Lessons from the great financial crisis — the ticking bomb story
By: Kasia Chojecka
Tags: Policy, Banks, Finance, Crisis, Banking

source: iStock

Everyday millennials and younger generations learn the hard way that the future doesn’t seem bright at all. We’re basically surrounded by the evidence: take, for example, last week’s ‘breaking news’. We’re now experiencing the so called climate catastrophe — the global warming is very easy to perceive and we can see it at a glance. There’s a huge chance that its dramatic consequences will be, in the worst case scenario, the end of our civilization. Some might think — thank God, if I am going to die, then everyone is going to die, so I don’t have to worry about FOMO. But before it happens — people are going to suffer from heat, thirst, hunger, migration crises, maybe even wars — which sounds horrifying.

Back in the day we would probably treat such news only as a dystopian sci-fi story — there was this Doctor Who episode, which pictured the Earth after ‘extraterrestrial damage’ (if you know what I mean), struggling with cataclysms, epidemics, closed borders, and even death camps — basically everything we thought was never going to happen again. Well, there’s a chance that we are going to go through these things once again. The end of history? I don’t think so.

I’ve just started this blog, so I’m still a little bit shy writing in a language that is not my native — but anyway, I decided to share a little part of my research which — frankly speaking — sometimes makes me experience existential dread. If you think that PhD thesis on intriguing subject shouldn’t be, in any way, depressing — I’ll prove to you that my work appears to be the banking Apocalypse of John.

So I present you — things we haven’t learned from the 2007+ financial crisis and why we can expect a radioactive dust in our throats. This is me, your party killer.

Girls too big to cry, banks too big to fail

What we experienced during the global financial crisis was traumatizing for all of us. Not only did we face the consequences of the pathological decisions made by the big players such as creating risky and dangerous financial instruments. Not only did we see a complete lack of control over the creditworthiness of consumers and superficial assessment conducted by rating agencies. Finally — not only did we experience a tragedy of the poorest part of society which basically bore the costs of crisis and sponsored the decision makers. It was also the case of complete lack of responsibility on the part of the regulators — it was them who allowed establishing interlinked banking conglomerates, financial operations of which were impossible to be properly controlled. Links between those entities were so deep and so large that allowing any of those giants to fall would trigger a devastating avalanche. It happened anyway — everyone knew that in globalized financial sector based on cross-border transactions, the collapse or even liquidity problems of one large entity may have caused similar distortions in other banks. Yeah, well. We saw it with the naked eye.

What I’m describing right now is a theory of so-called banks ‘too-big-to-fail’ (TBTF) which used to be on everyone’s lips during the crisis. Now, normies will probably associate this puzzling phrase with the sexiest version of Ryan Gosling in Big Short or — if you don’t like Ryan Gosling (impossible) — with Occupy Wall Street movement. We should remember, however, that this expression is nothing new and it wasn’t new also a decade ago — it is claimed that TBTF as an economical theory had been discussed already in the 80’s. You may have heard it already many times, but let me explain the whole thing in simplified way once again: banks too-big-to-fail are those entities which remain under the special protection of financial authorities and may expect a bail-out in case of drastic liquidity problems. This belief arises from the fact that potential bankruptcy of such bank may entail shocks in other financial institutions and, as a consequence, the level of systemic risk skyrockets. Therefore the idea was this — the TBTF banks shouldn’t be allowed to fail and should they be on the verge of collapse — financial aid must be granted to rescue them.

This concept has been extended several times and it’s now classified in various terms — scholars mention systemically important financial institutions (SIFIs), banks ‘too-systemic-to-fail’ or ‘too-interconnected-to-fail’. Criteria to be taken into account in assessment of the nature of such institutions are actually diversified — this could be a cross-border activity, size, complexity, interconnectedness.

Well, there’s more

Okay, let’s sum up what we’ve just said — the significant problem of the financial crisis was allowing giant financial conglomerates to grow uncontrollably and benefit from state aid. The concept of too-big-to-fail has become a slogan associated with pride and greed of bankers.

