or The True Cause of the 2008 Financial Crisis (Questions and comments in subsequent post.)

Oceans of ink have been spilled in attempts to explain the 2008 Financial Crisis. Yet its true causes remain obscured by a fog of myth and bias.  Now, as we witness the creeping socialization of our credit industry and listen to populists push ever more onerous regulation, it seems like a good time to take a deep breath and consider what really did cause the crisis.

Spoiler alert: Hollywood got it wrong. The crisis was not caused by subprime lending, or CDO’s, or CDS’s, or savings gluts, or Glass Steagall repeal, or even “Greedy Wall Street Bankers”. Yes, some of these played ancillary roles, but they were small potatoes.

So what did cause the crisis? The causes were complex, but one force overwhelmed all others: regulation. Bad regulation.  Mainly, the Basel I and Basel II Capital Standards.

This news will be a letdown for many.  “Where’s our scapegoat?” they will ask.  “It’s easy to get a good hate on for ‘Greedy Wall Street Bankers’.  But ‘International Bank Capital Standards?’   Forget it.  Who do we blame?  Ourselves?”

Fact is, we have drawn all the wrong lessons from the financial crisis.  The crisis was not a failure of the free market, but of government. Further, it was limited to the European banks and the US shadow banks.  In fact, the great untold secret of the crisis was the strength of the US commercial banking industry.

The story is a simple one.  So simple, in fact, that I’m astonished so few have focused on it.

With typical American myopia, we remember the 2008 financial crisis as a purely domestic disaster.  Europeans like to pile on this myth, bloviating at the evils of American capital finance.  So one can be forgiven for not noticing that the 2008 crisis was not entirely, or even mostly, an American crisis. It was above all a European crisis (and still is.)  The proportion of US banks that failed or needed to be recapitalized was peanuts compared to Europe.

A brief word about bank capital standards.  Because bank assets (mostly loans) are risky while bank liabilities (mostly deposits) are fixed and largely government guaranteed, regulators rightly require banks to hold a minimum amount of shareholder’s capital with which to absorb any losses on bad assets. Historically, 10% has represented quite a lot of capital while 5% has been the frontier between adequate and insufficient capital.  Very simplistically, a bank with 5% capital could suffer a 5% loss on its assets before creditors are compromised and the bank fails or authorities elect to bail it out.

Basel I was promulgated in 1988 to establish a new regime for bank capital standards.  The new rules made sense in theory as regulations occasionally do. Instead of a fixed capital requirement for a bank — requiring, say, equity of 5% across the board — Basel tried to make capital requirements proportional to a bank’s balance sheet risk.  Its method was to assign “risk weightings” to each class of assets.  Thus, a bank whose assets consisted of nothing but Treasury Bills would need to hold very little capital, while a bank specializing in construction lending might need to maintain quite a high capital ratio.

Fair enough.  But Basel I had two fatal flaws.  First, there was no lower limit on a bank’s leverage ratio (equity less goodwill divided by assets.)  This proved to be a crucial difference between European regulation and more conservative U.S. regulation, which retained a leverage constraint.  The second failing was that the risk weightings proved completely bogus.

Basel II was issued in 2004 and compounded the deficiencies of Basel I.  The essence of Basel II was the abdication by international regulators of any role in bank supervision.

Basel I drove European banks to become much bigger and more highly leveraged.  As long as banks were adding assets that Basel deemed “low risk”, there was virtually no limit to the size of a bank’s balance sheet or the leverage a bank could attain.

Think for a minute about the implications of this expansion.  First, heightened leverage alone made the financial system far more unstable, as a top-heavy ship is vulnerable to a rogue wave.

Second, Basel stoked an insatiable appetite for assets of all kinds. Especially coveted were assets that Basel (erroneously) classified as “low risk.”  Things like AAA rated sub prime MBS and Greek sovereign debt (oops.)

Just how big was this Basel-driven demand for assets?  Massive, stupendous, and colossal are three descriptors that come to mind.  But they are woefully inadequate.

European banks in 2007 had aggregate tangible equity of roughly 1 trillion euros (at the time, about $1.1 trillion.) With a sensible leverage ratio of 5.0%, this equity would have supported E20 trillion in assets.  But by 2000, the average European bank leverage ratio already had dwindled to 3.8% (insufficient), and then fell further — to 3.0% (wow) in 2007.*  That may not sound like a big deal, but it’s more than a 20% systemic increase in leverage in just 7 years. This meant that for European banks alone, the Basel Regs goosed asset demand by at least E7 trillion ($8 trillion).**  To think of it another way, European bank assets in 2007 exceeded what would have been prudent leverage (i.e. 5%) by E13 trillion ($15 trillion) — a third of European banking system assets.

