Deregulation Could Trigger Another Global Banking Crisis

The rally in US banking stocks hinges on expectations that the (US President Donald) Trump administration will relax or even remove regulations imposed on the sector in the wake of the 2008-09 global financial crisis. The danger is that since big banks are still not too big to fail, deregulation, both in the US and globally, could trigger another financial shock.

A large banking system is not necessarily problematic. For example, in the UK, reflecting the status of London as a major global financial center, financial services contribute significantly to economic activity. Financial and insurance services contributed £125.4 billion ($156.18 bilion) in gross value added to the UK economy, or 9.4% of the UK’s total GVA, around 46% from London alone, MarketWatch reported. 

Trade in financial services contributes significantly to the UK’s trade surplus in services. The sector provided 3.6% of UK jobs and contributed £21.0 billion to UK tax receipts in 2010-11.

But a large banking system does create a number of issues.

First, the role of banks expands beyond support for the real economy, facilitating payments, capital formation and deployment and risk transfer. Economic activity becomes inordinately dependent on trading financial instruments and channeling rapid capital movements, which are largely zero-sum games or relatively low economic value-added functions.

Second, the commercial drive for growth and higher profitability leads to increased risk taking. For example, the need to grow loan volumes may require lowering lending standards or taking other risks. This is what happened in the led up to the 2008 financial crisis, exemplified by the sub-prime loans in the US.

Third, there are complex linkages between banks and financial entities, both within countries and internationally, reflecting the mobility of capital and cross-border transactions. In 2008, the dangers of these connections were exposed as the globalized financial system’s intricate linkages became a conduit for transmitting contagion. This led to a sharp fall in cross-border capital flows, which remain well below the pre-crisis levels.

 Rise in Risks

Fourth, frequently (untested) financial innovations create new risks, both for individual institutions and systemically. It also allows rent-seeking by banks and financiers, who exploit the asymmetry of information between sellers and buyers of complex products. It also creates control issues as managers, directors and regulators are unable to keep up with new developments. During the 2008-09 crisis, the problems of higher-risk mortgages, collateralized debt obligations and the shadow banking system populated by off-balance sheet vehicles illustrate these risks.

Fifth, the identified problems are amplified by the leverage of financial firms. Capital ratios and liquidity reserves of banks have fallen sharply over the past two decades. Leverage is increasingly used to drive higher and more volatile returns on equity. During the global financial crisis, the high leverage, both on- and off-balance sheet, accentuated the problems.

Sixth, the banking system’s risk and complexity is implicitly underwritten by the state, a fact that is recognized by credit-rating agencies. This guarantee typically takes the form of deposit insurance, liquidity insurance, and implied capital support. Given the central role of banks in payments and credit provisions, it is difficult for governments to allow banks to fail.

Following the global financial crisis, governments in the US, UK, Ireland, and Europe were forced to step in and support their banks. Many other governments indirectly supported their banks by increasing the scope of deposit guarantees.

 Too Big to Fail

Yet in the years since, banks have not grown smaller. Instead, their size and concentration has increased. Since the crisis, the six largest US banks now control almost 70% of the assets in the US financial system, having increased around 40% (against overall asset growth of only 8%). JP Morgan Chase, the largest US bank, has more than $2.4 trillion in assets—larger than most countries.

The growth and increased concentration is the result of forced consolidation (“shotgun” mergers) and the effect of new capital and liquidity regulations that favor larger banks. A flight to the perceived safety of TBTF (Too Big to Fail) banks, combined with contraction of alternative funding sources, such as securitization, has reduced competition from smaller entities. Governments and regulators have also favored larger banks as national champions that are internationally competitive and theoretically easier to regulate.

The increased importance of banks also reflects their role in now financing beleaguered states by increasing their holding of government bonds. The banking system has also gained from such policies such as quantitative easing. Liquidity-fueled asset price rises has also encouraged a return of dubious banking practices.

The confluence of government support (which protects depositors and creditors), limited liability (which protects shareholders), profit maximization, and incentive pay for financiers encourages a culture of “rational carelessness”. Rather than dismantle this financial doomsday machine, governments and regulators have perpetuated a large financial system, which increases the risks for the economy. 

In June 2013, then-Bank of England governor Sir Mervyn King stated that: “It is not in our national interest to have banks that are too big to fail, too big to jail, or simply too big.” Policy makers would do well to heed this advice.