But too-big-to-fail was actually being followed by its nasty cousin, the Fifth Horseman of the Apocalypse, hardly mentioned by the public, and which was, after all, probably the primary cause of the crisis. I’m talking about moral hazard. Sounds weird? Rather terrible.

Moral hazard is a situation in which one entity decides to take a risks and the other entity bears the costs of this risk if the consequences of the first entity’s actions prove negative. To put it another way: you know that for the results of your behavior pays another person (or entity), so you begin to increase the level of your risk, because you’re 100% sure that if you drown, someone will pull you out of the water. Moral hazard is particularly common in the insurance sector — if you’re aware of the fact that you’re insured, you tend to take, even if only slightly, more risk because you know that in the case of the negative incident occurring, you’ll get your compensation. The same thing happens in the banking sector from the perspective of consumers — depositors tend to ignore risky performance conducted of the bank keeping their savings because they know that in the event of collapse, the deposit guarantee will cover their losses.

Moral hazard emerged from the dark during the financial crisis like Babadook . Like a mould on the ceiling. Like a pimple on the forehead. Like a kiss on the cheek from the aunt you hate. Large banks and other financial institutions, aware of the fact that they can expect bail-out, didn’t hesitate to invest in risky financial instruments for a simple reason — such assets brought much higher profits in a shorter term.

Sloths and other fantastic beasts

Scholars interested in macroprudential policy very often mention also the phenomenon called inaction bias (or omission bias). Usually, this concept is presented as a cognitive bias — it is based on the assumption that a person has a tendency to assess harmful actions as worse than equally harmful passivity. As for banking — in general, there’s no consensus whether this theory exists within the sector, but — for the sake of discussion — we can treat it as a possible (but not fully confirmed by science) hypothesis.

Inaction bias in the banking sector means that regulators are not particularly inclined to use macroprudential instruments towards financial institutions and prefer rather to wait out crises rather than to take supervisory actions. The reasons they stand aside is assumption that their actions, if introduced too early, can have more severe consequences — investors withdrawing their assets, bank runs or high criticism from the public and market participants. Omission bias was noticed during the global crisis and has been regarded as one of the factors that contributed to its dramatic consequences. The phenomenon was also indirectly mentioned by Steven Pearlstein who suggested that the US regulators tend to wait too long until the bubble actually burst out. And again, Federal Reserve Chair Jerome Powell says everything is fine, but at the same time points out that leverage loans might have created other bubble that has already sucked in billions of dollars. Just a small explanation — leveraged loans are those granted to entities being already in considerable debt. These new debts are then bundled together and then transformed to financial instruments — collaterized loan obligations (CLO). Basically very similar mechanism as the one from 2007+ crisis. Remember what have subprime credits and CDOs done to us? Did I mention radioactive dust in our throats?

Last week I also read an article about Amazon launching a credit cards aimed at customers with bad or no credit history. There was this bitterly funny comment below: ‘New Amazon Subprime Russian Roulette Edition, invest and die”. Well, yeah.

By the way, maybe it’s not relevant for you, but I’ll just put it to make my homeland look better than it really is. As you might have heard, Poland wasn’t that much affected by the financial crisis — it was a unicorn, a green island among contaminated European countries. One of the probable reasons is that the National Bank of Poland (at that time — responsible for macroprudential tools), is considered to be a relatively active regulator that tends to act rather than stand still. Same with the microprudential regulator — Polish Financial Supervision Authority.

So how did we clean up this mess?

After the great crisis, legislators faced a significant challenge — the main principle was to create a new regulatory framework for banks in order to protect them (and the society) in the event of potential shocks. The goals were simple: first and foremost, regulators put an emphasis on increasing banks’ liquidity requirements and strengthening the macroprudential supervision. All of these measures were implemented and compiled as Basel III framework which provided adequate macroprudential instruments, for instance: liquidity and capital requirements, updated leveraged ratio or stress tests. Due to the lack of space and time — I’ll spare you the details on the all legal acts that currently support the sector and which were implemented after the financial crisis. I can only summarize it as a substantial amount of legal mumbo jumbo which now forms a banking safety fundaments in Europe.