This is, I believe, a conservative estimate, and these are very, very, very, big numbers.  Eight trillion dollars was far more than the total US issuance of sub-prime mortgage backed debt in the 2000’s.  It was many multiples of Chinese dollar holdings. Eight trillion dollars was roughly equivalent to the US national debt in 2007. 

The biggest European universal banks drove most of this demand, largely through their United States dollar-based offices.  Here, they found easy funding through money market funds and gorged themselves in our bountiful capital markets. (For a far more elegant treatment of this issue, I strongly recommend reading “The Global Banking Glut” published in 2012 by Hyun Song Shin.) By 2007, leverage ratios for these banks were wafer thin, even though by Basel standards capital remained adequate.  Some banks were off the charts.  The leverage ratio for Barclay’s was 2.1%, and for UBS 1.8%.  Even mighty Deutsche Bank, that paragon of financial probity, was leveraged nearly 100 to 1. 

Leveraging US shadow banks (including Lehman, Countrywide, WAMU, General Motors, and especially Fannie and Freddie) contributed further trillions to this demand.  The much decried leverage of US brokerage houses was largely a competitive response to the Basel-driven leveraging of the European universal banks (along with some poorly timed capital liberalization from the SEC.)

Moreover, these superfluous assets were overwhelmingly funded short term, typically overnight.  Thus, European banks became extremely vulnerable to runs if (when) short term creditors got jittery.  Runs don’t occur because short term creditors know something bad is going on.  Runs occur because short term creditors think something bad might happen and want to get their money out before anyone else gets wise.  Shoot first and ask questions later is always the default strategy.  That is why it is essential for the central bank to stand foursquare behind the funding of every bank in the system.

Just about the only expert I have found who correctly identified Basel as the principal cause of the financial crisis is Jeffrey Friedman in his 2011 book “Engineering the Financial Crisis.”  In it, he focuses on the “Recourse Rule”, an offshoot of the Basel II discussions that reduced by 80% the capital required for AA and AAA rated tranches of asset backed securities.  Adopted in 2001, the Recourse Rule allowed US-based banks (including US branches of foreign banks) to employ dramatically higher leverage if deployed in “low risk” RMBS.

The mechanisms that enabled banks to borrow in such obscene amounts were the Asset Backed Commercial Paper and Repo markets (see any number of superb books and articles by Gary Gorton.)  Because short term financing was ostensibly “collateralized,” there was an illusion that these loans were without risk.  But as things came apart, collateral values plummeted, and ultimately lines to banks were pulled entirely.

Credit standards declined as well.  One of the most powerful concepts in economics is “the law of diminishing marginal returns.”  As European banks and shadow banks reached for that marginal asset, they increasingly had to compromise on credit quality.  Deferring to Basel’s guidance, most did not understand (or chose to ignore) the risk inherent in these assets, and rating agencies happily abetted this willful self delusion.  Turned out that as long as one could borrow and was not too choosy about credit, one could always find an investment bank willing and able to whip up that marginal asset and feed the beast.  If it smelled a little too much, no problem.  A small fee to AIG got you a credit default swap.  Hey presto, AAA.

Much of the leveraging I describe was done with derivatives.  For instance, the value of UBS’s derivatives book soared from E26 billion in 2002 to E450 billion in 2007.  Now, derivatives are very useful tools.  Properly managed,  such increases would not necessarily have heightened risk for a bank or for the system overall.  But too often, these derivatives were used to create “synthetic” assets structured to skirt Basel standards and boost trader bonuses; remarkably, Basel II allowed banks to value most derivatives using their own internal models.  Moreover, as we now all know from the “London Whale” fiasco, even derivative positions intended as conservative hedges have a funny way of ballooning out of control.

Worse, this explosion in derivatives engendered a silent, insidious rise in systemic counter-party risk.  Off balance sheet SIV’s exacerbated this problem. When crunch time came, there were hundreds of trillions of dollars of notional claims piled on top of tens of trillions of book commitments, with no capital to back them up.   No European bank could have any confidence in the ability of any counter-party to meet its obligations.  Moreover, since each European country had its own regulatory and bankruptcy regime, it was unclear how these claims would be resolved even if the counter-parties could be identified and held accountable.

