Real causes of the financial crisis

The worldwide financial crisis not only eroded the confidence in market economy, but also created strong demand for extensive regulation. People really dislike the rescue of banks with the help of taxpayers money. Regrettably, our media do not report all reasons of the financial crisis and focus only on the greed of gain and the irresponsibility of bank managers. It is necessary to talk about all causes of the financial crisis. Thereby a distinction of causes, i.e. factors that caused the financial crisis, and „fire accelerants“, which only worsened the impact of the financial crisis, is required.

First of all, the low interest policy of the Federal Reserve and the zero interest policy of the Japanese central bank caused artificial low interest rates and exploding money supply over years. The overwhelming majority of financial crises since the early 1970s has been caused by mistakes in monetary policy.[1] Banks could create money as an illusion and broaden the monetary base excessively. But sustainable growth required real savings, because production factors had to be served up to the end of the production process. Fractional reserve banking allows companies to receive new loans without increasing real savings. Thus, interest rates fall down below the level covered by real savings.[2] Investments are made which would not be profitable, if interest rates were „usual“. The resulting economic growth is based on an illusion of money and bubbles that occur on markets.

Second, the often criticized indebtedness of countries as well as companies and private persons rests upon state failure and political interventions. Too many countries have spent more than they have earned for decades. If there are doubts about the solvency of countries, the solvency of those banks which own government bonds of these countries decreases. A systemic crisis of confidence results.

One of the main reasons were mortgages of debtors with poor credit ratings, i.e. subprime mortgages. The policy of cheap money had an especially fatal impact on the market for subprime mortgages. Interest rates of long-term government bonds and fixed interest mortgages with a higher quality (prime) fell down by two percentage points between 2000 and 2003. Additionally, the risk premium of fixed interest mortgages with lower quality fell down to the same extent. In the light of a continuing drop in the quality of the mortgage debtors, this is especially incomprehensible.[3] The falling quality of mortgage loans could not only be observed by measurable factors like the decreasing equity capital of the borrower or the ascending ratio of debt servicing to available income, but also by manipulations of the ratings of consumer loans which are used to assess the overall credit rating. Most notably, the American mortgage banks didn´t stop these practices.[4] The mortgage banks supported willingly the governmental policy of residential property even for moneyless citizens by careless, partially negligent examination of credit ratings.

$1 house image by Paul Heasman from Fotolia.com

Sadly, also national surveillance authorities often failed to prohibit the securitisation of inferior mortgages. The German surveillance authority, BaFin, knew about the exposure of German banks regarding such securities. While surveillance authorities in some southern European countries and especially in South-East Asia did not allow the purchase of these securities, the BaFin did not stop the German banks.[5] Also the national surveillance authorities did not stop the excessive use of term transformation[6] and the indebtedness of banks and special purpose vehicles of banks.[7]

Third, misjudgements of rating agencies caused the financial crisis. The big traditional American rating agencies received an oligopoly in the U.S. in 1975 by the decision of the governmental Securities and Exchange Commission and only three of them were acknowledged as state-approved rating agencies. Thus, all three agencies remain private, but had to care less about the quality, reliability, and market demand of their ratings. So the profitability of the three rating agencies depended more on the protection of the U.S. government.[8] Nevertheless, in 1997 the three big agencies refused to rate securities based on inferior mortgages of private real estate with an „AAA“. Later on the big three put up their resistance.[9] The rating oligopoly has been cemented by governmental rules, the necessity to trust the judgements of the rating agencies implies a systemic risk.

Fourth, banks are taking higher risks, because they could expect support from central banks and governments. Governments and central banks were not able to abdicate from their role as lender of last resort during financial crisis and even now.[10] The consequence is moral hazard, because mistakes of banks could be absorbed or reduced by governments and central banks. The own risk awareness of the creditors decreases. Also an inadequate economic and fiscal policy of highly indebted countries could be explained by moral hazard. Finally, the taxpayer is liable for risky investments of banks respectively rescue packages or debt reliefs to other countries which pursue an irresponsible policy.

Fifth, due to the separation of ownership and management, the remuneration of the top management is tied to the development of stock prices and current profits. Since the duration of employment of the board members has shortened, decisions were always dominated by the up-to-date stock price. This implies that short-term profitable, but long-term more risky investments are preferred. Investments which secure the existence of the enterprise, but raise profits mainly for the following management are less attractive for the current managing board. If the executive board ruins the company, it will be replaced according to previously negotiated settlement agreements and pension promises. The short-term bonuses remain at the dismissed manager.[11] Thus, the focus on the current company value and the risk boosting bonuses could be interpreted as fire accelerant of the financial crisis.

Another fire accelerant was the introduction of the fair value principle in accounting standards in 2003. In contrast to the traditional „generally accepted German accounting principles“ according to the code of mercantile law, the fair value principle focuses on an assessment close to the market. Thus, the value of a company is more dependent on business cycles and is pro-cyclical generally. Especially if markets do not operate in the short-run and current prices are not available, affected companies will run into a debt overload.[12]

Insufficient risk management of banks caused the financial crisis too. Government bonds regarded as almost safe became default, e.g. Greek government bonds. Many assumptions in the risk models of banks turned out to be wrong. The likelihood of default was underestimated, particularly many risks have been located outside the regular balance sheet in special purpose vehicles. External information has been trusted without check-over. However, some banks survived the financial crisis much better than their competitors. Those banks which identified their risks and were aware of them, overcame the financial crisis better than others. „Every risk manager is as good as his boss allows him to be.“[13] Some risk managers of banks advised their executive board against threatening risks before 2005, but mainly received incomprehension and denial.

Evaluating all reasons, wrong political decisions dominate:

Source: Altmiks, Peter, Die Sehnsucht nach Finanzstabilität: Regulierungsfülle und -defizite, S. 158, in: Altmiks, Peter (Hg.), Marktordnung im Finanzsystem – Bankenregulierung, Rating-Agenturen, Risikomanagement, Berlin: Universum, 2013, S. 125-166.

Of course, entrepreneurial mistakes occurred and management made huge mistakes, but the list of state failure is longer and moreover threatens financial stability. The German Bundesbank draws the same conclusion when the Bundesbank lists all the influential factors affecting the stability of the German financial system.[14]