In the financial crisis of 2008 the catastrophic collapse of the entire financial system emerged as a real possibility. As the financial system is the heart of the economy with its responsibility to ensure the flow of funding between investors, businesses and consumers, its system-wide collapse would have far-reaching consequences. The 2008 experience revealed a highly inter-connected system of financial institutions operating based on trust and routine with a less than adequate understanding of risks.
Challenges remain
Although the majority of the financial institutions managed to climb out of the abyss that they tumbled into in 2008, they are not out of the woods yet at all. Challenges and risks remain.
Some of these were brought about by the impact of the 2008 crisis as it unleashed destructive economic forces that businesses and governments worldwide struggle to bring under control. Other problems are the natural outcome of a still somewhat unstable industry that has just recently been rocked by a major upheaval. Yet other challenges are legacy issues carried forward from the storm.
While none of the currently existing threats seems to be powerful enough to unsettle the system the way the events of 2008 did, the risk of several of them combining into a new major storm is not negligible.
Uncertainty
Threats for commercial and investment banks are slightly different given their business models, but uncertainty is a major threat for both.
Their business is based on their ability to continuously circulate money throughout the system. Banks make money and maintain the overall economy when they sell money as loans, mortgages, investments to private customers and businesses. For this they have to buy money from other financial institutions, investors and the Federal Reserves.
The price and liquidity of these sales and purchases depends primarily on market participants’ expectations about their counter-parties’ financial strengths and the general economic and financial trends. Heightened and prolonged uncertainty will hamper financial institutions ability to accurately price their products and efficiently circulate money in the system.
Although the hysterical uncertainty of the 2008-2009 period is largely gone, spikes relating to the sew-sawing of the US mortgage market, the lack of clear resolution of the European sovereign financial crisis, a brewing storm in US municipal debt markets or the growing concerns over the US debt situation continue to frustrate financial institutions. Should any of these problems explode, levels of uncertainty will rise potentially igniting a new acute financial crisis where institutions will stop borrowing and lending and the critical flow of capital in the economy will be disrupted. .
Legacy of the 2008 crisis
Commercial banks that were the biggest players in the feverish mortgage business in the last decade continue to be at high risk for exposure to these potentially toxic loans. They carry significant amounts of mortgage loan assets on the balance sheets. The real value of these mortgages is still unclear: it depends on borrowers’ ability and willingness to repay them and on the realizable market value of the underlying properties.
Both of these two variables – borrowers’ behavior and the developments in the real estate market – are extremely difficult to forecast and continue to be at high risk. Moreover, the two are inter-connected: negative trends in the property market will have a negative impact on borrowers’ mortgage repayment which can further pressure real estate.
This puts banks owning such mortgages at risk for having to take severe hits to their net worth. If the mortgage assets that they own turn out to be less valuable than they now think, those assets have to be written down.
Since a bank’s assets have to equal their liabilities, which are composed of obligations towards their own creditors who include their depositors and the net wealth of their shareholders, reduction in the value of the bank’s assets can result in a hit to shareholders’ net wealth.
As the majority of banks’ obligations are owned by deposit-holders and other private and business clients temporarily investing their funds with the financial institution, in the protection of these funds financial institutions have to adhere to strict rules relating to the level of net worth they have to maintain. Any shortfall has to be addressed by raising additional equity capital, which can be very costly or under adverse circumstances outright impossible Banks with potential vulnerabilities remain cautious, slow their lending business to preserve capital. This will have a negative impact on both their profitability, as well as the availability of credit for consumers and businesses.
Assets of uncertain value present a problem for financial institutions that have not been involved in direct mortgage lending, but have bought securitized mortgage products. Unfortunately, the risks are not confined to mortgages: in more general ways, the stability of financial institutions hinges to a great extent on the banks ability to accurately value their assets and obligations. Obscure and inaccurate valuations have had and threaten to have dire consequences for individual players, as well as for the industry as a whole.
Pressures on the old business models
The financial crisis put forces into motion that have undermined the sustainability of once profitable business models, especially for investment banks. Many of these business models shave been based on the underestimation of risks the institutions were willing to take.
To put it simply, rewards – profits – are expected to be in line with risk: the more risk institutions are willing to take, the higher the expected payoffs will be. At the same time, chances of big losses also increase. To protect the system against shocks due to big, unexpected losses, rules have always existed to force institutions to protect themselves against big losses by maintaining adequate capital reserves to be set up in proportion to the assumed risk of the various products that the banks sold and bought. Additional guidelines existed to discourage or outright ban certain types of institutions from markets with high risk.
However, the experience of the 2008 financial crisis showed that the rules were not stringent enough or were based on an inadequate understanding of risk and consequently it failed to shelter the system from shocks. The institutions themselves seemed to have lacked adequate internal motivation to properly deal with risk; they were making too much money for too long.
The once profitable old business models based on excessive risk-taking in trading have become impossible to continue for most investment banks due to the compounded impact of new government regulation, pressures in the market and the institutions’ growing risk-aversion.
Unfortunately, no new, proven models of sustainable profitability have emerged yet. Most banks with investment banking businesses continue to struggle with identifying the new formula of success as they pare back trading operations and other businesses focused on high-risk products. The lack of a clear vision for their future impacts their overall operations and introduces new uncertainties into the markets’ perception of these companies’ future. Unfavorable market perception leads to constraints on these companies’ ability to secure funds and investments that provide the key ‘raw materials’ for banks’ operations.
Additional factors slowing recovery and growth in the industry
Even if no major new upheaval rips through the financial markets threatening their basic operations, institutions will continue to face many challenges that significantly impact their profitability and limit their ability to participate in once highly profitable and liquid markets which may have play an important role in providing financing to important economic sectors..
Examples of such challenges include the misalignment between a legacy compensation structure calibrated to continuously high expected profits and the reality of a yet-undefined model for sustainable rapid growth. While the immediate impact of this is localized to banks’ ability to attract and retain talent, the evaporation of innovation from banking can have an impact on the financial markets impacting all participants.
The disappearance of entire financial product lines due to banks’ unwillingness to provide a market for riskier products can stifle growth in areas of the economy that have been benefited by the existence of these products. While it is clear that some of the riskiest products – exotic derivatives or highly speculative consumer loans – need additional safeguards and systematic supervision, their total elimination from the financial markets can have adverse impacts, as well.
The future: slow and painful progress towards a new, lower risk equilibrium
A risk-free financial system is a self-contradiction. However, it is clear that the highly charged system of the late 1990s, early 2000s will not return any time soon. As banks slowly navigate the minefield of residual risk the newly emerging threats, they have to work their way through to a new, lower-risk model. Clearly, rewards and profits will be lower, the new model should allow for better containment of major shocks..