So we can see that, far from causing the crisis, the subprime bubble was simply the bastard child of Basel I.  By allowing minimal capital to be held against assets that turned out to be garbage, Basel created an appetite for these assets that would not otherwise have existed.

The important point is that, in January, 2008, there was an immense overhang of dodgy longer term assets held by a variety of egregiously leveraged players, most of it funded overnight.  The Basel I and II capital standards mandated a European banking system that became like a forest overstuffed with dry tinder.  The sub prime crisis was just the spark that set it all alight.

Incidentally, the ferocious demand for assets from 2002 to 2007 also meant that trading anything always made profits.  That’s why all those bond traders on Wall Street made so much money in the 2000’s; the trade only went one way. So when we decry the billions in Wall Street bonuses for the 1%, recognize that they were just a gift from the guys and gals in Basel.  We can’t really blame the traders for confusing that gift with genius.

In contrast with their European counterparts and the “shadow banks,” American commercial banks in 2007 boasted strong balance sheets. They, too, were subject to the Basel Regs, but US managements and regulators had prudently insisted on higher capital ratios for US domestic operations than Basel permitted. Wells Fargo’s tangible ratio was 5.8%, Wachovia’s was 4.3% and US Bancorp’s was 5.3%.  (I omit Citi, JPM, and BAC because of differences in accounting for their sizable derivatives portfolios.). The average leverage ratio of US commercial bank holding companies in 2007 was  5.6%***. Not only was this nearly double that of the Europeans, it turned out to be far more than adequate to weather the crisis

Crucially, the funding profiles of US banks were also far superior to those of the Europeans.  This made them far less vulnerable to runs.  In 2007, Wells Fargo had $500 billion in assets and only $50 billion in what one might classify as “hot” funding.  Compare that to UBS, with E2 trillion in assets (ex-derivatives!) and E1.2 trillion in hot funding.  (You can easily check all these numbers for yourself on Edgar.)  Truth is, most US commercial banks and European universal banks were not then, and still are not, in the same business.  This is a fact that has evidently not dawned on US regulatory authorities.  The Europeans had much more in common with the US “shadow-banks.”

Listening to populists pontificate today, one would think that the entire US banking industry had needed a bailout back in 2008. But in fact, the banking industry suffered a loss in only one year and that loss was manageable— roughly $40 billion in 2008.*** If not for Citigroup and Wachovia (whose losses stemmed largely from its acquisition of Golden State, a shadow bank), the industry would have been profitable even in that dismal year.

 Let me emphasize this point.

 In the worst financial crisis in 80 years, the entire US banking industry suffered an aggregate loss that was less than what was spent to bail out Chrysler and GM.  Some crisis.

Yes, some banks failed or were forcibly merged.  That’s entirely to be expected, even welcomed, in a capitalist economy. Yes, TARP was imposed on the industry by government fiat, but that was completely unnecessary.  Yes, Citi and BankAmerica were given equity infusions. That was unfortunate, but of course, the bank “bailouts” ultimately made a tidy profit for us taxpayers.  In contrast to the European banks and the shadow banks, the US commercial banking system functioned effectively during the crisis and essentially as intended.

To summarize:

  1. Thanks to abundant capital, adept management and effective regulation, the broad US commercial banking industry proved extraordinarily resilient during the financial crisis of 2008.
  1. Far from destroying the economy, commercial banks, by absorbing troubled “shadow-banks,” helped stabilize the economy.
  1. Therefore, more oppressive banking regulation was the last thing the industry or the economy needed.

In other words, this was not an industry that needed to be nationalized by the regulators, some of whom were the very people who had caused the crisis to begin with. To socialize the delivery of credit to our economy, which seems to be the unspoken agenda of the current administration, is a breathtakingly misguided policy.  (If you think I’m alone in holding these views, read “Comradely Capitalism” in the August 20 Economist.)  With apologies to Bernie Sanders, it seems that Wall Street has not cornered the market in arrogance.

Just to be clear.  No one believes that the banking industry should be entirely unregulated.  Deposit insurance and the Fed backstop make moral hazard a real issue.   But the threat of moral hazard is way overblown. If moral hazard were really as imminent a threat as some contend, it would have been the commercial banks, not the shadow banks, that took the most risk prior to the crisis.  The critical point is that, imperfect as it may have been, the US commercial bank regulatory regime ex-ante proved more than up to the job.

