Is the financial system more secure than in 2008?
Updated: May 1, 2022
IAE Paris – Sorbonne Business School
*Member of the faculty of the Business Science Institute.
Article originally published on The Conversation France.
On September 15, 2008, the investment bank Lehman Brothers went bankrupt, victim of the subprime crisis. The echoes of its collapse reverberated around the world, shaking the stock markets. Ten years later, with the help of governments, global finance has recovered. But will more stringent financial regulation be enough to prevent new crises? Is the financial system really more stable than in 2008?
Objectively speaking, the picture is mixed. Overall, the stability of the system has been undeniably reinforced and the regulatory framework to which banks are now subject is clearly more restrictive, with more safeguards. Nevertheless, there are still a few areas of fragility that lead me to believe that in the event of a major incident at a large institution, the safeguards that have been put in place will not be sufficient to avoid a new crisis, potentially even more serious than the one from which we have just emerged.
More capital and liquidity
Let's look at the progress made. A study of the balance sheets of the main French and European banks shows that their size and structure have not fundamentally improved, but the amount of equity capital has practically doubled over the period. In other words, their capacity to absorb losses has doubled, because the main purpose of equity in a company is to enable it to withstand losses.
The low level of equity of some banks in 2008 was clearly the cause of their demise, and no one had really paid attention to their low level, despite what some experts say. Banks can therefore take a shock twice as big as in the past. The regulations, issued by the Basel Committee and transposed into national law, have therefore had the desired effect.
In another area, that of liquidity, the same regulatory framework has required banks to be able to withstand a 30-day liquidity crisis. Ten years ago, the most imprudent ones were only two or three days ahead! However, the question that keeps coming up is: is this enough? All stakeholders agree that it is.
Demanding stress tests
To ensure the soundness of the measures adopted, the European Central Bank, the new joint supervisor of the major European banks, has introduced the system of stress tests, crisis scenarios based on macroeconomic data that directly impact the banks' balance sheets. These tests are carried out on a regular basis to assess the resilience of banks to events that impact their capital and liquidity. The stress tests simulate a certain level of catastrophe; to draw a parallel with climate risks, the financial dikes have been significantly raised in order to be able to cope with more violent cataclysms than in the past.
In addition, as analysts and researchers, we have much more data on the risk exposure of banks, again as a result of regulation. The risk functions have been strengthened, and the boards of directors are now directly involved in defining and controlling risks, which has required a strengthening of their skills. Executive managers are thus better supervised in their decision-making if the risk management system is functioning properly.
Additional measures have been taken to organize the bankruptcy of an institution according to the so-called "resolution" mechanism, which consists of calling on the bank's creditors to assist the shareholders in case of extreme distress. This procedure, called bail-in, aims to avoid, or at least postpone, the moment when a State, called bail-out, and therefore taxpayers, must intervene to save a bank and guarantee deposits, as happened in 2008.
Measures that may not be enough
What if it's still not enough? The question remains. The proponents of this theory indicate that the stress scenarios retained by the regulator are not ultimately so difficult for balance sheets to withstand. Some point out that, despite the efforts made in terms of capital, this does not represent more than 5% of a bank's balance sheet, whereas the least capitalized industrial and commercial company is around 20%.
Moreover, there are no indisputable academic studies indicating the optimal level of equity capital that a bank should have. The question is whether we can anticipate what the next disaster in Europe or North America might be, because, to use the climate metaphor, the biggest tsunamis can only come from there! In 2007 it was the subprime defaults that started the chain reaction that shook the entire global economy. As always in banking systems, it is the non-repayment of loans that causes the most serious crises.
Europe, a risk area?
Let's take two European examples that may constitute a threat. First of all, non-performing loans (the term used to refer to bad debts), particularly on SMEs (small and medium-sized enterprises) and VSEs (very small enterprises or micro-enterprises). The European Banking Authority estimates that they amount to more than 1,000 billion euros for banks in the euro zone and that only half of them are provisioned.
They lead the balance sheets of many European banks and the country most in danger from this point of view remains Italy. The State had to intervene in 2017 to save two banks directly, even though they had sworn not to call on the taxpayers anymore! The commitment of several European banks on Italian banks could then serve as a transmission belt to the entire European economy of a default of a bank in this country and that the state could not save.
Secondly, the sovereign debt of the eurozone states: it amounts to almost 10,000 billion euros, or about 90% of European GDP. The ECB has played a major role by buying its own debt, but a significant part of it is held by European banks. Italy, with a debt of more than 2,200 billion (like France), which represents almost 135% of its GDP, is again a source of concern. All the more so since this debt is considered practically risk-free and as such is not covered by the equity of the banks that hold it...
A decade after its near knockout, the financial system is back on its feet, but not without difficulty. The future will tell if the feet of this colossus remained of clay.
Article translated from French with https://www.deepl.com/translator
Eric Lamarque's articles on The Conversation France.
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