Can We Survive the Next Financial Crisis?

Ten years ago this week, Lehman Brothers Holdings Inc. collapsed, triggering the worst financial crisis in almost a century, a seismic event that still reverberates today.

Then the fourth-biggest U.S. investment bank, Lehman declared bankruptcy on Sept. 15, 2008. Stocks plunged and credit markets froze. Investors, not knowing how interconnected the biggest financial players were, feared the entire global financial system could implode.

A decade later, amid signs of new asset bubbles, a big question is whether the steps taken after the crisis have made that system strong enough to withstand the next shock.

While banks are safer on many counts than before the crisis, the economic and political repercussions are still being felt. Leverage has shifted to companies from consumers, and some risk has migrated to shadow banks from traditional lenders. Links between shadow and mainstream banks persist, and taxpayer bailouts, though less likely, are still possible.

The most important change for banks has been a sharp increase in capital requirements and what qualifies as a buffer against losses. Lehman and the other big firms had so little of it in 2007—about $2 for every $100 of assets—that it didn’t take a lot of losses to erase that cushion. That meant the value of the assets had to fall just 2 percent for the equity to be wiped out. Now, with almost $7 for every $100, banks have a bigger buffer to handle unforeseen losses when the next downturn strikes.

More Capital, Less Risk

“The resiliency of the biggest banks is pretty high right now,” said Daniel Tarullo, who oversaw financial regulation at the Federal Reserve until last year. “It would be good for them to have a bit more capital and be even more resilient, but what we’ve got right now, if preserved, is pretty good.”

Shrinking Banks

Regulations have constrained the biggest banks’ growth. Despite swallowing weaker rivals at the height of the crisis, even JPMorgan Chase & Co. and Bank of America Corp. are smaller than they were in 2007, when accounting for U.S. economic growth since then. Some European giants such as Royal Bank of Scotland Group Plc and ING Groep NV, both bailed out by their governments, are less than a third of their pre-crisis selves when measured against national GDP. One outlier is China, now home to five of the world’s 10 biggest banks by assets. Those five had assets in the first quarter that equaled 131 percent of China’s annual GDP, up from 114 percent in 2007.

Related story: China’s Giant Banks Top This Ranking. That’s a Cause for Concern

The largest firms have been forced to simplify their legal structures. The U.S. lender with the most business units cut the number in half in the past decade, to 1,335, according to a May study by the New York Fed. Living wills—blueprints that explain how the biggest institutions can be unwound in bankruptcy—have also required that cash be parked at operational entities instead of with the holding company. During Lehman’s first week of bankruptcy, creditors to its European units were dismayed to find that all cash from all subsidiaries routinely went to the parent in New York at the end of each day.

Funding is more stable. Half of the short-term financing that came from overnight repurchase agreements and other shaky sources has been replaced by deposits—the stickiest type, because they’re backed by insurance. Goldman Sachs Group Inc., which had hardly any deposits before the crisis, now relies on them for 16 percent of its financing, and the firm is seeking to expand its retail-banking franchise even more. Deutsche Bank AG, Europe’s biggest investment bank, is trying to become more of a consumer lender in Germany.

Less Risky Business

That means big banks have partially turned away from trading risky structured products that few people can fathom and more toward plain-vanilla banking functions such as lending to companies and consumers. The relative shift has reduced the share of revenue garnered from capital-markets trading at most of the biggest firms. The post-crisis capital regime and other regulations such as the Volcker Rule, a key provision of the 2010 Dodd-Frank Act, have contributed to this shift by discouraging risky trades.

The Fed was the first central bank to cut interest rates to almost zero at the end of 2008 to halt the free fall in asset prices. The European Central Bank and Bank of England followed suit in early 2009, though it took the ECB five more years to reach zero after the currency bloc had its own crisis, with Greece needing to restructure its debt and several other governments seeking financial assistance from Brussels.

Even as the Fed has slowly raised interest rates in the past three years, other central banks have stuck to zero or even negative rates.

Central banks bought about $10 trillion of bonds to help asset prices, a practice that’s now well known as quantitative easing, or QE. The asset purchases and sub-zero policy rates helped push yields on many sovereign bonds into negative territory as well. That means lenders pay governments to hold their debt, instead of demanding interest. Such warped debt dynamics are part of the “new normal,” a term popularized by Allianz SE chief economic adviser and Bloomberg Opinion columnist Mohamed El-Erian. The Fed, while departing from other major central banks on rates, has been reluctant to shrink its balance sheet.

