The Global Financial Crisis is NOT Financial

So, Susan, thanks so much for joining today. What were the origins of the financial crisis? Where was the epicenter, and how did it happen? The epicenter of the global financial crisis was really the housing market. It started in the United States, but it turned out that similar housing bubbles were building in other countries, like the UK, Spain, and Ireland. Households were borrowing more than they could afford.

World economy at risk of another financial crash, says IMF | Business | The Guardian

Banks were giving out loans at very low interest rates and increasingly having enticing features like interest rates that were very low but then ballooned after a year or two. This meant that households could borrow more than they could really afford to borrow and buy a bigger house. At the same time, all of this was fueling housing-price increases. These houses are worth a lot, so they have an asset. But the problem started when housing prices stopped growing and instead started declining. And suddenly a lot of households found that they had a lot of debt. Sometimes more than the value of the house.

But what made the financial crisis so globally devastating was that it turns out there were a lot of complex, opaque derivative securities that had been built on top of these underlying mortgage assets. So the subprime mortgage market in the US was pretty small. It was not more than maybe 10 percent of all US mortgages. Yet banks had taken these mortgages, pulled them together, and created something called asset-backed securities. Then they took those and pooled them together again.

And so they built trillions and trillions of dollars of financial instruments whose value was riding on those mortgages being repaid. When a few households started defaulting on mortgages, the pain went far beyond those households and the banks that originated them to all these investors around the world.

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So the obvious question for a microeconomist would be, where were the regulators in all of this? Well regulators were there, but banks were creating new types of financial instruments. And credit default swaps. As it started to unravel, we found out that those risks, rather than being diversified and spread around the world, were concentrated in some very large banks like Bear Stearns and Lehman Brothers.

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At the same time, I have to say, banks had very little capital. When large numbers of mortgages started to go into default, they were facing losses that pushed them into a solvency crisis. From a macro point of view, something that was discussed a lot of the time was the whole question of global financial imbalances. Global financial imbalances refer to the fact that some countries save a lot and invest less, and other countries invest a lot and save very little. The US is an example of a country that was investing a lot in real estate, but its own savings rate was actually going down, down, down.

To finance a lot of the investment that was occurring, foreigners were putting money into the US market. One of the things they did with all this surplus savings was channel it into the US treasury market. That had the effect of pushing down US interest rates. While the housing crisis was building up, you saw very large inflows of foreign money into the US.

Often it started in the treasury market, but then that pushed down interest rates. Liquidity worked its way through the system and financed, to some extent, this housing bubble. In that sense, I think that surplus global liquidity, combined with an interconnected global financial system, did play a role in setting the conditions for this massive housing bubble.

Could we get a repeat of the same pattern of a real-estate bubble fueling a banking crisis and that spreading across the world? History shows us that real-estate bubbles and banking crises go hand in hand and have plagued countries throughout history. But a lot has changed over the past ten years. First, you see that the households that had borrowed too much prior to the crisis, like households in the US, Ireland, Spain, and the UK, have really cut down on debt a lot.

That said, one of the most surprising things over the last ten years is that the total amount of debt in the world has continued to grow. Government debt has grown very rapidly in advanced economies [Exhibit 1]. Globally, government debt has more than doubled. A lot of this came from advanced economies. The combination of a recession that reduced tax revenues and increased social-welfare payments for unemployment really put a big dent in government fiscal balances. And around the world, governments, to one extent or another, provided financial support to the banking system and other critical industries.

All of that has made governments more indebted than ever before. But at the same time, companies have borrowed almost as much in addition as governments have. About two-thirds of the growth from that comes from developing countries. And here China stands out in particular. This means that the country now has one of the highest corporate debt ratios in the world.

There are other pockets of corporate borrowing, ranging from Turkey to Chile to Vietnam. I want to know when the debt is in US dollars, or euros, or other foreign currencies, because it means that these companies face a risk. If their own domestic currency, such as the Turkish lira today, depreciates, it means that repaying that foreign currency debt is much more expensive. And the likelihood of default goes way up. Tell us a little more about household borrowing. US households have taken on this mortgage debt.

What is the pattern of household borrowing globally? Is there less household debt than there used to be? Or is there also more? Globally, household debt has also continued to grow since [Exhibit 2]. Households in what I think of as the core crisis countries of the US, UK, Spain, and Ireland have all reduced household debt quite significantly. So, for instance, households in Canada have seen household debt continue to grow, and real-estate prices have continued to rise quite rapidly.

