Reason
May 2012
Every politician, central bank, and regulator in the developed world spent 2008 and 2009 saying, “This must never happen again.” “This” was the financial meltdown that almost took down the world economy. They differed in their proposed solutions but held one demand in common: Banks must never again take the kind of highly leveraged risks in exotic securities that were widespread at the tail end of the housing bubble. Financial institutions should instead build a large buffer of risk-free investments that will always be liquid and never result in losses.
The favored buffer: government bonds. The economic consensus after the financial collapse was that banks should lend more money to governments. Politicians and regulators demanded it, twisted arms, and wrote new rules to make it happen.
In the last chapter of my 2009 book Financial Fiasco, I wrote: “If the government’s capital requirements favor certain ways of holding assets, all banks will hold their assets in those ways, and they will all be struck by the same type of problems at the same time.…After each crisis, the authorities investigate what worked better and then force market players to conform to this ‘best practice.’ All these attempts to make the system as safe as possible really make it extremely sensitive to small blows and changes.”
Since 2009 this warning has been tested on a continent-wide scale. European governments told banks that sovereign bonds were risk-free, that they didn’t need to be backed by additional capital, and that they were necessary. The new liquidity requirements in the Basel III agreement on global regulatory standards, written in response to the financial crisis, obligated banks to hold more government bonds on their balance sheets. The banks predictably loaded up. When the European Central Bank (ECB) lent financial institutions €442 billion in June 2009, they used half the amount to buy still more government bonds.
At the end of 2010, Europe’s 90 biggest banks had lent more than €760 billion to the PIIGS countries—Portugal, Italy, Ireland, Greece, and Spain. As I write this, due to the losses from those bonds, the entire European banking system is on the verge of collapse.
The problem is not faulty valuations of particular securities; those have been wrong before, and they will be wrong again. The problem is the false conceit that regulators can protect financial markets from risk simply by deciding what is less risky, then getting everybody to march in that one direction. This approach just gives every bank the same weakness. If the defense is breached, everybody will tumble to the ground together.
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