“When you set an equilibrium at zero percent interest around a big balance sheet, it’s very hard to change that,” said Thomas Hoenig, a former member of the Fed’s monetary policy decision-making group. “Balance sheets will stay large for a long time. Policymakers want to eliminate the imbalances created by those large balance sheets, but they have to be very careful unwinding all that.”

QE and low rates have boosted stock markets worldwide, with the Dow Jones Industrial Average tripling since 2008, and Germany’s DAX and Japan’s Nikkei more than doubling. But as stocks surged, wages and salaries stagnated, rising more slowly than they typically do in post-recession rebounds, exacerbating income inequality. The uneven benefits of the recovery have fueled populism in the U.S. and Europe, which is what typically happens after financial crises, as voters blame minorities or foreigners for their economic plight, according to a 2016 paper co-authored by Manuel Funke, a researcher at the Kiel Institute for the World Economy in Germany.

The 2008 crisis was the result of U.S. households feasting on cheap credit to buy homes. The loans weren’t cheap because interest rates were low—in fact they were higher compared to today—but many mortgages were made with low introductory rates for several years before resetting at much higher levels. That meant homeowners could refinance before the new rates kicked in, thanks to the nonstop rise of home prices as new buyers were constantly joining in the frenzy.

These Ponzi-like conditions created a giant subprime-lending industry that persuaded millions of people with bad credit or unstable incomes to take on mortgages they couldn’t afford. When house prices stopped going up, it all came crashing down. The harm caused by the housing bust was amplified by the complicated securities that Wall Street devised to package and repackage the loans, as well as the derivatives bets made on them. Almost half of the costs were borne by European institutions that had bought a lot of the securities.

As millions of Americans lost their homes and became renters again, some of the debt was written down to match the collateral, whose value had crumbled. U.S. consumers have been paying off their debt, too. Helped by those factors and lower interest rates, the percentage of household income used to make debt payments is now at a 40-year low. But as consumers deleveraged, companies borrowed, some using the debt proceeds to repurchase their own stock. The average debt-to-capital ratio of nonfinancial companies in the S&P 500 Index had surged to 49 percent by the end of June from 32 percent in 2006.

“The aggregate data probably understates the problem,” said Phil Suttle, a former Bank of England economist who now runs his own shop, Suttle Economics. “There are some companies flush with cash and very little debt while others are up to their ears in it.”

Surge in Riskiest Corporate Debt

The search for yield in the current low-rate environment has led to a surge in junk bonds as well. Companies whose debt is seen as risky have been able to borrow at increasingly lower spreads compared with those actually considered safe for investors.

The subprime machine that led to the crisis was actually built on a generate-and-distribute model, where big banks like Lehman financed third-party mortgage lenders or owned them outright, and then packaged those loans into securities they could sell to investors. The machine sputtered when buyers for the securities grew scarce, but the origination factories kept humming—filling bank balance sheets with unsold mortgage-backed securities, or collateralized debt obligations made up of those securities. In some cases, the CDOs created by trading desks were being bought by traders on other desks who were authorized to invest a bank’s own funds.

So perhaps it’s comforting that the biggest banks have lost their hold on the riskiest type of lending in today’s market—leveraged loans. Higher capital requirements and regulators ordering the biggest firms to dial down their risk in that area precipitated the shift. Hedge funds, smaller banks and broker-dealers with no banking units filled the void. Jefferies Financial Group Inc., an independent brokerage whose market share in leveraged loan underwriting was 0.07 percent in 2007, is now among the top underwriters with 3 percent, according to Bloomberg data. There were some 150 bookrunners last year arranging such loans, compared with 60 a decade earlier.

The leveraged loans are now being packaged into collateralized loan obligations and sold to investors. Sound familiar? And the CLO market has grown to match the size of the CDO market at its pre-crisis peak. Yet one major difference makes the CLOs of today less scary: The loans that comprise them are backed by collateral, and if one of the companies in the mix defaults, an investor can find recourse through the sale of that collateral. Pre-crisis CDOs built on mortgage-backed securities had no such backstops.

Yet leveraged-loan covenants—the financial conditions that lenders place on borrowers—are getting lighter, Moody’s Investors Service has been warning for more than a year. And for many firms, the leveraged loans are the only debt, removing the safety of being the most senior lender in a chain of creditors and reducing the potential to recover losses in case of a default, according to Moody’s.

