The crisis the financial system is undergoing leaves an open debate both on the outlook and the amount of time needed for a way out, and on the tools to use in the field. In addition, we still need an assessment of what has brought about this crisis situation and what the possible resolutions are.
Looking at the causes, the crisis was unleashed by a number of very different contributory factors which, for particular reasons, are not interconnected. Implementing a new regulatory system concerning bank capital has significantly and deliberately reduced the size of the guaranteed capital necessary to operate on the market, which did drive greater efficiency, but also contributed to reducing its solidity.
With the elimination of the Glass Steagall Act in 1999 and the less strict SEC taking control of investment banking from the stricter Fed in 2002, the US oversight authorities' regulatory choices have led to a more relaxed view of operations, creating a large risk of conflict of interest. Among these conflicts are the securitization of non-performing finance and the connivance of financial companies in rating and placing obligations.
The strong growth in the US real estate market and the irresponsible use of mortgage loans on purchased housing as a form of consumer credit has led to a progressive unsustainability of borrower debt as real estate values decrease. Furthermore, the application of IAS principles to all banking balance sheets has exposed an excessive volatility of active stakes and net assets, while the presence of significant "ethical gaps" (promoting derivatives to unaware and unprepared clients), has fed a growth of default risks.
These determining factors are coming out of a US financial system made up of banks that have become too big and too interconnected. The repercussions thus emerge on the global level through three large-scale phenomena. First of all, the spread of illiquidity and defaults originally linked to mortgages, then extended to other instruments and obligations has finally reached banks and businesses, assuming intolerable proportions, both financially and emotionally.
Secondly, the fundamental motor of the interbank system is now shot through with trading mistrust among its participants, leading to growth in interest rates which shows up both in terms of a credit crunch and a rise in financing costs.
Third, retail customers have lost trust in the financial system, and have started to liquidate their investments by simple withdrawal, by moving them to safer circuits (such as postal accounts), or by selling their shares in investment funds. Taken together, these events push toward a reduction in funds available for lending, making the use of the financial system more costly.
Ways out of this dilemma are being developed in both the short- and medium term. In the short term, actions have been taken in Europe and the US to recapitalize (bail out) the banks and mitigate the risks of default for retail customers. While such moves seem to be the duty of a responsible government, the real game for exiting the crisis will be played out with medium-terms actions.
On this front, two scenarios are beginning to take shape. The first pivots on state intervention that would combine the separation of commercial and investment banking with government participation in the banks' capital and a tighter regulation of risk assumption. The second, more challenging, would depend on a decisive recovery of customer trust, placing value on localism, territory and the renewed role of foundations.
Regulatory choices may appear more reassuring, incisive and rapid, but customer centrality is patiently awaiting its turn.
by Stefano Caselli,
Professor of Financial Markets and Institutions, Università Bocconi