The banking crisis of 2008 had its roots in the US real estate and subprime lending market. The real estate boom began in the 1990s and continued rising throughout the decade, leading to complacency and misjudgement of the banking industry and government.
Complacency was at the root of this unfortunate event. The financial services industry had become lax and distributed mortgages and loans to people who were unqualified to meet the repayment criteria. The US government’s deregulation blurred the lines between traditional investment banks and mortgage lenders, and real estate loans were spread throughout the financial system in the form of complex collateralised debt obligations (CDOs) and other complex derivatives to disperse risk.
However, home values did not rise and when home owners could not keep up with their payments banks had no choice but to write off these products, this led to escalating debt forcing banks to the brink of insolvency. Essentially both banks and consumers bit off more than they could chew.
Until today the ramifications of the 2008 crisis have caused stagnating growth in the US economy, as the country struggles to get back on its feet. Recent rumblings from the eurozone have sent stocks tumbling under the jittering fears of a Greek default and a possible domino effect in both Italy and Ireland – which are considerably bigger in size than Greece.
As we move into 2012, there is likely to be a climate of caution as the eurozone crisis could have even worse implications than the subprime crisis of 2008. Even banks which are not based in Europe will be badly hit because they hold a lot of the bad debt in the affected European countries – which will affect the bottom line with any downgrade from rating agencies.
Lesson 1: No one country can get out alone
Hot on the heels of the US subprime crisis was the eurozone sovereign debt crisis which surfaced in late 2009. Certain European states, such as Greece, Ireland and Portugal, were unable to refinance their debts and had to be bailed out. With intricate political implications involved among the European states the debt issue currently remains unresolved despite endless summits and meetings.
According to economist Henry Kaufman, the sagging economies of Europe and the US could affect each other both ways. The tenuous link between American and European financial institutions means that both sides could potentially remain bogged down as we move into 2012. The European bank failures could lead to a credit squeeze in the US, hurting an already lagging economic recovery.
Lesson 2: Even giants can fall
The subprime crisis showed that even the US – the core of the world economy – can collapse. Recently, Standard & Poor (S&P) downgraded the triple A rating that US banks had held for 70 years. Even the recent budget deal proposed by the government was not enough to solve the currently pessimistic outlook of US finances.
S&P downgraded six US banks, namely Bank of America Merrill Lynch (BofA Merrill), JP Morgan Chase, Goldman Sachs, Citigroup, Wells Fargo and Morgan Stanley.. S&P also put the new grade on ‘negative outlook’ meaning that the US has little chance of reinstating its top ratings in the near future.
Traders and investors will now have to reconsider any major fiscal decisions, as the downgrade will definitely have an impact on the financial landscape. Interestingly rival ratings firms Moody’s and Fitch have maintained their top-notch ratings for US debt in recent days. But with S&P’s downgrade of American debt it will be increasingly difficult to re-instil the faith in investors. Numerous companies and states could see their debt being downgraded, driving up borrowing costs.
Lesson 3: Don’t put all your eggs in one basket
While the uncertainty of the global economic climate remains growth opportunities still exist in Asia. A telling sign of Asian banks on the upward trend includes S&P recent update of ratings for Bank of China and China Construction Bank.
Emerging markets, such as Malaysia and Indonesia, continue to project high levels of economic growth and several multinationals are now looking to boost their presence in these markets due to the attractiveness of a lower-cost location. We anticipate money to flow into these emerging markets as the west continues their battle with ongoing debt crises that will not be resolved in the immediate future.
Asia will definitely be impacted if there is any significant slowdown in the American and European economies, but it presents an attractive alternative for businesses particularly if western economies continue to stagnate. At the same time, banks and organisations should adopt a more conservative investment strategy by investing in less risky assets and away from exotic or toxic assets. They should put regulatory safeguards in place to prevent risky lending practice.
Lesson 4: Need for corporate governance
An important lesson gleaned from the events of 2008 is the need for corporate governance within the financial services industry.
Failures in corporate governance are most apparent in Greece where until today, taxpayers continue to abscond tax-free and as a result of this the country continues to sink under mounting debt that other European states are reluctant to absorb.
Stress tests that were carried out by the EU across 91 European banks recently showed that Greek banks continued to fail the long-running stress test. The test poses a hypothetical scenario to ensure that its Tier 1 capital ratio – the key measure of financial strength – remains higher than the passing mark of 5%.
The Federal Reserve has also put six of the largest banks in America – Bank of America, JP Morgan Chase, Goldman Sachs, Citigroup, Wells Fargo and Morgan Stanley – to the test. These banks will need to present plans by 9 January 2012 on how they will react against a hypothetical ‘global market shock’ related to the eurozone turmoil.
As showcased by the cascading meltdown from 2008, there is a pressing need for corporate governance arrangements to safeguard against excessive risk being taken by financial services organisations to prevent history from repeating itself.
Within any financial services organisation there needs to be stringent accounting standards and regulatory requirements to ensure healthy balance sheets that will remain resilient against any market slowdown. Remuneration packages should be related to the strategy and risk appetite of the company and not be given out at whim.