Despite our extensive knowledge on the causes and preventions of financial crises, why do they persistently occur? This was the pressing question addressed by regulators, academics, and investors at the London School of Economics (LSE) during the 10th anniversary of the university’s Systemic Risk Centre. The consensus was clear: a combination of old issues and emerging risks continues to create fertile ground for financial turbulence.
Established after the 2008 financial meltdown, the Systemic Risk Centre aims to study past financial mishaps and prepare for future ones. However, the last decade has been anything but stable. The Centre opened just as the eurozone crisis peaked in 2012. Since then, the financial landscape has faced numerous systemic shocks: the extreme market volatility during the onset of the COVID-19 pandemic, the collapse of Archegos Capital Management in 2021, turmoil in UK sovereign debt in 2022, and the recent failures of Credit Suisse and several U.S. regional banks. Regulators are therefore on high alert, anticipating the next potential crisis.
Five Key Risk Factors
1. Shift in Risk Bearing
Efforts to ensure banks have more robust shock absorbers have led to significant changes in risk dynamics. U.S. broker-dealers now hold assets worth less than 20 times their equity, down from over 40 times during the pre-crisis peak, according to Hyun Song Shin, economic adviser and head of research at the Bank for International Settlements. This retrenchment by traditional lenders has shifted riskier activities to investment funds, intermediated through securities exchanges and clearinghouses. Central banks had to intervene early in 2020 to support debt markets distressed by the pandemic, highlighting the vulnerabilities in these new structures.
Asset managers like Blackstone (BX.N) and Apollo Global Management (APO.N) are aggressively expanding into private markets, sometimes bypassing banks altogether. While these structures are argued to be more resilient due to lower leverage and less liquidity risk, the consequences of a sudden market downturn remain uncertain.
2. Homogenization of Banking Models
Regulatory measures have inadvertently made banks more similar. Stringent rules and tighter supervision reduce the diversity in business models, as noted by SRC Director Jon Danielsson. This homogenization makes the financial system more susceptible to systemic shocks, as a problem in one large institution is likely to affect others similarly structured.
3. Evolution of Banking Practices
Post-2008, customer deposits were deemed a more stable funding source compared to wholesale finance. However, recent bank failures have prompted a reassessment. Silicon Valley Bank’s reliance on large corporate depositors, whose holdings exceeded the $250,000 limit for U.S. deposit insurance, proved unstable. Similarly, Credit Suisse witnessed massive withdrawals from private and corporate clients within days. Regulators, like Michael Barr, the U.S. Federal Reserve’s vice chair for supervision, are now reconsidering the assumptions about the stability of large deposits.
4. Fundamental Systemic Weaknesses
The financial system is inherently fragile due to certain entrenched practices. For instance, allowing companies to deduct debt interest from taxes incentivizes borrowing, increasing systemic vulnerability. Economist Charles Goodhart highlights the widespread use of limited liability ownership structures, which encourage risk-taking by insulating financiers and entrepreneurs from personal financial repercussions. Stock-based compensation further ties executives’ fortunes to the riskiest parts of the capital structure, exacerbating moral hazard.
Regulatory frameworks post-2008 aimed to mitigate moral hazard by ensuring that investors, not taxpayers, bear the brunt of losses through sufficient equity capital and subordinated debt buffers. However, the reluctance to utilize these crisis management tools persists. Uninsured depositors at SVB and other regional banks were protected by U.S. regulators, while the Swiss government facilitated a taxpayer-backed takeover of Credit Suisse by UBS (UBSG.S) instead of allowing it to fail.
5. Political and Social Influences
Increased public exposure to the financial system through retirement savings and mortgages has created a paradox. During economic booms, there is resistance to regulation that might curtail risk-taking. However, during crises, governments and regulators face intense political pressure to protect the public from financial losses. Research by LSE’s Jeffrey Chwieroth and the University of Melbourne’s Andrew Walter indicates that support for bailouts in U.S. newspaper editorials has surged in recent decades compared to the past.
Conclusion: Anticipating the Next Crisis
The specific trigger for the next financial crisis is uncertain. Some experts point to the rapid growth in government debt, while others see potential instability in real estate markets. Historically, financial turmoil often arises in areas considered safe, underscoring the unpredictable nature of crises. Nevertheless, the recurrence of financial disasters seems inevitable, providing ample material for future analysis and discussion among financial observers.