Strengthening liquidity and supervision are not the only tasks faced by legislators: it was also necessary to minimize the moral hazard and create regulatory framework to prevent formation of banks too systemic to fail. Well, this plan was only partially fulfilled. The unfinished part will soon blow up in our faces.

The worst student in class

Well, let’s discuss an example from practice — I wouldn’t like to make empty promises because you’d probably roast the hell out of me.

Recently, basically in every Member State of the EU, there was this one, really hot topic in banking news. Deutsche Bank, Germany’s big fish, recorded a historical decline in its share price and basically smashed its face on concrete. For a long time DB has been considered to be the black sheep of the European banking, contributing to the deterioration of the local market. It wasn’t able to adapt to the new regulatory conditions and for a long time has been using outdated business model which hadn’t matched to post-crisis reality.

We can distinguish three alternative proposals for rescuing this sinking ship: Deutsche Bank’s merger with another bank (here it was supposed to be Commerzbank, also failing), resolution procedure led by SRB, or German government’s money. Simple as that.

The first option has already been eliminated as the transaction turned out to be unprofitable, and there was also a possibility of creating bank too big to fail and — at the same time — too weak to sustain. The second alternative, namely bank resolution, is probably the most desirable. In a huuuge simplification — resolution is initiated against a failing systemically important bank and the main goal is to let this bank continue its critical functions — contrary to traditional restructuring and liquidation which is aimed to retain as much investors’ and shareholders’ assets as it is possible. The main idea here is to protect taxpayers from the harmful effects of bank’s insolvency, so the most important feature of this procedure is that it should be funded by the sector itself, using especially remaining assets of the failing bank. Bail-outs are excluded as a measure harmful for taxpayers. For instance, one of the possible instruments to use against a failing bank is a highly controversial bail-in tool — equity and debt of the failing bank can be written down or converted to capital — and therefore the burden is placed rather on shareholders and creditors — especially those investing in the most risky assets. So, to summarize it: resolution is an administrative procedure led by an independent authority, financed mostly by the private sector, serving the principle that the cost of bad bank management, and irresponsible business decisions should be born by the banking sector itself. This regulatory tool is planned for Deutsche Bank and Commerzbank, and we can only hope it works.

Okay, I know it all sounds like gibberish, especially to laymen, but trust me — I tried to put it as simple as possible. More here.

If resolution doesn’t succeed, then only Angela Merkel ‘s iron fist can save those banks, and, to be honest, I have an uncomfortable feeling this is what is going to happen. Do you know what it means? That the bank which wasn’t able to comply with the new regulatory requirements and invested in risky financial instruments — will again fall on its feet. The largest German bank is going into pieces, but perhaps — no one’s going to suffer any consequences. Oh, excuse me — I forgot to mention the German society.

We learned nothing

If all of this hasn’t made you anxious yet, then let me add some fuel to the flame. We’re going to die from heat and thirst anyway, so it cannot get any worse.

We’ve discussed the post-crisis problem regarding banks too big (or too systemic) to fail. Unfortunately, we haven’t solved it yet — and haven’t found any solution which could make sense (we’re still trying, though). The financial sector is still based on global conglomerates, which might seriously harm us, if they lose their stability.

We’ve also mentioned regulators’ reluctance to initiate proceedings in the event of crisis. Finally, we’ve discussed the worst — moral hazard, which, together with a simple greed, intensifies risky activities among banks.

I know it all sounds horrifying, but I can go on and on. We’re facing not only the above mentioned leveraged loans bubble hanging above us like guillotine, but also a huge student loans debt, especially in the US, very vulnerable to scams. Also, corporate debt bubble. Global interest rate reduction. Shadow banking. Regulatory vacuum concerning cryptocurrencies which probably cannot — or maybe shouldn’t — be filled.

Anyway, the conclusion is: the sector learned as much as I did in geography classes in elementary school — zero.

Okay, so what?

You’re reading this and you wonder — ok, this is some legal/economic mumbo jumbo, how does it supposedly affect me and how big is the danger?

