Palgrave Macmillan Studies in Banking and Financial Institutions

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Thoughts on the current economic crisis
Phil Molyneux - series editor

On 13th October 2008 the world's central banks injected an estimated $1 trillion into global banking systems in order to bail-out mainly western financial institutions. This followed on from the $700 billion US bailout, the failure of large profile commercial banks in the US, UK, Germany, Iceland and Benelux countries and the virtual disappearance of 'bulge-bracket' investment banks. Even non-banking institutions, such as the US insurer AIG have not been immune from the credit crisis that has spun around the globe since the summer of 2007. Stock markets have plummeted, short-sellers have been made to go long, and even the doyennes of financial markets - hedge funds - are posting serious negative returns. Stock indexes are lower than they were in the late 1990's and the regulatory framework for banking and the financial system has pretty much been shown to be ineffective in stalling a crisis in the confidence of the financial system. Governments, with their limitless taxpayer dollars, now own major chunks of the banking system and the role of the state looks like it will prevail over the medium-term.

So what went wrong? Why did nobody see the boom turning into a bust? Why did nobody identify that the banking industry had captured their regulators and 'the lunatics were really running the asylum'? Why were excess risks taken and mis-priced? And how come some of the brightest minds did not, for one minute, over at least a decade think nothing was amiss? We all know that busts follow booms - but this time the bust is the biggest since (and maybe worse than) that experienced in the Great Depression.

In retrospect the above questions seem relatively easy to answer. Economies were growing rapidly, domestic demand was increasing and this fuelled a property boom. Credit growth accelerated munch faster than retail deposits and the gap was funded by borrowing from other banks and issuing new-fangled structured products and other instruments that repackaged risks backed by US sub-prime debatable and property assets which were given top credit ratings. Banks engaged in virtually Ponzi style activity issuing billions of dollars of such instruments which they parked in off-balance sheet vehicles or sold on to other banks and financial institutions. When the US housing market collapsed the value of these assets became non-measurable, nobody knew who held what or what these assets were worth. Black holes appeared in banks' balance sheets and they stopped lending to one another. Credit was squeezed and thus started the onset of the crisis.

So why did this happen? Well, the main explanation seems to relate to perverse incentives. Banks were encouraged to boost their profits and stock returns by shareholders that encouraged senior managers to undertake high risk-return activities (dressed up in low-risk clothing) and participants were massively financially rewarded for creating this activity. Bonuses sky-rocketed and regulators (who had pretty much been captured by the banks) were allowed to manage and monitor their own risks to the extent that they were allowed to systematically hold less liquidity and even capital from the early 1990s onwards. When the business bust, banks just did not have enough capital or liquidity to protect themselves.

Many of the aforementioned issues are going to plague the thoughts of policymakers, academics and bankers over the coming decade. This book series acts as one of the few forums where contemporary banking and financial institution trends and developments can be aired. As the institutional framework in global banking is likely to be radically transformed over the coming years we hope the series will continue to be a major source for topical analysis and discussion on these critically important features of our economies.

Phil Molyneux