Has financial reform been radical enough?

Five years on from Lehman Brothers’ collapse, have we reformed radically enough to make the financial system safer?

I think we have achieved a lot and that the chances of a major financial crisis involving the failure or public rescue of major banks have been significantly reduced. Higher bank capital requirements, new liquidity rules, progress towards better resolution regimes and initial steps towards control of shadow banking risks are all major achievements.

But we have not yet addressed the fundamental cause of both the 2008 crisis and the painfully slow recovery, which is an excess of debt.

Narrowly defined financial system risks have been reduced, but wider and more important macroeconomic vulnerabilities remain severe and unresolved.

Most economists and policy-makers failed entirely to predict the crisis. And, once the immediate crisis had been contained, we failed to foresee how painful its consequences would be. Both failures reflected a lack of understanding that high debt burdens, relentlessly rising for several decades, were an important threat to economic stability.

In 1960, UK household debt was less than 15% of GDP; by 2008, the ratio was over 90%. Total US private credit grew from around 70% of GDP in 1945 to well over 200% in 2008. As long as the debt was in the private sector, most policy-makers assumed that its impact was either neutral or benign.

That assumption was dangerous, because debt contracts have important implications for economic stability. They are often created in excess because, in the upswing of economic cycles, risky loans look risk-free.

As long as times are good, rising leverage can seem to make underlying problems disappear. Subprime mortgage lending delivered illusory wealth increases to lower-income Americans at a time when they were suffering from stagnant or falling real wages.

But in the post-crisis downswing, accumulated debts have a powerful depressive effect, as over-leveraged businesses and consumers cut investment and consumption in an attempt to pay down their debts. Japan’s lost decades after 1990 were the direct and inevitable consequence of the excessive leverage built up in the 1980s.

Faced with depressed private investment and consumption, rising fiscal deficits can play a useful role, offsetting the deflationary effects. But that simply shifts leverage to the public sector, with any reduction in private-debt-to-GDP ratios more than matched by increases in the public-debt ratio. Across the world, limited deleveraging in advanced economies has been offset by rising leverage in developing economies; for example, Chinese debt-to-GDP (private and public combined) has risen from 120% in 2008 to 200% today.

Private leverage levels, as much as public, must in future be treated as crucial economic variables. Ignoring them before the crisis was a profound failure of economic science and policy.

The immediate challenge is how to manage our way out of the debt overhang left to us by past policy failures; and there are no easy answers. Paying down private and public debt simultaneously depresses growth; austerity can be self-defeating; but running large public deficits can leave intractable debt sustainability problems. Ultra-easy monetary policy is essential to stimulate the economy as best possible, but risks fuelling complex carry trades whose dangers regulators only imperfectly understand.

Realism and imaginative policy are required. Some combination of debt restructuring and permanent debt monetization (quantitative easing that is never reversed) will, in some countries, be unavoidable and appropriate.

The longer-term challenge is how to achieve economic growth without relentlessly rising leverage. The current financial reform programme, while valuable, fails to address this fundamental issue.

Fixing the “too big to fail” problem is important, but the direct taxpayer costs of bank rescues were the small change of the damage wreaked by the financial crisis. Higher capital requirements plus improved resolution regimes could eliminate the danger of future taxpayer subsidy but still support a banking system able to tolerate excessive leverage growth in the real economy.

Our policy response needs to address the issue of excessive leverage growth head on. To do this, it must combine more powerful countercyclical capital tools than currently planned under Basel 3, the restoration of quantitative reserve requirements to the policy toolkits of advanced-country central banks, and direct borrower constraints, such as maximum loan-to-income or loan-to-value limits, in residential and commercial real-estate lending.

Without such radicalism, there is a danger that we construct a safer financial system within a macroeconomy still mired in slow growth in the immediate future and dangerously unstable over the longer term.

Five years after the collapse of Lehman Brothers, the Forum:Blog will be publishing a number of personal views by key figures on the event and its implications. The views expressed are those of the author.

Read more blogs on the start of the financial crisis by Yvan Allaire and Robert Johnson.

Author: Lord Turner is a member of the UK’s Financial Policy Committee and former Chairman of the Financial Services Authority.

Image: City workers make phone calls outside the London Stock Exchange in Paternoster Square in the City of London at lunchtime October 1, 2008. REUTERS/Toby Melville