond doubt that the guarantor can and will buy any bond that trades below the announced target (which in this case is a floor).The total value of Eurozone public debts stands at some €8300 billion (more than three times the German – or Chinese – GDP). This is beyond any enlargement of the EFSF. This is beyond current and future IMF lending resources, currently some €400 billion. The unavoidable conclusion is that the ECB is the only institution in the world that can backstop public debts and make reasonably orderly defaults possible. The current ECB position – “we have done what we can, now it is up to governments” – dramatically misses the point. Of course, the ECB may be concerned about taking on such a momentous task; an imaginative solution is for the ECB to provide the commitment through the EFSF, as suggested by Gros and Maier (2011).Finally, how can the two rescues – of sovereign debts and banks – be carried out simultaneously, as required? If Greece defaults, its banks, pension funds, and insurance companies will fail in large number. It seems that Greece will not be able to bail them out. Assume, just as an example, that Greece defaults on half of its public debt (about% of its GDP). Assume that bailing out its banks, pension funds, and insurance companies costs 30% of GDP. The government can do the bailout and still come out with a debt that is lower than now by 40% of GDP. Greece can afford to borrow what it needs to bail out its financial system. The solution then is that the ECB – directly or indirectly via the EFSF – partially guarantees the existing stock of debts and fully newly issued debts simultaneously. Obviously, the guarantee of future debts cannot be given without absolute and verifiable assurance of fiscal discipline in the future.