Today, household Canadian debt is much higher than it was in the US at the peak. Switzerland has very high household debt, as does South Korea. Australia has an extraordinarily high household-debt level. There are also some developing countries where households have borrowed quite a lot over the past ten years. This would include Thailand and Malaysia. In China today, the household debt, when measured against household income—not GDP but household income—is actually similar to the US level today.

And many are not financially well. So in the US you see that student debt to fund postsecondary education has exploded. That has a significant impact on overall economic growth. At the same time, there are other metrics. They would need to borrow money to do so. I think that the point that you make about the US underlines for me that a lot of pain was taken by households—not only in the US but also in a lot of countries—in the aftermath of the financial crisis.

When you look at Greece, for example, today, as we record this, is the day that Greece is formally out of its bailout package financially. But Greek households have been left a lot poorer. Average wages in Greece are down by about 20 percent. Taxes have gone way up. The same would be true in Spain, where the economy has grown quite strongly, but real wages have gone down quite substantially. And youth unemployment in particular remains high. And is the global banking system more secure, more stable than it was going into the crisis?

There are two parts to the answer to that. Banks are definitely more stable and secure. For one thing, they now hold a lot more capital. For US and European banks, the average Tier 1 capital ratio has risen from about 4 percent of their assets before the crisis to 15 percent today. And the biggest systemically important financial institutions actually hold even more capital than that.

In addition, banks have been subject to a whole host of different new regulations, and they have reduced the risk on their balance sheets, and off their balance sheets, in terms of the assets that they hold and the activities, like proprietary trading, that they engage in. At the same time, though, you see that banks are doing a lot less cross-border lending.

When you look at the average just in the amounts of money crossing borders, it has shrunk by about half since Prior to the crisis, the price-to-book ratio of banks in advanced economies was at or just under 2. But in every year since , most advanced economy banks have had average price-to-book ratios of less than one including 75 percent of EU banks, 62 percent of Japanese banks, and 86 percent of UK banks.

In some emerging economies, nonperforming loans are a drag on the banking system.

How secure is the global financial system a decade after the crisis?

In India, more than 9 percent of all loans are nonperforming. The best-performing banks in the post-crisis era are those that have dramatically cut operational costs even while building up risk-management and compliance staff. In general, US banks have made sharper cuts than those in Europe. But banking could become a commoditized, low-margin business unless the industry revitalizes revenue growth. Traditional banks, like incumbents in every other sector, are being challenged by new digital players.

Platform companies such as Alibaba, Amazon, Facebook, and Tencent threaten to take some business lines, a story that is already playing out in mobile and digital payments. Yet technology is not just a threat to banks. It could also provide the productivity boost they need.

A decade after the global financial crisis: What has (and hasn’t) changed?

Many institutions are already digitizing their back-office and consumer-facing operations for efficiency. But they can also hone their use of big data, analytics, and artificial intelligence in risk modeling and underwriting—potentially avoiding the kind of bets that turned sour during the crisis and raising profitability. One of the biggest changes in the financial landscape is sharply curtailed international activity. Simply put, with less money flowing across borders, the risk of a style crisis ricocheting around the world has been reduced. Since , gross cross-border capital flows have fallen by half in absolute terms Exhibit 5.

Eurozone banks have led this retreat from international activity, becoming more local and less global. Nearly half of the decline reflects reduced intra-eurozone borrowing and especially interbank lending. Two-thirds of the assets of German banks, for instance, were outside of Germany in , but that is now down to one-third.

Swiss, UK, and some US banks have reduced their international business. The retrenchment of global banks reflects several factors: These relationships enable banks to make cross-border payments and other transactions in countries where they do not have their own branch operations. These services have been essential for trade-financing flows and remittances and for giving developing countries access to key currencies.

But global banks have been applying a stricter cost-benefit analysis to these relationships, largely due to a new assessment of risks and regulatory complexity. Some banks—notably those from Canada, China, and Japan—are expanding abroad but in different ways. Canadian banks have moved into the United States and other markets in the Americas, as their home market is saturated.

Japanese banks have stepped up syndicated lending to US companies, although as minority investors, and are growing their presence in Southeast Asia. It partly reflects a decline in corporations using low-tax financial centers, but it also reflects a sharp pullback in cross-border investment in the eurozone. However, post-crisis FDI accounts for half of cross-border capital flows, up from the average of one-quarter before the crisis. Unlike short-term lending, FDI reflects companies pursuing long-term strategies to expand their businesses.

