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September 23, 2009

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Home » Opinion » Foreign Views

Slow! Danger Ahead! But no one brakes

By Gerard Lyons | September 23, 2009, Wednesday | Print Edition

THIS was a financial crisis made in the West.

While this crisis appears to have taken everyone by surprise it was also the most predictable financial crisis in history.

How can that be? The analogy I use is that if you drive a car at 200 miles per hour on a winding road where you do not know what is ahead I will tell you with certainty that you will crash.

However, I cannot tell you when you will crash, how bad the accident will be and who will be injured. So it was with this crisis.

There were many warnings but it was impossible to say when problems would materialize.

There had been many warnings about the build up of debt and excessive leverage. I know of no one who did not think, for instance, that UK property prices had risen too far. No one!

There were countless concerns that markets were not pricing for risk. I remember, for instance, the Bank of England's Financial Stability division hosting a well-attended seminar in December 2006 titled "Pricing for Risk" and, among other things, highlighting the dangers of crowded trades.

To quote a Fed Governor, who spoke at a conference I was at two years ago, "People heard but did not listen." This is a critical lesson. And it explains much of what went wrong.

In some of the countries worst impacted by this crisis it was not just the scale of the financial sector but, more particularly, that imbalances emerged.

Rapidly rising house prices were a central feature of those economies that suffered most. Not only did this go hand in hand with poor behavior on the way up, but where house prices have collapsed it has left the banks with debts and undermined household balance sheets.

Within the financial sector the failure of risk management reflected many things, including a belief that house prices would not fall sharply, or even not fall, a misunderstanding of how derivatives work and a willingness to use too much leverage.

The crisis demonstrated many things, one of which was that banks are the lifeblood of an economy.

Despite the crisis, the banking sectors in some countries or regions survived better than others: Canada, Australia, (China's) Hong Kong where loan to value ratios were low, limiting the amount that could be borrowed in relation to the price, and India and China where central banks had sufficiently tight monetary policies including higher reserve requirement ratios.

Are some of the more direct methods used in China, in addition to reserve ratios, such as loan quotas, of greater potential use elsewhere in controlling credit booms?

Even in the UK, badly impacted by the crisis, not everything broke. Those banks that stuck to the basics of banking and managed risk fared well and parts of the wider financial system in the City of London such as insurance and financial services were largely unscathed, although they have since been hit by the recession.

Those banks that got into trouble fell into a number of categories. In the case of the UK they did not manage their liquidity (in the case of Northern Rock or Alliance & Leicester), or their risk (in the case of Royal Bank of Scotland).

Or more generally, one could say their business models resulted in their forgetting, or ignoring, the basics.

Ideally the management and governance structure within banks should ensure this. But in addition, the regulatory and financial stability environments need to ensure sufficient checks and balances are in place.

Perhaps most important is the need to ensure confidence and trust as these are central to the operation of the financial system.

In many businesses if a competitor fails this may be seen as good. But in banking if a competitor has problems it can have an asymmetric impact if it undermines overall confidence and trust.

This contributed to the freezing of the interbank market last autumn, causing severe disruption in the wider economy and forcing central banks to add liquidity.

The motto of the London Stock Exchanges was, "My word is my bond," and until the middle of the 1980s it was the phrase used across the City of London. Trust is central. And it needs to be won back and reestablished as quickly as possible.

(The author is chief economist and group head of global research, Standard Chartered Bank. Shanghai Daily adapted the article from his speech at a forum held by the China Europe International Business School and Caijing Magazine in Shanghai on September 5.)

Foreign Views


 

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