Five years after the financial crisis: Reexamining the “deadly sins” of banking

by. Jim Allen

Most of us in the financial markets were well aware of the micro issues that led to the financial crisis that reached its zenith five years ago this month. The bubble in the housing market; the moral hazards created by the bailout of Bear, Stearns & Company; the poor and conflicted ratings of the “Big Three” credit ratings agencies; and unfettered risk taking and leverage in the swaps and derivatives sectors all were micro causes that contributed to the creation and severity of the crisis. But they don’t give the bigger picture as to why the rotting from the inside was occurring without anyone stepping in to stop it.

For that, I believe, we need to recognize the dangerous combination of leverage, asset concentrations, and size over the course of the 15 years prior to the crisis.

Relearning the Dangers of Financial Leverage

Everyone in finance 30 years ago was well aware of the dangers of leverage because it was regularly taught in business school at the time. Yes, we were taught it could goose earnings per share and return on equity handsomely in the short term — but at a cost. That cost, of course, was default, bankruptcy, and failure should revenues slip, should rates jump, should anything go wrong.

But many investors, regulators, and lawmakers over the past 20 years seemed to believe that the laws of finance had been suspended. Indeed, the low-interest rate policies of the Fed, the European Central Bank, and the Bank of Japan facilitated this view, in part by flooding the marketplace with so much liquidity that debt had become the funding mechanism of choice.

Making matters worse, large financial institutions were given more leeway to increase their leverage thanks to the risk-weighting processes embedded in Basel II under which most of the world operated. These risk weights cut the capital cost of loans and investments for mortgages, highly rated mortgage-backed instruments, and debts of Organization for Economic Cooperation and Development (OECD) sovereigns. Theoretically, under this structure (which will continue under Basel III) an institution could own a €1 trillion portfolio consisting solely of OECD sovereign debt, and be permitted to maintain de minimis capital as support.

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