Ten years ago this month, Northern Rock experienced the first depositors' run on a British bank for 150 years and failed shortly afterwards. This was not the first manifestation of the global financial crisis: French bank BNP Paribas had frozen withdrawals from mortgage funds the month before; US bank Bear Stearns had bailed out two of its hedge funds in June; and a large US sub-prime mortgage broker had failed earlier in 2007. The worst of the crisis was still a year into the future – the failure of Lehman Brothers and the rescue of insurance giant AIG in September 2008. But Northern Rock's failure revealed many of the vulnerabilities that were to prove widespread.
The decade since has seen major changes in regulation and prudential supervision. Everyone agrees that the financial system is much stronger. But one of the unexpected lessons of the decade was just how fragile and vulnerable the sector had been, how imperfect was prudential supervision and how ill-motivated were financial market participants. It's easy to say that things are better, relative to that dismal standard – there is less agreement on whether the global financial system is now strong enough to be immune from a new crisis.
The main global reform has been to increase substantially the capital which banks must hold. Shareholders' capital is the loss-absorbing buffer which is available to keep banks solvent when things go wrong. In the careless pre-crisis world, many banks operated with dangerously high leverage – small losses were enough to bring them, cap in hand, asking for taxpayers' assistance to avoid bankruptcy. Not only have capital requirements been raised but as well the measurement and definitional issues which banks had used to game the rules have been tightened.
But is this increase enough? Admati and Hellwig, Morris Goldstein, William Cline and others have argued that a crisis such as 2008 does so much damage that substantially higher capital is justified. Banks, for their part, are reluctant to expand expensive equity capital. The G20 was instrumental in achieving a compromise approach in which the biggest global banks would strengthen their balance sheets by issuing debt that could be converted into equity if needed. But if this loss-absorbing debt is held by vulnerable holders such as households or pension funds, governments will be reluctant to see those asset-holders bear the losses when a crisis arrives.
These measures to increase bank capital have been designed to address 'too-big-to-fail' (TBTF) – governments will not allow banks to fail, because one failure will trigger contagious runs on other banks. Thus, the taxpayers end up absorbing the losses of the financial system. TBTF has also been addressed directly by making it much harder for US and European central banks to provide 'lender-of-last-resort' support. This is an understandable response to the public anger at the bank bail-outs, but restricting the use of this powerful crisis-management tool has made the financial system more vulnerable in a crisis.
What of the many other regulatory changes incorporated on the 2010 US Dodd-Frank Act? These certainly put greater compliance obligations on banks, adding to their costs. Wall Street's powerful lobby inside both the White House and Congress is busy white-anting as much of this as possible. The key test here is whether the 'Volcker Rule' provisions survive. The original Volcker Rule enforced a separation between banking business and riskier financing (such as derivatives and market trading). It was repealed in 1999 at the behest of Wall Street, with the result that banks then took on a smorgasbord of high-risk exposures that proved an element in their 2008 undoing. Banks benefit greatly from being able to use their government-protected status to raise money cheaply to fund these high-risk activities, and will work hard to water down the Volcker provisions.
If the Volcker rule (and its European equivalents) holds, that still leaves a problem. Tighter rules on banks encourage more financial transactions to move into the less-regulated shadow banking sector, where many of the 2007-08 problems appeared. The Fed's Vice-chair Stan Fischer, while affirming that 'the soundness and resilience of our financial system has improved since the 2007-08 crisis', also acknowledges that 'we still have limited insight into parts of the shadow banking system'.
So much for the response through new rules and regulations. Far more important in avoiding another crisis are the environment and behavioural standards of the financial sector as a whole. The experience of 2008 revealed that banks were willing to finance borrowers without proper regard for capacity to repay; market operators were ready to bend the rules; credit rating agencies would put commissions ahead of competent evaluation; financial salesmen were looking to unload risky assets onto unsophisticated investors; risky derivatives became a game of 'pass-the-parcel'; and prudential supervisors were either too sanguine or too constrained to do a competent job. Low standards were contagious – if others were doing it, you had to join in.
Abetting these low standards was the prevailing doctrine of 'efficient markets' – financial markets should be allowed to operate with minimal regulation and light-touch prudential supervision. Former Fed Chairman Alan Greenspan has issued his mea culpa, but it's hard to see much change in Wall Street's mindset.
The other critical factor is the macro-environment. After a decade of abnormally low interest rates and massive quantitative easing, investment decisions and portfolio choices have been biased and prices distorted. Low interest rates have encouraged 'search for yield', down-playing risk. Earnings in pension funds have been inadequate. If a new crisis arrives, monetary policy is in no position to offer further stimulus and fiscal policy is constrained by accumulated debt. And in most countries credit has continued to grow faster than GDP, leaving borrowers more exposed.
Considering this compendium of imperfect reforms and unaddressed vulnerabilities, why does Fed Chair Janet Yellen say that another financial crisis like 2008 is 'not likely in our lifetime'? The short answer is that memories of the post-crisis trauma are a powerful antidote against a repeat, strengthening the hand of prudential supervisors and restraining the risk-takers. Yellen is affirming that, for the foreseeable future, there will still be enough people around in positions of authority who remember 2008. Memory, however, offers limited protection against new crises with different characteristics (perhaps beginning with China's over-extended financial sector or Japan's huge government debt). It won't be like 2007-08, but the tirelessly ingenious financial sector will find new ways of getting into trouble.