Investors have endured a torrid 6 months with considerable uncertainty around the path for financial assets. March saw an unprecedented spike in volatility as asset markets adjusted to the news of a widescale lockdown of the global economy. Oil prices, currency markets and even government bonds saw wild swings as investors pressed the panic button.
Scary as the first few weeks of March were, asset prices stopped falling as soon as policymakers started to act. Central banks stood behind credit markets acting as lenders of last resort. The fact that developed market banks held large capital buffers in liquid assets, was undoubtedly another positive. While the real economy was not prepared for widescale disruption, it appears the financial economy was in much better shape.
The banking system sits at the heart of the global economy. Working with the central bank and regulators, banks allow credit to flow throughout the globe. My career in the city thus far has been the tale of two banking regimes.
The first started when Citicorp – a commercial bank, merged with Travelers Group an insurance and financial service company. The combined firm became Citigroup, the largest bank in the world. The merger itself was illegal under Glass-Steagall, a law that prohibited banks from investment banking activities. Congress repealed the law and laid the foundations for the Global Financial Crisis a decade later.
Citigroup’s expansion into investment banking and insurance kicked of a merger frenzy in financial services. Facilitating the deal making was a light touch regulatory regime that allowed banks to use their own models to assess risk for required capital. Most banks chose models that were overly optimistic allowing increased leverage to boost returns. We all know how the rest of the story played out. Regulators, rating agencies, lenders and borrowers failed to act responsibly, and the global economy has not been the same since.
These events, after a period of soul searching, led to the second banking regime of my career. This regime came with annual reviews, risk weighted capital requirements and the need for higher capital. The recent crisis has come at the tail end of a decade of cost cutting, restructuring and capital building for the sector. Western banks face death by a thousand cuts as low interest rates crimp margins and make lending less attractive.
The health of an economy is closely tied to the health of its banks. Quantitative easing- with its various offshoots, plugs a hole in money supply but can never stimulate credit growth. The Bank of England and the Federal Reserve understand the limitations of ever lower rates but find themselves with few policy options. While the banking system is better placed to deal with the consequences of a severe downturn, it has lost its ability to meaningfully accelerate the economy.
This is the challenge that now faces us. A highly indebted economy reliant on government support and a banking sector unable to expand credit is hardly the basis for an economic boom.
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