The Banking Crisis: Causes, Consequences and Remedies | 3 a Similar Story Can Be Told About the US Housing Figure 4

No. 178 y November 2008 Abstract The Banking Crisis: The paradigm that financial markets are efficient has provided the intellectual backbone for the Causes, Consequences deregulation of the banking sector since the 1980s, allowing universal banks to be fully involved in and Remedies financial markets, and investment banks to become involved in traditional banking. There is now Paul De Grauwe overwhelming evidence that financial markets are not efficient. Bubbles and crashes are an endemic banks are unable to satisfy these withdrawals as their feature of financial markets in capitalist countries. assets are illiquid. A liquidity crisis erupts. Thus, as a result of deregulation, the balance sheets of universal banks became fully exposed to these In normal times, when people have confidence in the bubbles and crashes, undermining the stability of the banks, these crises do not occur. But confidence can banking system. The Basel approach to stabilise the quickly evaporate, for example, when one or more banking system has as an implicit assumption that banks experience a solvency problem due to non- financial markets are efficient, allowing us to model performing loans. Bank runs are then possible. A the risks universal banks take and to compute the liquidity crisis erupts that can also bring down sound required capital ratios that will minimise this risk. I banks. The latter become innocent bystanders that argue that this approach is unworkable because the are hit in the same way as the insolvent banks by the risks that matter for universal banks are tail risks, collective movement of distrust. associated with bubbles and crashes. These cannot be The problem does not end here. A devilish quantified. As a result, there is only one way out, and interaction between liquidity crisis and solvency that is to return to narrow banking, a model that crisis is set in motion. Sound banks that are hit by emerged after the previous large-scale banking crisis deposit withdrawals have to sell assets to confront of the 1930s but that was discarded during the 1980s these withdrawals. The ensuing fire sales lead to and 1990s under the influence of the efficient market declines in asset prices, reducing the value of banks’ paradigm. assets. This in turn erodes the equity base of the banks and leads to a solvency problem. The cycle 1. The basics of banking can start again: the solvency problem of these banks ignites a new liquidity crisis and so on. In order to analyse the causes of the banking crisis it is useful to start from the basics of banking. Banks The last great banking crisis occurred in the 1930s. are in the business of borrowing short and lending Its effects were devastating for the real economy. long. In doing so they provide an essential service to Following that crisis the banking system was the rest of us, i.e. they create credit that allows the reformed fundamentally. These reforms were real economy to grow and expand. intended to make such a banking crisis impossible and had three essential ingredients. First, the central This credit creation service, however, is based on an bank took on the responsibility of lender-of-last- inherent fragility of the banking system. If depositors resort. Second, deposit insurance mechanisms were are gripped by a collective movement of distrust and instituted. These two reforms aimed at eliminating decide to withdraw their deposits at the same time, collective movements of panic. A third reform aimed at preventing commercial banks from taking on too Paul De Grauwe is Professor of Economics at the University of Leuven and Associate Senior Research Fellow at CEPS. CEPS Policy Briefs present concise, policy-oriented analyses of topical issues in European affairs, with the aim of interjecting the views of CEPS researchers and associates into the policy-making process in a timely fashion. Unless otherwise indicated, the views expressed are attributable only to the author in a personal capacity and not to any institution with which they are associated. Available for free downloading from the CEPS website (http://www.ceps.eu) y © CEPS 2008 many risks. In the US this took the form of the beautifully there was no need for regulation Glass-Steagall Act, which was introduced in 1933 anymore. And bankers achieved their objective. and which separated commercial banking from They were progressively deregulated in the US and investment banking. in Europe. The culmination was the repeal of the Glass-Steagall act in 1999 by the Clinton Most economists thought that these reforms would administration. This allowed commercial banks to be sufficient to produce a less fragile banking system take on all the activities investment banks had been and to prevent large-scale banking crises. It was not managing, e.g. the underwriting and the holding of to be. Why? In order to answer this question it is securities; the development of new and risky assets useful to first discuss the concept of ‘moral hazard’. like derivatives and complex structured credit In most general terms, moral hazard means that products. Thus banks were allowed to take on all the agents who are insured will tend to take fewer risky activities that the Great Depression had taught precautions to avoid the risk against which they are us could lead to problems. The lessons of history insured. The insurance provided by central banks and were thus forgotten. governments in the form of lender-of-last-resort and The efficient market paradigm provided the deposit insurance gives bankers strong incentives to intellectual backing for the deregulation of financial take more risks. To counter this, authorities have to markets in general and the banking sector in supervise and regulate, very much like any private particular. At about the same time financial markets insurer who wants to avoid moral hazard. experienced a burst of innovations. Financial And that’s what the monetary authorities did for innovations were allowed to design new financial most of the post-war period. They subjected banks to products. These made it possible to repackage assets tight regulations aimed at preventing them from into different risk classes and to price these risks taking on too much risk. But then something differently. It also allowed banks to securitise their remarkable happened. loans, i.e. to repackage them in the form of asset- backed securities (ABSs) and to sell these in the 2. The efficient market paradigm market. This led to the belief, very much inspired by the From the 1970s on, economists were all gripped by optimism of the efficient market paradigm, that the intellectual attraction of the efficient market securitisation and the development of complex paradigm. This paradigm, which originated in financial products would lead to a better spread of academia, also became hugely popular outside risk over many more people, thereby reducing academia. Its main ingredients are the following: systemic risk and the need to supervise and regulate First, financial markets efficiently allocate savings financial markets. A new era of free and towards the most promising investment projects, unencumbered progress would be set in motion. thereby maximising welfare. Second, asset prices An important side effect of securitisation was that reflect underlying fundamentals. As a result, bubbles each time banks sold repackaged loans they obtained cannot occur, and neither can crashes. History was liquidity that could be used to extend new loans that reinterpreted, and those of us who thought that the later on would be securitised again. This led to a tulip bubble in the 17th century was the quintessential large increase in the credit multiplier. Thus even if example of a price development unrelated to the central bank kept tight control of the money base, underlying fundamentals were told it was all driven credit expansion could go on unchecked with the by fundamentals (see Garber, 2000). same money base. The banking sector was piling up The third ingredient of the efficient market paradigm different layers of credit – one on top of the other – is the capacity of markets for self-regulation. The allowing agents to speculate in the asset markets. All proponents of this paradigm told us that financial this undermined the control central banks had on the markets can regulate themselves perfectly and that expansion of credit in the economy. regulation by governments or central banks is unnecessary, even harmful, for as we all know bureaucrats and politicians always screw things up. 3. Are financial markets efficient? All this led Greenspan to write the following poetic Deregulation and financial innovation promised to words in his autobiography: “authorities should not bring great welfare improvements: better risk interfere with the pollinating bees of Wall Street” spreading; lower costs of credit, benefitting firms (Greenspan, 2007). who would invest more and benefitting millions of The efficient markets paradigm was extremely consumers who would have access to cheap influential. It was also seized upon by bankers to mortgages. Who could resist the temptation of lobby for deregulation. If markets work so allowing these market forces to function freely without the unseemly interference of governments? 2 | Paul De Grauwe The trouble is that financial markets are not efficient. What happened in the US economy between July We illustrate this lack of efficiency in the two 2006 and July 2007 to warrant an increase of 30% in dimensions that matter for the stability of the the value of stocks? Or, put differently: in July 2006 banking sector.1 First, bubbles and crashes are an US stock market capitalisation was $11.5 trillion. endemic feature of financial markets. Second, One year later it was $15 trillion. What happened to financial markets are incapable of regulating the US economy to make it possible that $3.5 trillion themselves.

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