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The Financial Crisis: A Perfect Storm of Deregulation, Financial Innovation, and Mismanagement

The financial crisis of 2008 was a catastrophic event that reshaped the global economy and highlighted the dangers of unchecked financial innovation and deregulation. In 2014, Eric Bigham FCCA joined a panel of experts to give a keynote address held at The London Transport Museum (LTM) in Covent Garden, London sponsored by The Association Of Chartered Certified Accountants ACCA.

ACCA published an accompanying white paper How The Regulators Changed The World, and this article summarises insights from his Key Note Address given at the event. It offers a concise analysis of the Great Financial Crisis, the roles of regulators and central bankers, and the impact on global finance. Discover how regulatory changes have reshaped the financial landscape and the lessons for the future.

At the center of this crisis was Alan Greenspan, often hailed as one of the most successful central bankers of all time. As the Chair of the U.S. Federal Reserve, Greenspan maintained a policy of low interest rates, which many argue contributed to the crisis through what became known as the "Greenspan Put."

The "Greenspan Put" and Risky Behavior

The "Greenspan Put" refers to the perception that the Federal Reserve, under Greenspan's leadership, would step in to rescue financial markets whenever they showed signs of trouble. This belief encouraged reckless behavior among investors, who felt protected against potential losses. As markets soured, Greenspan would lower interest rates, effectively bailing out investors and reinforcing risky practices.

The Subprime Mortgage Boom

One of the most significant factors leading to the crisis was the boom in the subprime mortgage market, particularly in the U.S. Midwest. Property-related products became highly popular, with investors borrowing heavily to invest in real estate. Lenders offered easy access to finance, often on a self-certification basis, meaning that borrowers could secure loans without stringent checks on their financial standing.

Financial Innovation: Securitization and CDOs

The financial industry also saw the rise of new technologies that allowed banks to securitize loans, packaging them into complex financial products known as collateralized debt obligations (CDOs). These CDOs combined high-risk residential mortgage-backed securities with low-risk bonds, creating instruments that appeared to offer high returns with minimal risk. Rating agencies, often too lenient, stamped these products with high ratings, making them even more attractive to fund managers starved for returns.

The Domino Effect: Leverage and Collapse

As investors and banks became highly leveraged, purchasing vast amounts of these seemingly low-risk securities, the financial system became increasingly fragile. By 2008, cracks began to show. The credit markets faltered, and banks, wary of each other's exposure to bad debt, stopped lending to one another. This freeze in credit availability led to a full-blown crisis.

The Role of Basel Accords: Insufficient Safeguards

Part of the reason banks became so dangerously leveraged was the inadequacy of regulations, particularly those set out in the Basel Accords. The Basel Accords, international regulatory frameworks designed to ensure that banks hold enough capital to protect themselves against financial and operational risks, were supposed to promote financial stability. However, they lacked the necessary "bite" to prevent banks from taking excessive risks.

Under the Basel framework, banks were required to hold a certain level of capital based on the riskiness of their assets. However, these regulations allowed banks to categorize assets by risk weight, enabling them to hold less capital against assets deemed "low risk." Banks exploited these rules by loading up on assets that were artificially classified as low risk, thereby multiplying their leverage and churning capital at alarming rates.

This regulatory loophole allowed banks to build enormous portfolios of risky assets without holding sufficient capital to cover potential losses. When the housing bubble burst, many banks found themselves undercapitalized and unable to absorb the massive losses from mortgage-backed securities and other toxic assets. The resulting financial instability was a direct consequence of these regulatory failures.

The Bank Collapses and Government Bailouts

The crisis reached a critical point in September 2008, when several major financial institutions either collapsed or were on the brink of collapse:

The Big Short: Predicting the Collapse

A few, like Michael Burry of Scion Capital, recognized the growing risk. Burry noticed a troubling trend: while default rates on residential mortgages were rising, the cost of insuring against these defaults remained low. Sensing an opportunity, he bet against the market, predicting the collapse that would soon follow. His insights were later chronicled in Michael Lewis's book, The Big Short.

The Aftermath: Federal Reserve Intervention and Long-Term Impact

In response to the unfolding disaster, the U.S. Federal Reserve and Treasury launched unprecedented interventions:

The Deleveraging: A Once-in-a-Generation Event

One of the most profound consequences of the financial crisis was the massive deleveraging that followed. Deleveraging refers to the process of reducing debt levels across the economy, often through asset sales, defaults, or paying down debt. In his study, "How the Economic Machine Works," Ray Dalio, founder of Bridgewater Associates, explains that the economy operates in cycles—specifically, the short-term debt cycle and the long-term debt cycle.

