We spend a great deal of time studying history, which, let’s face it, is mostly the history of stupidity.”
-Stephen Hawking
“We learn from history that we learn nothing from history.”
-George Bernard Shaw
I don’t want to sound pessimistic, but it cannot be helped when reviewing what lessons have been learned since the Financial Crisis. It has been a decade since the Financial Crisis; however, some of the same problems that led to the crisis seems to still exist. Yes, there are differences; subprime loans, mortgage excesses, and bank leverage will not be the problems. Some of the structures have changed and our knowledge of financial channel dynamics on the real economy has improved, but the meta-issues of credit, leverage, and liquidity still seem to exist with limited solutions and discussions.
Here is a list of issues that need to be better addressed:
Too Big to Fail and Concentration – This threat has only gotten worse with more bank and financial concentration. Bank capital may be higher and leverage lower, but the risk from the size of financial institutions is still real. While monitoring of large institutions has increased, the idea of reducing size has been forgotten.
Concepts of networks – This research has been a positive development with a refocus on the connectivity or relationships between institutions and the potential for risks in the plumbing of finance. Unfortunately, policy-makers are still trying to determine how to best use this information. Agent-based models of finance along with understanding the structures and plumbing of financial flows are necessary to properly address the next set of problems.
Global issues and capital flows – While there are some focused researchers in this area, not enough attention has been given to the impacts from cross-boarder capital flows. The BIS is doing a good job in this area but the more general knowledge base is lacking. An issue not given enough weight or often discussed in detail was the impact of global capital flows for causing and perpetuating the Financial Crisis.
Shadow banking – Financial intermediation has become more complex or at least has changed from ten years ago. Banks may be a smaller part of the overall financial system with hedge funds and private equity playing greater roles in credit markets. Non-bank financial intermediation is growing and not fully understood as a driver of systemic risk.
Counter-Cyclical policies – Current fiscal policy is decidedly more pro-cyclical, and coordination between monetary and fiscal policy and regulation is a dream for the future. The fiscal policies of 2009 did not target opportunities to have the most important impact on long-term economic development through infrastructure, education, and health care. This issues still need to be addressed.
Liquidity – You only have it when you don’t need it. Credit markets have increased significantly without a corresponding increase in dealer inventories and market-making activity. A crisis that places more trades on one side of the market will not find capital to take the other side of the trade. The corollary to the liquidity shortfall is the limits to arbitrage argument.
Regulation – Increases in regulation such as Dodd-Frank has responded to the excesses of the Financial Crisis, but governments have not moved beyond reactionary relations to a more holistic coordination with policy. There is systemic risk assessment but this role has not lead to new regulation to reduce crisis risks. Regulation for the next crisis is never easy to develop.
Politics – Polarization in politics will slow reaction time in a crisis. Policy may be adjusted too late and by too little. The bailouts in 2008 were done with haste and not often with a vision of long-term growth. The voting on these issues was not bipartisan and required luck in order to succeed. While there be national and global coordination during the next crisis? It does not seem likely.
Monetary policy – While QE1 provided the necessary liquidity to protect markets during the height of crisis, subsequent policies were less helpful and may have worked against long-term economic development. Normalization is underway, but there are few who can articulate or describe the global monetary policy end game.
Credit extremes – If the last crisis was about credit extremes and leverage in mortgage markets and banking, the current environment is now about extreme in corporate credit, some consumer credit, and government deficits. Balance sheets may look better only because asset levels are inflated. If credit was the driver of excess before, then growing credit today should not be viewed as a success.
Structural changes – Hedge funds and private equity have grown as well as an explosion of new assets in the ETF market. The issue of structural response to a liquidity event by this structural change is still unknown.
These issues are not a wall of worry but a review of finance after ten years living with the aftermath of the Financial Crisis. We will not make the same mistakes but we will make mistakes that are associated with same themes.