Five reasons financial disasters are hard to avoid

If we understand the causes of financial crises and how to prevent them, why do they keep happening? That was the provocative question posed to a group of regulators, academics, and investors at the London School of Economics last week. The participants, who had gathered to mark the 10th anniversary of the university's Systemic Risk Centre, reached a sober conclusion: old problems and new dangers create the conditions for more turbulence.

The Systemic Risk Centre was set up after the 2008 meltdown to study what had gone wrong and, more importantly, be better prepared for future trouble. The intervening period has hardly been calm. The center opened its doors shortly after the euro zone crisis peaked in 2012. In recent years, financiers and watchdogs have grappled with a succession of system-wide problems: the extreme market turbulence caused by the onset of the Covid pandemic, the collapse of Archegos Capital Management, in 2021, the turmoil in UK sovereign debt,  in 2022, and the failures of Credit Suisse and several US regional banks a few months later. It's therefore no surprise regulators are anxiously scanning the horizon for the next source of trouble.

Potential problems fall broadly into five categories. The first stems from efforts to make sure banks have bigger shock absorbers. US broker-dealers now have assets worth less than 20 times their equity, down from more than 40 at the pre-crisis peak, Hyun Song Shin, economic adviser and head of research at the Bank for International Settlements, told the seminar. As traditional lenders retrenched, much of the riskier activity they left behind has ended up happening instead through investment funds, intermediated through securities exchanges and clearing houses.

The US investment fund took over Serie A champions from China's Suning after the Asian conglomerate failed to repay 395 million euros on time.

This shift creates new sources of stress, as central banks discovered early in 2020 when they intervened to support debt markets freaked out by the pandemic. Yet asset managers like Blackstone,  and Apollo Global Management, continue to push aggressively into private markets, at times bypassing banks entirely. Executives like Apollo CEO Marc Rowan argue that these structures are more robust because they have less leverage and, unlike bank depositors, investors cannot quickly withdraw their money. Still, given the growth of private markets, the real-world consequences of a sudden downturn are hard to predict.

Regulators also bear some responsibility for another potential vulnerability: they have made banks more alike. Tougher rules and tighter supervision make it less likely that different banks will pursue different business models, SRC Director Jon Danielsson argued. Smaller upstarts also find it harder to get a foot in the door. The result is a system where a small number of large banks do similar things. When something goes wrong – as it inevitably does – the problems are unlikely to be confined to one institution.

A third issue is that banking has evolved. After 2008, policymakers concluded customer deposits were a more stable funding source than wholesale finance, which had dried up at the first sight of trouble. Last year's bank failures on both sides of the Atlantic have forced a rethink, however. One of Silicon Valley Bank's weak spots was its heavy dependence on large corporate depositors, whose holdings exceeded the $250,000 limit for US deposit insurance. When the bank got into trouble, those customers scattered, aided by online apps which enabled near-instant withdrawals. Credit Suisse's private and corporate clients withdrew tens of billions of dollars in a matter of days.

Regulators are catching up. Last month Michael Barr, the US Federal Reserve's vice chair for supervision, signaled the regulator was planning to change its assumptions about the stability of large deposits when calculating banks' liquidity reserves. It's a reminder that financial systems are constantly evolving.

The fourth reason crises are hard to stamp out is that the financial system still suffers from some fundamental weaknesses. Take the practice of allowing companies to deduct debt interest from taxes. This creates a bias for borrowing, which in turn makes the system more fragile.

Charles Goodhart, the veteran economist, identifies an even more elemental flaw: the widespread use of limited liability ownership structures. This allows financiers and entrepreneurs to take risks in the knowledge they will not personally be on the hook if things go wrong. Stock-based compensation, which ties executives' fortunes to the riskiest part of the capital structure, offers further incentives to gamble. "Limited liability is the most extreme structure of moral hazard that we have in our system," Goodhart told the seminar. "We have based our capitalist system on moral hazard."

This is ironic, because regulators explicitly designed many of the rules introduced after 2008 to reduce moral hazard. If banks have sufficient buffers of equity capital and subordinated debt, the theory is that investors will bear the brunt of the losses – not taxpayers. Yet policymakers have been reluctant to use their crisis management tools. US regulators protected uninsured depositors at SVB and other regional banks. The Swiss government, meanwhile, arranged a hurried takeover of Credit Suisse by local rival UBS with a taxpayer backstop, rather than winding down the troubled Swiss lender.

Why this continued fondness for bailouts? One explanation is that people in developed countries have become more exposed to the financial system, through retirement savings and mortgages. In good times, they oppose regulation which might rein in risk-taking. "There is hardly any constituency against the inebriating feeling of getting richer during a financial boom," Claudio Borio, the head of the monetary and economic department of the BIS, wrote in 2019.

But in times of turmoil, governments and regulators face increased political pressure to protect this constituency from losses. The LSE's Jeffrey Chwieroth and the University of Melbourne's Andrew Walter studied US newspaper editorials, during financial crises dating back to the mid-19th century and found that support for bailouts was much higher in recent decades.

Opinions differ on what will cause the next financial crisis. Some expect the rapid growth in government debt to cause problems; others think real estate will be a source of instability. The history of finance suggests trouble often begins in areas people mistakenly believed were safe. Either way, it seems likely that observers of financial crises will not have to wait too long for the next case study.