According to Dalio, the financial crisis marked the end of a long-term debt cycle—a rare event that occurs once every 75 years. During such a period, the excessive accumulation of debt leads to a massive deleveraging, where the focus shifts from borrowing and spending to saving and paying down debt. This process can be painful, leading to reduced economic growth, lower asset prices, and widespread financial instability.

The Role of Quantitative Easing and the Zero Lower Bound

During times of economic prosperity, demand often outstrips supply, leading to inflation as prices rise. Central banks typically counter inflation by raising interest rates, which increases borrowing costs and cools down the economy—a mechanism known as the short-term debt cycle. However, during the Great Deleveraging that followed the 2008 crisis, interest rates were slashed to near-zero levels to stimulate borrowing and spending.

Once interest rates hit the so-called "zero lower bound," traditional monetary policy tools lose their effectiveness. At this point, the cost of borrowing cannot be reduced further to encourage spending, and in some cases, real interest rates become effectively negative when adjusted for fees and inflation. This means savers are essentially paying to keep their money in the bank.

With the floor of zero interest rates reached, central banks turned to unconventional tools like Quantitative Easing (QE). QE involves printing money to purchase financial assets, particularly government and mortgage-backed securities, with the goal of injecting liquidity into the economy and keeping interest rates low across the board. This flood of new money helps to raise asset prices, which in turn can support spending and investment, but it also carries the risk of inflating asset bubbles and exacerbating wealth inequality.

Regulatory Response: The Basel III Reforms

In the wake of the crisis, the Basel Committee on Banking Supervision introduced Basel III, a set of reforms designed to strengthen the regulation, supervision, and risk management of banks. Basel III aimed to address many of the shortcomings exposed by the crisis, including the need for higher capital requirements, improved risk management, and greater transparency.

Key features of Basel III include:

Have the New Regulations Gone Far Enough?

While Basel III represents a significant improvement over previous regulatory frameworks, there is ongoing debate about whether these measures are sufficient to prevent another financial crisis. Critics argue that while Basel III has strengthened the resilience of the banking sector, it may not fully address the underlying issues that led to the crisis, such as the reliance on complex financial products and the potential for regulatory arbitrage.

Moreover, some economists worry that the higher capital requirements could reduce banks' ability to lend, potentially slowing economic growth. Others believe that more radical reforms are needed, such as breaking up large financial institutions that are "too big to fail" or imposing stricter limits on the types of activities banks can engage in.

Ultimately, while Basel III has made the financial system more stable, it is not a panacea. The global financial system remains complex and interconnected, and new risks are constantly emerging. Regulators must remain vigilant and be willing to adapt rules as needed to ensure that the financial system can withstand future shocks.

The Social Impact and the Need for Productivity

Dalio warns that while QE can provide temporary relief, it cannot replace the need for genuine economic productivity. The massive injection of liquidity through QE can lead to a transfer of wealth, where the rich benefit disproportionately from rising asset prices, while the middle and lower classes face stagnant wages and rising living costs. This growing inequality can lead to social unrest, as those left behind by the economic recovery demand changes to wealth distribution and economic policies.

Ultimately, Dalio emphasizes that productivity growth is the only sustainable way to improve living standards and ensure long-term economic stability. While credit and QE can provide short-term fixes, they are no substitute for increasing productivity—whether through innovation, education, or infrastructure development. Without productivity gains, the economy risks falling into a cycle of stagnation and recurring financial crises.

Conclusion

The 2008 financial crisis was the result of a perfect storm of deregulation, financial innovation, and mismanagement. The massive deleveraging that followed was a once-in-a-generation event, with profound impacts on the global economy. While central banks employed unprecedented measures like QE to stabilize markets, the long-term challenge remains: fostering productivity growth to ensure sustainable economic prosperity. The introduction of Basel III has made the financial system more resilient, but questions remain about whether these reforms are sufficient to prevent future crises. As Dalio notes, the cycle of debt and deleveraging will likely repeat, but the key to avoiding future crises lies in addressing the fundamental drivers of economic growth and social equity.