• The Invisible Hand

Special Report: Have we learnt our lessons from the Financial Crisis of 2007-2008?

This is the first special report on this blog. A special report is a longer than usual post which covers a important topic in more depth. Here one of the most significant economic events is discussed. I look at the financial crisis and the impact it has today and whether we can avoid such an event in the future.

Ten years ago we experienced possibly the greatest economic catastrophe of all time, where UK GDP plummeted by nearly 30% between 2007-2009. With the rise in unemployment and national debt after 2008, the people of the UK and the Treasury cannot afford another crisis, therefore, we must do everything we can to prevent it. This means learning the lessons of the financial crisis so a similar event won’t occur again. For example, we had to clamp down on the reckless corporate culture and strengthen the inadequate regulatory system. But, have such lessons been learnt and our economic stability restored, or is the situation no different from 2008?

Generally, after a crisis there is a wave of regulation, intended to fix the regulatory failures relating to the crisis, for example the Financial Services Act 2012 in the UK. However, the real indication of whether lessons have been learnt is whether that regulation remains, or whether as prosperity resumes deregulation creeps in and creates a more hazardous macroeconomic environment. 

The regulatory framework during 2008 was based on the Tripartite system where the Financial Services Authority, Bank of England and the Treasury regulated the sector. Since 2008, however, this system is blamed for failing to recognise the financial instability before 2008 and therefore, the subsequent bust. George Osborne believed the FSA was too narrow and only focused on rules-based legislation and it failed to make clear who was supervising which sector. Subsequently, he abolished the FSA in 2013 and replaced it with the FCA and PRA. The Financial Conduct Authority now protects customers from poor practices and regulates business conduct while the Prudential Regulation Authority oversees the stability of large firms. The Bank of England gained more power over regulation as the PRA is a subsidiary and the Financial Policy committee, which monitors the other two watchdogs, is also based in the Bank. This makes regulation more independent from government manipulation as it is in the hands of the independent Central Bank. These new organisations are more specialised, so they can focus on individual tasks and it is clear who is responsible for each sector. To the extent that inefficient regulatory institutions have been replaced by more specific and prescriptive ones, this suggests the UK has learnt its lesson that weak regulation is a significant financial risk. 

The Financial Policy Committee of the Bank of England

In response to a lack of a holistic focus on the stability of the system, macro-prudential regulation has been established which aims to concentrate on the financial system as a whole. Part of it includes stress testing to ensure the financial system can survive a crisis. Macro-prudential regulation addresses the issue of regulation taking a separatist view of the financial system and neglecting considering how the parts of the system are interrelated. 

In many ways regulation is more tailored towards customer satisfaction as many of the public were outraged at the financial system’s disregard for them. For example, the FCA enforces conduct rules more sternly and, to protect borrowers, the FSCS can award compensation of up to £85,000 for cash deposits defaulting, an increase from only £31,700 in 2007. Here the lesson learnt is to take greater regard for customers. 

Much of the regulation above does address some of the lessons learnt from the financial crisis, yet, there are some signs of the UK neglecting them and creating a more unstable macro-economic environment.

Moral hazard created from the ‘too big to fail’ ideology still persists as the banking industry has continued to grow to nearly a third bigger today than in 2008. Although fines for Britain’s big four banks have been £50bn, the industry still prospers thanks to UK government support of up to £955bn so clearly firms haven’t suffered enough for their mistakes so they know that in future they will not, therefore, moral hazard hasn’t gone away. Although the government has introduced a bank levy, it is only a pitiful 0.08%. Instead banks should face the punishment for their malpractice, for example, the government should tax any extra profits they have earned since 2008, at a level proportionate to the cost of bailing them out. In this instance, we have not learnt our lesson as we are allowing the too big to fail ideology to persist.

Renewed cries for deregulation from senior politicians, especially as we leave the EU, also show we have not learnt the dangers of becoming complacent and using deregulation. Some have suggested a regulatory race-to-the-bottom when we won’t have to follow European regulations, so the UK becomes a Singapore style economy with low regulation and low-taxes. The fact that senior politicians such as Theresa May and Phillip Hammond are suggesting these ideas shows the threat that becoming complacent poses and would greatly endanger the economy.

Significant strides have been made in regulation since 2008, however, in the UK stricter regulation could still be used to hold banks accountable. However, with the Conservatives in power there is little political will to challenge large multinational firms. 

Another aspect of the financial system that failed during the crisis was that of corporate governance as bumper bonuses encouraged reckless behaviour and banks gained huge leverage ratios, including in risky assets. 

The banking system is infamous for large bonuses, especially as many hold them accountable for the crisis because they created perverse incentives, for example, making individuals maximise personal gain because the firm will absorb any losses. Particularly deleterious were guaranteed bonuses because they rewarded short-term failures.

Fortunately, many lessons have been learnt since the crisis and to a large extent this culture has been tamed. However, much regulation has come from Europe so it could be said that the UK government hasn’t personally taken action. The Committee of European Banking Supervisors has restricted the amount of a bonus that can be paid in upfront cash to 20-30%. 50% must also be paid in shares and there has been a maximum level based on a percentage of an individual’s pay, which has necessitated transparency on pay details of “senior management and risk takers”. All of these are decisive and strong steps towards a less subversive banking sector. Evidence of these changes is seen in many banks cutting bonuses, however at the same time RBS has paid bonuses of £575m in 2013, despite being mostly owned by the government and experiencing a loss of £8.2bn in the same year[5]. To combat guaranteed bonuses, regulators are supporting banks claiming compensation from individuals whose performance didn’t deserve such a high bonus, e.g. Lloyds has cut £2m from bonuses to 13 executives. “Clawing back” compensation is an important step to hold traders accountable for mistakes they made in the crisis and shows we have learnt people can’t go unpunished for endangering the system.  Part of holding individuals to account and achieving high standards is achieved through ‘significant influence functions’ interviews by the FCA, which has so far led to 39 SIF applicants being withdrawn. This tackles the lesson from the crisis that staff must be professional and diligent. 

Another recent constraint on banks’ behaviour is the bank levy introduced in 2010 which has since been raised up to 0.088% in 2012. Unlike past crises where banks have caused damage and the government has been left to fix the damage after them, this levy aims to make the financial sector contribute to economic recovery and hopefully discourages risky forms of borrowing as it will be more expensive for banks. Part of the government’s aim to reduce the size of banks includes a £20bn exemption to encourage banks to shrink. Compared to nothing this is a significant lesson that has been learnt, however, it could still go further. 

A bank levy only generated £2.975bn a year in 2016/17 [6]which has only fulfilled 5.8% of the fiscal deficit. Since banks contributed to our massive debt which has fuelled large budget deficits, they should contribute to fixing the poor state of our public finances. There are also worries banks may pass greater costs onto consumers, in which case they aren’t being held sufficiently to account.

Overall, much in corporate culture has changed in light of what we have learnt from the crisis and although it is not perfect, the environment is much less toxic than it used to be.

Significant strides have been made in enhancing the stability of the financial system so, now, it seems unlikely such a catastrophic event could occur again. The regulatory system is more specialised and their powers have been strengthened, while corporate culture is more restrained and less irresponsible. The UK government has pursued much of this regulation, however, they have had to be encouraged by European regulation. The real test of whether lessons have been learnt is whether the current situation remains as the economy improves and pressure from far-right Thatcherites wanting deregulation causes our safety net to quickly crumble. However, for the time being, we seem to have learnt our lessons and the system is much safer. 

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