My belief, and I think the belief of most Americans, is that regulation is often necessary, but that less regulation is always preferable to more.  It’s not that we have unquestioned faith in the free market to get the economy right. It’s just that we have a whole lot more faith in the free market than we have in the teeming minions who populate the D.C. bureaucracy.  Clearly not everyone agrees with us.  Democrats who even give lip service to admiring private enterprise are now vanishingly rare.  And, if the banking industry is any indicator, the influential populist fringe seems to regard the private sector with a distrust that borders on contempt.

If it is true that flawed regulation caused the financial crisis, then we should all be profoundly skeptical of the crush of new regulation now being imposed on the banking industry. For instance, few US banks needed more capital after the crisis, and they certainly don’t need more now.   For US banks, there was no need for Basel III (no, I’m not kidding. It’s baaaack), let alone the additional capital burden arbitrarily levied on the large US banks to “break them up” through the back door.  It is especially disheartening to see our US regulators kowtow before global regulators whose competence is, let us say, an open question.

Dodd Frank was far more an effort to pass “landmark legislation” that aped FDR and was seen to punish “the banks” than it was a good faith effort to fashion an effective regulatory framework.  It was an attempt to fix a system that wasn’t broke.  Flawed as it was on paper, its implementation has made things much worse.  It’s pretty clear, as underscored by the GAO’s recent criticism of “Living Wills” implementation, that the regulators are mostly making this stuff up as they go along.  And woe betide the bank that complains.

Just as the Basel Regs produced monstrous unintended consequences, Dodd Frank and Basel III are having profound negative repercussions of their own. Today’s Rube Goldberg meets Alice in Wonderland world of contradictory and redundant regulation, in concert with adversarial audits, has imposed a massive continuing burden on the banking industry and has cost the economy hundreds of billions of dollars with scant benefit to anyone except bureaucrats and lawyers.  It has contributed to the economy’s growing inequality and is, I believe, the primary reason for our dismal economic recovery.

Bank geeks far more qualified than I agree with me that the regulatory world has spun out of control.  One is Andrew Haldane, former Executive Director of Financial Stability at the Bank of England who penned a 2012 article titled “The Dog and the Frisbee” that has not gotten nearly the attention it deserves. In it, he contends that the current regime of regulatory micro-management is misguided at best and self-destructive at worst.  He argues persuasively that simpler regulation is far preferable to complex regulation.

When I first considered writing this piece I had intended to open with my favorite Mark Twain quote.  So imagine my consternation when I went to see “The Big Short” and discovered that Hollywood had cribbed the very quote I had wanted to use. I said to myself, “I can’t use that now.”  But thinking on it, I reckoned that Mark Twain can be called on to skewer all kinds of myths and foolishness and such like, even myths passionately embraced by Hollywood.  So I’ll see your Mark Twain and I’ll raise you an Einstein:

“It’s not what I don’t know that worries me.  It’s the things I know for sure that just ain’t so.”

“The problems that exist in the world today cannot be solved by the level of thinking that created them.”

With a nod to Maynard Keynes, I would conclude by saying that when times are good, euphoria reigns and we think prosperity will never end.  When times are tough, as they continue to be for many, we regard the future as a thing of radical uncertainty.  We can’t imagine that conditions will ever improve.  But our economy is not nearly as fragile as we sometimes think it is. Now is not the time to further rein in our animal spirits.  Let’s loosen the reins — just a bit — and see what a little more freedom can accomplish.


*I derived these averages myself using available historical data.  I’m confident that they are not too far out of line. They include all of the large surviving European Institutions.  They do not include failed banks like Fortis, nor the Greek, Baltic, or Icelandic banks.  Nor do they include British building societies, Spanish cajas, or German landesbanken.  Once commanding a major share of European financial assets, these institutions, of course, were vaporized.

** 7,000 = (1000 /.038- 1000 / .030).  13,333 = (700 / .050 – 700 / .030).

***  Note that these are my own estimates for bank holding companies.  I was unsuccessful in obtaining aggregate numbers for BHC’s from Y9 data.  A recent Fed publication shows roughly a 6.6% leverage ratio for the industry in 2007, but this seems too high.  It may be based on risk-weighted assets.  Also, FDIC data (which do not include holding companies or non-bank subsidiaries) show commercial banks losing money in just one year — $11 billion in 2009.  My estimate probably double counts these bank-level losses and includes non-cash items like goodwill write-downs, DTA write-downs, and reserve building far beyond realized economic losses.