The 2008 global financial crisis brought us right to the brink of economic disaster. Governments had to bail out banks, lending dried up and many fears of a deeper collapse and depression began to surface. But more than a decade on, is the worst behind us, or is the banking crisis yet to come?
Understanding the Banking Crisis
The banking crisis of 2008 was the worst financial disaster since the Great Depression. But why did it happen in the first place? Fundamentally, it was triggered by the destabilizing of the mortgage market, linked to a wider instability in the housing and stock markets. This coupled with an unusually deep credit crunch was all it took to send the global economies into a tailspin.
Loose Lending and the Global Financial Crisis
At the heart of the 2008 banking crisis was the idea of loose lending. This ‘sub-prime’ lending involved banks approving mortgages even for those with low credit, meaning that many could borrow more money than they could afford to pay back.
When US mortgage bonds started to decline heavily in value, inversely the rate at which lenders were able to borrow money also declined sharply – leading to a squeeze on the funds available to many financial service companies that had previously made their profits by buying and selling these bonds. Consequently, many of these companies began to collapse.
The Global Impact
The resulting banking crisis spread through the markets, affecting bigger institutions and investment companies with economic ramifications felt all across the world. One of the most direct consequences was a tightening of liquidity – the rate at which lenders were willing to lend money to businesses and individuals – as banks were less able to take on the risk.
As a response to this, governments and central banks had to step in to break the downward spiral, using a variety of tools including quantitative easing and bailouts. The IMF estimates global losses from the banking crisis of 2008 to be in the region of $2.2 trillion.
Lessons Learned
The 2008 banking crisis will no doubt remain in people’s memory for some time. Thankfully, it appears lessons were learned from the incident and numerous changes were made, in particular to financial regulations. Banks now have to pass more stringent tests to be able to take on risk, as well as create clearer records of their activities.
Examples of these regulations are Dodd-Frank in the US, the Basel Accord and the Bank Recovery and Resolution Directive (BRRD) in Europe. A global regulatory body also exists in the form of the International Association of Insurance Supervisors (IAIS), set up to ensure a coordinated effort in the supervision of financial services and risk management.
Are We Entering Another Financial Crisis?
These regulatory changes brought more transparency and reduced risks of another financial crisis. However, with economies now struggling with the additional burden of the coronavirus pandemic, some experts are asking whether we are headed for another crisis.
There are a number of factors that could potentially lead to this, although it is worth noting that despite all the challenges, the banking sector has proven itself relatively resilient even through times of the pandemic. This has been reflected in bank profits that remain higher than before the 2008 crisis, as well as a generally improved loan portfolio quality.
Simple and Stress Testing
One potential long-term risk to banks is the Volcker Rule, which is designed to restrict certain trading activities by banks. Many big banks are now subject to there rules, but this has been criticized in some quarters as merely a sideshow, with little real impact in terms of changes to banking practices – meaning that risky activities such as proprietary trading remain unchanged.
An additional form of testing put in place in response to the 2008 crisis is simple and stress testing, designed to help identify potential risks in lending and other activities. These tests are designed to demonstrate a bank’s ability to withstand certain risks, replicating the potential impact of such a crisis as the one that occurred in 2008.
The Road Ahead
The risk of another banking crisis is there, and we need to remain vigilant in managing this risk. But on the whole, the sector appears to be largely better equipped to handle such crises, with increased capitalization, improved risk management and stronger regulations in place.
The continued reliance on central banks and their policies are likely to be a primary factor in preventing a similar crisis in the future. With questions such as the form of stimulus, increasing interest rates and financial public policy likely to remain of central importance in 2021 and beyond, we must remain vigilant in order to ensure the banking system remains safe and secure.
The banking crisis of 2008 was the worst global financial disaster of our generation, but the measures that were implemented in its wake have helped to ensure we don’t experience a similar crisis in the near future. Banks are now better equipped to handle shocks, with increased capitalization and improved risk management in place. Central banks will remain of primary importance going forward and will be key determinants in managing the potential risks that remain. That’s not to say a banking crisis could never happen again, but with the lessons of the past – and the banking regulations that were implemented in its aftermath – we’re much better placed to prevent it.
