By Manav Khindri
Illustration by Keo Morakod Ung
The causes and consequences of the 2008 Global Financial Crisis are very well-known; a cocktail of sub-prime mortgages, murky mortgage-backed securities and irresponsible banking practices all came together to trigger one of the most devastating worldwide recessions in history. The post-crisis reforms are equally as well-documented – internationally, the Basel III framework introduced higher capital and liquidity requirements for banks in order to protect against future collapses. In the immediate few years after their implementation, the general consensus in the international community was that increased regulation has had the desired effect. However, we are approaching the 20th anniversary of the crisis and the global finance scene is not what it was even 10 years ago. Such a unique, unstable world as we have in 2024 begs the question: is the world of banking any safer than it was before 2008?
One of the pivotal pieces of legislation in the post-crisis era was the Dodd-Frank Act in the United States, which introduced measures including the Volcker Rule (which limited banks’ proprietary trading and hedge fund/private equity firm ownership) and better stress testing measures imposed on SIFIs (‘Systemically Important Financial Institutions) who were deemed “too big to fail”, yet did so to almost everyone’s detriment in the late noughties. In the last few years, we have seen rollbacks of these regulatory measures; in 2018, the threshold for banks deemed SIFIs was raised to $250bn from $50bn, meaning many regional banks, still capable of posing significant risk to the global financial system, can act away from the heightened scrutiny originally introduced to protect the interests of the majority. Similarly, the Volcker Rule has been relaxed to allow banks under a certain valuation threshold (yet still indubitably big, important regional/national institutions) to engage in previously impermissible risky trading operations. There has also been a relaxation of the oversight of derivatives trading, the buying and selling of complex financial instruments, which many often deem as a key driver of the Global Financial Crisis owing to its murky, intransparent nature. While many of these relaxationary measures have been implemented in the name of financial innovation, market efficiency and correcting an overly aggressive regulatory reaction, it sets a precedent. As times move on, the political pressure to release banking from its regulatory shackles could prove too lucrative. While the notion of achieving the ‘sweet spot’ of regulation is desirable, banking’s notoriously shady reputation means that knowing where this sweet spot is becomes a seemingly impossible task, and there exists the fear that we may end up back at square one. As was made famous at the end of the blockbuster film ‘The Big Short’, banks not being made accountable for their failures has meant that old habits do die hard. ‘Bespoke tranche opportunities’ have arisen as a popular financial product that resembles, if not perfectly mimics, the CDOs which came before them and triggered a global recession.
There exists another side to this argument; while some see regulatory relaxation as leading us back to square one, others see the still high levels of oversight as being even more destabilising than a completely unregulated banking sector. In his book The Illusion of Control, Dr Jon Danielsson of the London School of Economics argues that the incredibly high levels of regulation in its current state mean a major financial crisis ‘is now more likely than ever’. He posits that successful regulation balances growth and risk management, but that risk is simply impossible to measure, and comes in varying shapes and sizes with varying causes that require different policy responses. Overregulation does bring short-term stability, but, as he argues with reference to Hyman Minsky, ‘stability is destabilising’. Risk can build up and push us to a dangerous, inevitable tipping point. Dr Danielsson’s overall message is that, if we were to remove the one-size-fits-all style of regulation and choose to embrace its lack of uniformity to foster diverse financial institutions, the system would be able to withstand shocks more resolutely on its own, rather than muddle through by abiding by the existing cost-draining, inefficient compliance measures.
However, while I tend to believe in the merits of the free market and looser regulation, the financial sector is indisputably a special case. For an industry mired in as much controversy, secrecy and danger as it is and has been, I believe a stringent level of regulation is necessary for banking. As the recent past has shown, the moral hazard in banking, of bearing very little personal cost when gambling with others’ money, is high. Given the lucrative rewards of the sector, regulation is a must – as the rise of ‘bespoke tranche opportunities’ shows us, the desire to take on a high risk, high reward approach is far more compelling than the scars of 2008.
Clearly, there is no right answer to the question of whether the banking industry in its current state is headed down the right path. The answer, as is with most of economics as a discipline, is dependent on personal values and ideologies. What I believe cannot be disputed is the idea that the industry understands its unique position of being ‘too big to fail’, and cannot be made to feel too comfortable that old mistakes are allowed to be made once again.
UCL Rethinking Economics 