Predicting the 'Super GFC': two very different views

Two new books give very different pathways to the next financial collapse, one quite conservative and the other radical but both coming from a realist perspective, meaning they extrapolate from facts rather than pinning their faith in simplistic economic theory. Bringing them together provides some additional depth.

The Bankers' New Clothes: What's Wrong with Banking and What to Do about it (Anat Admati and Martin Hellwig)

The two authors are highly respected academics, Admati from the US and Hellwig from Europe. The book has endorsements from former central bank leaders, Paul Volker (US) and Mervyn King (UK), plus the well-known Kenneth S. Rogoff and many more.

The message is fairly straightforward. The GFC was caused by lax regulation of banks. After massively expensive bailouts of banks by governments nothing much has been done to change the controls on banking. In fact things have got worse, so we can expect an even more horrific crash unless governments quickly do some simple things to make the financial system safer. Their final point is that all we need is the political will, but that seems to be lacking.

Their most important prescription is for higher equity to debt ratios for banks, and they demolish all the arguments banks trot out as to why this can't or shouldn't be imposed. The simple point is that with more equity the banks shareholders stand to lose more in a downturn before they go running off to the government for a bailout.

Big changes are also recommended to the contractual bonus incentives that currently encourage bankers to take excessive risk. There are more good ideas in what is at times a fairly dry text.

But along the way some interesting points are made.

The authors point out that banks have incentives to merge, and get bigger in other ways, to achieve the status of 'too big to fail'. Their borrowing becomes cheaper at that point because lenders believe they will be bailed out by governments if it all goes wrong. However, the authors claim banks are going beyond 'too big to fail' and achieving the status of 'too big to save'. With government debts already enormous the bailout costs after another great crunch would be impossibly large.

On March 31, 2012, the debt of JP Morgan Chase was valued at $2.13 trillion and that of Bank of America at $1.95 trillion, more than three times the debt of Leman Brothers [when it collapsed]. The debts of the five largest banks in the United States totalled around $8 trillion. These figures would be even higher under the accounting rules used in Europe. [US GDP is generally believed to be around $15 trillion but see below.]

They go on to say that the situation is even worse in Europe.

The complex interconnection of banks and other financial institutions is outlined as part of the explanation of 'contagion', or how panic can close down the system even when losses are apparently manageable.

Total global banking assets are put at $80 trillion. It is worth remembering that total global domestic product, depending on how it is calculated, ranges between $70 and $85 trillion.

The book includes a quote from Adair Turner, chair of the Financial Services Authority of the UK, made in 2010. '"There is no evidence that the growth of the scale and complexity of the financial system in the rich developed world over the last twenty to thirty years has driven increased growth or stability, and it is possible for financial activity to extract rents from the real economy rather than deliver economic value." He continued, "We need to challenge radically some of the assumptions of the last thirty years and we need to be willing to consider radical policy responses."'