It is, by far, the least volatile type of capital flow. Because much of this capital surplus was invested in US Treasuries and other government bonds, it put downward pressure on interest rates. This led to portfolio reallocation and, ultimately, a credit bubble. Today, this pressure has subsided—and with it, the risk that countries will be hit with crises if foreign capital suddenly pulls out. The US deficit hit 5. Large deficits in Spain and the United Kingdom have similarly eased. Still, some imbalances remain. Germany has maintained a large surplus throughout the past decade, and some emerging markets including Argentina and Turkey have deficits that make them vulnerable.

Many of the changes in the global financial system have been positive.

Better-capitalized banks are more resilient and less exposed to global financial contagion. Volatile short-term lending across borders has been cut sharply. The complex and opaque securitization products that led to the crisis have fallen out of favor. Yet some new risks have emerged. The growth of corporate debt in developing countries poses a risk, particularly as interest rates rise and when that debt is denominated in foreign currencies. If the local currency depreciates, companies might be caught in a vicious cycle that makes repaying or refinancing their debt difficult.

At the time of this writing, a large decline in the Turkish lira is sending tremors through markets, leaving EU and other foreign banks exposed.

As the corporate-bond market has grown, credit quality has declined. Even investment-grade quality has deteriorated. Of corporate bonds outstanding in the United States, 40 percent have BBB ratings, one notch above junk status.

We calculate that one-quarter of corporate issuers in emerging markets are at risk of default today—and that share could rise to 40 percent if interest rates rise by basis points. Given that interest rates are rising and some borrowers already have shaky finances, it is reasonable to expect more defaults in the years ahead. Another development worth watching carefully is the strong growth of collateralized loan obligations. A cousin of the collateralized debt obligations that were common prior to the crisis, these vehicles use loans to companies with low credit ratings as collateral.

One of the lessons of is just how difficult it is to recognize a bubble while it is inflating. Since the crisis, real-estate prices have soared to new heights in sought-after property markets, from San Francisco to Shanghai to Sydney. Unlike in , however, these run-ups tend to be localized, and crashes are less likely to cause global collateral damage. But sky-high urban housing prices are contributing to other issues, including shortages of affordable housing options, strains on household budgets, reduced mobility, and growing inequality of wealth. In the United States, another new form of risk comes from nonbank lenders.

New research shows that these lenders accounted for more than half of new US mortgage originations in While banks have tightened their underwriting standards, these lenders disproportionately serve lower-income borrowers with weaker credit scores—and their loans account for more than half of the mortgages securitized by Ginnie Mae and one-third of those securitized by Fannie Mae and Freddie Mac.

While China is currently managing its debt burden, there are three areas to watch. First, roughly half of the debt of households, nonfinancial corporations, and government is associated, either directly or indirectly, with real estate. Second, local government financing vehicles have borrowed heavily to fund low-return infrastructure and social-housing projects. In , 42 percent of bonds issued by local governments were to pay old debts. This year, one of these local vehicles missed a loan payment, signaling that the central government might not bail out profligate local governments.

Third, around a quarter of outstanding debt in China is provided by an opaque shadow banking system. The combination of an overextended property sector and the unsustainable finances of local governments could eventually combust. A wave of loan defaults could damage the regular banking system and create losses for investors and companies that have put money into shadow banking vehicles. The world is full of other unknowns. But their outsized popularity might create volatility and make capital markets less efficient, as there are fewer investors examining the fundamentals of companies and industries.

Cryptocurrencies are growing in popularity, reaching bubble-like conditions in the case of Bitcoin, and their implications for monetary policy and financial stability is unclear. And looming over everything are heightened geopolitical tensions, with potential flash points now spanning the globe and nationalist movements questioning institutions, long-standing relationships, and the concept of free trade.

Global debt continues to grow, fueled by new borrowers

If any one of these potential bubbles burst, it would cause pain for a set of investors and lenders, but none seems poised to produce a style meltdown. The likelihood of contagion has been greatly reduced by the fact that the market for complex securitizations, credit-default swaps, and the like has largely evaporated although the growth of the collateralized-loan-obligation market is an exception to this trend. But one thing we know from history is that the next crisis will not look like the last one. McKinsey uses cookies to improve site functionality, provide you with a better browsing experience, and to enable our partners to advertise to you.

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A decade after the global financial crisis: Great strides have been made since to prevent a recurrence of the financial crisis and recession that followed. Yet there is more debt than ever in the global financial system.