By Amol Agrawal
September 16, 2023 marked the 15th anniversary of the failure of Lehman Brothers, the erstwhile US-based global investment bank. The failure engulfed the entire global financial system, leading economists to call it the Global Financial Crisis (GFC).
The GFC questioned many pre-existing beliefs on role of finance and pointed to new lessons.
First, there was the notion that the financial system just acted as an intermediary, channelising savings towards investments. The crisis showed that the financial system was a major component of the modern economy and if not managed well, could lead to a major crisis.
Second, the belief that the failures of financial systems was mainly limited to developing countries was trashed. The crisis showed that the financial systems could fail in the developed world too.
Third, the crisis showed that risks were not in one segment of the financial system, but interconnected across financial segments. Regulators must watch out for non-regulated entities too.
Fourth, the crisis showed that even if financial entities looked health from a micro perspective, they could pose risks from the macro or systemic perspective.
Fifth, the crisis showed that financial innovation could be used to hide risks in the economy.
The crisis led to heightened action in developed economies. Commissions were established both in US and UK to study the causes of the financial crisis and reform the system. The financial system regulators pushed banks to raise capital and reduce their risky positions. There was also increased attention on non-banks. The regulators tightened regulation and supervision. They also widened the scope of their attention from micro-prudential risks, which looked at risks from individual entities, to macro-prudential risks, where they focused on systemic risks. The governments also established inter-regulatory forums of different regulators to focus on financial risks from both banks and non-bank entities.
The progress seemed reasonable as one did not see any major troubles for the next 12 years. However, critics cautioned that the financial stability was due to central banks keeping interest rates very low. It would only be known if the reforms had worked in case of an economic/financial shock.
The 2020 pandemic posed the first such shock. Governments imposed lockdowns worldwide, leading to the complete halt of economic activity. However, the financial system managed the storm well thanks to central banks infusing liquidity like there was no tomorrow. The 2022 Russia-Ukraine war posed the second shock, but again, it was weathered well. In 2023, the cracks suddenly widened and broke open, leading to the failure of three major US regional banks and a global European bank.
What happened in 2023? The pandemic and the war pushed inflation levels last seen nearly 40 years ago in developed economies. The central banks started to increase interest rates significantly. For more than a decade, the banks were used to low interest rates and had invested in government securities. With rising interest rates, the price of the securities started to fall leading to losses. In case of some of the US regional banks, a large percentage of deposits were uninsured. These depositors figured that their banks are incurring large losses, leading to classic bank run on the deposits and eventual failure. The crisis spread to European shores, where one of the largest Swiss banks which was struggling also failed. Even before the 2023 financial storm, UK and European economies faced currency storm in 2022 as their currencies depreciated significantly due to US monetary policy.
In several ways, it was again a case of deja-vu where once again the crisis spread from US to European shores. Thankfully, this time around, barring the initial negative reactions, the impact in other countries was contained. The regulatory measures taken post-2008 crisis helped mitigate another wave of GFC.
What do we make of the above discussion? Just as financial regulators tighten screws on older forms of risks, new forms of risks emerge. Currently, two new risks have surfaced: technology players entering finance and social media. The technology which was once at the periphery of finance as a support system is a core of finance. This has led to all kinds of technology companies entering the field. The biggest technology companies (BigTech) such as Google, Amazon, etc, are providing all kinds of financial services, from banking to payments to insurance. The smaller technology companies are operating in niche spaces of payments, loans etc. It is not clear what kinds of risks these entities pose and how to regulate them.
Social media has also emerged as a new risk. The research on 2023 US bank failures highlight the role social media played in transmitting information about the banks in matter of seconds. Even before the banks could react, the damage was done. While one could still figure tech companies getting into finance, how does one manage social media so that bank runs are prevented?
The 2022 Nobel Prize in economics was given to three scholars for their work on bank runs. While some of the fundamentals of bank failures remain unchanged, new forms of risks keep emerging, keeping researchers and future Nobel Prize awardees busy.
Amol Agrawal, The author teaches at Ahmedabad University. Views are personal.