Ten years on: what’s changed? Are the banks less dangerous now?

RBS © Getty Images
RBS had to be rescued by the taxpayer

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Ten years ago this month, the global financial system simply stopped working.

The network of rules and obligations (both formal and informal), which is absolutely critical to directing the daily activity of businesses and consumers around the world, just… stopped.

For a short period, trust – which is ultimately what the business of exchange and the existence of civil society hinges on – completely evaporated.

That’s terrifying.

So what’s changed to stop it from happening again?

How the banks critically undermined trust in the financial system

What we think of as money is mostly obligations owed to us by other people, often via intermediaries.

When you put your wages in the bank, you assume that you will be able to get them out again. But the money is not sitting in a safe. Its availability to you depends on a network of related assumptions.

These include the assumption that the bank will remain solvent – that it is reasonably competently run. And that the people who the bank lends the money to will mostly pay it back. And that if the bank does mess up, the government will step in to cover your losses.

In other words, in order to enjoy a financial network that enables us to spend and save money relatively easily, we have to trust an awful lot of people to do their jobs properly. And the reason we trust them is not because we know them, but because it’s in everyone’s interests to keep the system running smoothly.

It’s all basic Adam Smith stuff. We co-operate with one another, because at an emotional level, as social animals, most of us have some sort of empathy with our fellow human beings (The Theory of Moral Sentiments); and on a practical level, it’s in our own best interests to do so (The Wealth of Nations).

The financial crisis involved this network of obligations and counter-obligations being stretched to the point where it would only take a few weak links to rip the whole thing apart. And the basic problem was the intermediaries – mostly the banks.

In effect, the banks figured out ways to mix and match a batch of those obligations (in this case, mortgage-backed securities) so that it looked as though they were more trustworthy than they really were. Hence, you got bonds backed by subprime mortgages that attracted the same credit rating as a US government-backed bond.

The banks themselves then ended up holding so much of this stuff that their own solvency came into question. And because they were the key intermediaries – almost everyone needed to trust them at some point along the line – that meant the whole system collapsed.

The only solution at that point was for the taxpayer (because that’s ultimately who backs the government and even the central bank) to come to the rescue. Someone had to step in and restore trust – to say: “You can continue using this system and it will work.”

The banks are fixed for the time being

However, saying that we needed to save the system is very different to saying that we should have devoted all of our time to putting things back the way they were.

If the entire electricity grid collapsed, necessitating the mobilisation of the army and a mass hiring of diesel generators to restore power, say, then we would have to take a long hard look at what the utility companies had been doing. If it turned out that they’d been using substandard wiring (please forgive me for the shoddy metaphor, I’m not an engineer), then you’d like to think that we’d do something radical about it.

As far as the banking sector goes, though, it feels as though they got off easily. The main changes have been about reining in the activity of the banks, rather than fundamentally restructuring the industry.

Banks don’t do as much high-risk lending because they have stricter rules about how strong their balance sheets need to be. And that’s important, of course. But the big banks have only got bigger. The fundamental problem – that some sort of taxpayer intervention would probably be necessary if one of these things blew up in future – is still with us.

That said – and this is really important – if you’re looking for the source of the next crisis, it probably doesn’t lie with the banks.

You might not be particularly happy with the way that the banking sector has remained, for want of a better word, unhumbled. And in general, the arrogance demonstrated by its biggest players has been breathtaking, all things considered.

However, just as with driving, you shouldn’t invest angry. And on that front, it’s worth recognising that by and large, for now, the banks are “fixed”. Their balance sheets are healthier, they’re being more cautious, and – critically – while debt is still huge, it has shifted beyond the household sector, which is generally the source of the most havoc when it does go wrong.

That doesn’t mean that the banks won’t break again at some point in the future. It doesn’t vindicate our specific response to the crisis. (My own view remains that vastly more far-reaching reform of the monetary system will be necessary before this crisis is done with.)

But from an investors’ point of view, I think what it is important to understand is that it does mean that the next crisis is unlikely to come from that direction. Critically, even if a bank does hit the wall, Lehman-style, we now know what the rules are. It’ll get bailed out in some way, and central banks will be called on to print money to plug the holes.

So where will the next crisis come from? I’ll be looking at that in the next issue of MoneyWeek magazine, out on Friday. If you’re not already a subscriber, sign up here.