The financial system still looks vulnerable despite post-Lehman banking rules, experts say

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This week marks the 10th anniversary of the collapse of Lehman Brothers, an event that set in motion the global financial crisis. The meltdown triggered sweeping reforms in the financial sector, but questions remain over whether the banking system is that much stronger now than it was before the crisis.
“There’s certainly been a lot of regulation thrown at the banking system to try to make it safer. So banks have considerably larger capital buffers now than they had before the crisis, which means they could absorb more losses than was the case going into the crisis,” Charles Bean, professor at the London School of Economics and former deputy governor for monetary policy at the Bank of England, told CNBC on Monday.

“A lot of other regulations designed to try to make the banking system safer, such as the regime for handling the resolution of failing banks, have been considerably improved. (But) I still think it’s an open question whether they’re up to the task of handling the failure of a large, multinational bank. In principle, the rules are there, but until we’ve actually tried it (we don’t know).”

In a bid to shore up Europe’s financial system, sweeping banking regulations, increased risk management and closer supervision were introduced to prevent future banking collapses and to better protect depositors, and public funds, in the event of a crash.

For instance, European banks now have to hold much higher amounts of capital to protect themselves against the risk of failure.

Points of vulnerability

Central banks have played a major role in maintaining liquidity to keep the financial system afloat by slashing interest rates and introducing quantitative easing (QE) programs, essentially the mass purchase of government bonds and mortgage-backed securities, in order to stimulate the economy.

Bean said that central banks had a key role to play in crises but that there had been unintended consequences to programs like QE.

“One of the lessons of history is that when a liquidity problem starts developing central banks need to act fast,” he said. “The key to being an effective lender of last resort is indicating that you’re willing to lend freely against any good security, at a penalty rate to penalize people who have been taking excessive risk, but they’re the golden principles of liquidity provision.”

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QE by central banks including the Federal Reserve, Bank of England and European Central Bank has been accused of driving liquidity into financial markets with the consequence of asset prices being unduly inflated. This has led to fears of another financial market crisis.

“What is true is that quantitative easing, which involves the central bank buying assets … A prime way it works is by driving up asset prices and that does mean that, as QE is reversed, you would expect those prices to fall back.

“I think one of the concerns with QE is that the longer the recovery from the crisis has taken, (there have been) distributional consequences. Driving up asset prices makes those that already have assets richer; typically, they’re older people and the ones that lose out are younger people that have to pay more for them.”

The next crisis?

Central banks in Europe are starting to wind down their QE programs and the Federal Reserve has already done so, prompting a so-called “taper tantrum” in 2013 as extra financial liquidity in the economy was reduced. Central banks are keen to “normalize” monetary policy and end a decade of unconventional policies, however.

Paul Donovan, chief global economist at UBS Wealth Management, told CNBC on Monday that he feared a crisis of a different nature could be on the horizon, but that investors and bureaucrats were not prepared.

“One of the questions I have, is that this has become a dominant narrative, that the crisis was such a big effect that it’s seared onto the mind of investors and policymakers and everything is seen through the prism of the last crisis,” Donovan said.

“But is this just living in the past? And, in fact, the next crisis is going to be something totally different but because we were so affected by what happened 10, 11 years ago we can’t break away from that memory.”

Bean agreed, saying it was “reasonable” to believe the next crisis could be different in character from the one we’ve experienced.

“For instance, the tightening of U.S. policy is putting upward pressure on the dollar and you’ve seen a lot of emerging market countries and companies borrowing in dollars. And it’s looked attractive because interest rates were low.

“But now they’re potentially being hit by a double-whammy of higher interest rates and an appreciating dollar. I’m not saying there is going to be a crisis there but it’s another point of vulnerability.”

[“Source-cnbc”]