Liquidity & Capital Watch

Session 6 will reiterate the now familiar twin mantras: do not default, do not go bust. And we repeat a banker’s to-do list that involves gathering more information, diversifying, smart contract design, keen risk pricing together with plenty of capital and liquidity buffers.

Around a decade ago, the global financial system went into meltdown. What seemed so shocking at the time was that, despite the apparent sophistication and smartness of modern banking, the financial system proved tragically fragile and vulnerable.  In 2011 a senior Chinese central banker reportedly said to Lord King (former governor of the Bank of England)

“We in China have learnt a great deal from the West about how competition and a market economy support industrialisation and create higher living standards. We want to emulate that… But I don’t think you’ve quite got the hang of money and banking yet.”

The GFC was partly bad luck but, in finance, as in many walks of life, you make your own luck. Risk is typically endogenous not exogenous.

We shall learn that the property reversal from 2005 onwards was the GFC trigger, but the problems went much deeper

  • excessive leverage
  • poor liquidity management
  • reduced lending standards
  • misinformation & misaligned incentives
  • flawed rocket science
  • regulatory weaknesses
  • limited legal powers to resolve failing banks
  • contagious networks
  • doom loops (positive feedback mechanisms)

If you have not done so already, I recommend dipping into The Economist’s survey of past financial crises or the wonderful book by Rogoff & Reinhart, This Time Is Different: Eight Centuries of Financial Follies. As the FT’s Martin Wolf has commented, “This Time Is Different” are the four most dangerous words in finance.

You will notice that many of the GFC problems we list are common features in many past crises. The narratives vary but the underlying themes are remarkably similar.  So why do we keep making the same mistakes, over and over? Human foibles – greed and fear – play their part. Certainly, the ancient Greeks warned about hubris and nemesis, and yet many centuries later, the trap is still catching the unwary.

On the theme of human irrationality, the 2017 winner of the Nobel Prize in Economics, Richard Thaler has broadened our understanding. He makes a brief appearance in the following Big Short clip, with Selena Gomez, to describe one particular GFC folly (the synthetic CDO). Enjoy – and don’t skip the awesome interplay with the CDO manager; believe me, these sort of people really do exist!

9 Oct 2019