Other new players to take on risk once shouldered primarily by big banks are central clearinghouses for derivatives. Dodd-Frank required financial firms to clear derivatives transactions centrally where possible, so the big banks in the middle of all transactions would no longer face the risk of one side not paying. That has moved the clearing of almost 90 percent of interest-rate swaps—the biggest segment of the market—to clearinghouses owned by major exchanges worldwide.

With risks shifting to shadow banks—hedge funds, insurance firms, independent broker-dealers and other intermediaries that aren’t deposit-takers—critics have questioned whether governments will bail out non-bank institutions in the next crisis. In other words, now that the biggest banks have been reined in, have the shadow lenders themselves become too big to fail? Moody’s now assumes some level of government support in its ratings of central clearinghouses. All ratings firms assumed such backing for the world’s top lenders during the height of the crisis.

There’s also the danger that the shadow players could bring down the biggest banks. When a clearinghouse’s losses mount, it can tap its members—the big banks—for funds. So it’s not impossible to imagine a situation where a clearinghouse’s troubles ricochet throughout the financial system.

“The clearing entities are well-capitalized, and the big banks are better capitalized compared to before the crisis,” said Barney Frank, who co-authored the 2010 financial regulatory overhaul with fellow Democrat Chris Dodd. “That gives the system two layers of protection in case of defaults.”

Some shadow lenders have shrunk since the crisis, partly because of new regulations and low interest rates. Money-market funds that invested in non-government debt were a major source of funding for banks and nonfinancial firms before the crisis. They were de facto deposit-takers even though they never paid deposit insurance like banks do. When one of them blew up because of its lending to Lehman, the government had to temporarily guarantee the $3 trillion of savings stored in such funds. While the money market funds investing in Treasuries have grown somewhat, the others—so-called prime funds—have shrunk by three-quarters to less than $500 billion.

The post-crisis change in the rules for the funds now requires the prime funds to have floating net asset values—in other words, they can no longer pretend to be riskless savings accounts that can always return the original investments. Prime funds’ lending to banks has shrunk as well. The danger is that as interest rates rise, money could flow back to such funds, away from bank deposits, in search of yield. Then the banks would have to go back to borrowing from them, increasing their vulnerability.

“The money-market reform hasn’t been tested fully because of low rates,” said Jeremy Stein, a former Fed governor who teaches finance at Harvard. Will the floating net asset values “discourage people from flocking to prime funds even when rates increase? We don’t know for sure.”

The banks could end up being on the hook if smaller shadow lenders that have filled the void in risky markets end up failing. While the ties between the mainstream banking system and the shadow one aren’t very transparent, increased lending by banks to non-banks signals that some connections might have gotten stronger.

The biggest banks are still the largest players in the opaque derivatives market. Despite some of the risk shifting to clearinghouses, the top six U.S. banks still account for about 35 percent of all derivatives contracts worldwide, down from 45 percent in 2010.

Because there are no public data on the counterparties in the $532 trillion market, it’s impossible to know for sure whether the failure of a large hedge fund would create contagion for those banks through derivatives. It also continues to bind the six major players to one another.

And while shadow banking has grown since the crisis, taking share in some corners of the market, traditional banks still dominate lending worldwide, accounting for 60 percent of all credit extended. That ratio has hardly budged since 2002, the first year of data disclosed by the Financial Stability Board in its latest annual shadow-banking report.

As part of the post-crisis reform package, the U.S. and European Union also created resolution mechanisms for the biggest banks, which would facilitate the takeover and winding down of a systemically important firm by regulators. While some creditors would bear losses in such a resolution, the government is supposed to recoup all the funds it might temporarily provide for liquidity support by the end of the wind-down.

The U.S. resolution plan favors the bank units that have deposit-insurance backing over the parent companies in case of failure. The holding company’s shareholders would be wiped out and some creditors’ debt would be converted into equity, making them the new shareholders. That new capital would flow into the operational units to keep them functioning during the wind-down.

That differential treatment between parent and banking unit should have widened the spread between the interest rates of bonds the two issue, which hasn’t happened since the rules took effect, according to a recent New York Fed study. That signals the market believes there could be big bank bailouts next time around, according to the study. Critics contend that the resolution mechanism might work in the event of an isolated bank failure, but not when more than one top lender is in trouble. When a systemic crisis is at the door, policymakers might hesitate to use the resolution mechanism, said Tarullo, the Fed’s former regulation czar.

“Policymakers may say: ‘We’ve never done this before, should we try it now?’” Tarullo said. “There’s some chance they’ll say: ‘Let’s not roll the dice.’ Or perhaps they might roll the dice with the first failing firm, but not risk it with the others.”