Well — you’ll probably pay for all of this. You’ll pay with your pension, your savings, your salary, your credit interest — anyway, your ass will get kicked. We haven’t learned the most important lesson from the crisis — that if someone is aware that his butt is always safe and sound, he will party hard until his batteries are exhausted. This is not only the problem of banks, but FinTechs, big data, insurance companies, and OTC traders as well. If all of them know that someone else will pay for their risky actions — they won’t stop. Imagine Mark Zuckerberg keeping it in check while knowing that he will anyway go unpunished. Won’t happen. Moral hazard.

If you ask me what you can do in reaction to these things, my first suggestion is: go out, put off your clothes, set your bed on fire, lie in front of JP Morgan’s door, and scream at the top of your lungs. But unfortunately — the public doesn’t care, we’re all just a bunch of cosmic matter, and life is a dream. No, seriously — I believe there are some options (apart from the TBTF problem, for which, apart from enhanced concentration control, I don’t see any reasonable at-least-partially-free-market solution):

- creating interconnected institutional safety nets consisting of all public authorities involved in the financial market: central banks, supervisors, resolution authorities, deposit guarantee authorities and government representatives. Their mutual cooperation, but also mutual control mechanisms — this might be a solution that will lead to accountability and motivation on the part of the state;

- strengthening the instruments minimizing moral hazard — such as those described above — resolution and legal provisions concerning liability of shareholders, managers, directors, investors, agents (especially financial liability, not criminal);

- educating the society on the risky investments and encouraging them to get involved — but in a safe way. In short: financial education. Easy to say if the majority of (at least Polish) society has no creditworthiness.

And one more thing. Law enforcement. For all the issues I described above, there is — at least partially — a response in law. The post-crisis regulations, which I mentioned above, constitute a really solid pillar for proper and vigilant supervision. The problem is that the law is often not enforced . Because some people are more equal than others.



I must admit sincerely — all my thoughts and reflections, they’re just a silly tale of a minor researcher and watchful observer. At this point of my life I can afford a dinner in a good restaurant (fancy fish tacos and churros), but not necessarily Porsche Cayenne. I don’t invest in anything because I don’t have money to do so, I also don’t have creditworthiness, I have one savings account, but if someone would like to use it as a means to cover the effects of the crisis — it would probably be a FUNNY PRANK. But despite all of this — one day, maybe in ten years or more, I’ll pay for the mistakes that I haven’t made at all. My generation and younger generations will be the beneficiaries of the impending financial crisis, perhaps the largest one in history. Let me just remind you that the regulators partly managed to react to the market’s shortcomings — at least on paper. If they haven’t implemented those ideas yet, they already know how they should look like.

But I doubt they will. The law probably won’t be enforced. And we shouldn’t have any hope that we are not going to pay a tax on someone else’s greed and pride.

Coming back to the question I stated in the beginning. Well, you know the answer. You can feel how high is the temperature outside, you know how much money you’ll get when you retire, you can’t afford healthcare, your student debt is rising, you see your interest rate increasing, and you cannot do anything about that. Someone else should bear the consequences. And they know it.

I used the following sources:

– D. Acemoglu, A. Ozdaglar, A. Tahbaz-Salehi, Systemic Risk and Stability in Financial Networks, „The American Economic Review” 2015 nr 2 (105);

— A. D. Morrison, Systemic risks and the ‘too-big-to-fail’ problem, Oxford Review of Economic Policy, Volume 27, Number 3, 2011;

— Basel Committee on Banking Supervision: Global systemically important banks: updated assessment methodology and the higher loss absorbency requirement, Lipiec 2013;

— A. Barth, I. Schnabel — Why banks are not too big to fail — evidence from the CDS market, Economic Policy 2013;

— P. Schammo, Inaction in Macro-prudential Supervision: Assessing the EU’s Response, Journal of Financial Regulation, 2019;

— R.M. Lastra, Systemic risk, SIFIs and financial stability, Capital Markets Law Journal 2011, vol. 6 no. 2;

— C.O. Brown, S. Dinc, Too Many to Fail? Evidence of Regulatory Forbearance When the Banking Sector is Weak, The Review of Financial Studies, Volume 24, Issue 4, April 2011.

And:

- websites linked above,

- EU authorities websites,

- my own brain.