Leading article: Fatalism is not the way to react to the credit crunch

Share
Related Topics

It is a year since confidence in the Western banking sector suddenly evaporated, precipitating what has become known as the credit crunch. And it is perhaps appropriate that the anniversary coincided with the announcement from Northern Rock that it has recorded losses of £600m this year. The sight of ordinary depositors queuing to withdraw their money suddenly illuminated the connection between the tumult in global financial markets and our own savings.

We still do not know how long the crunch will continue, or how it will end. But, a year later, we have a much clearer picture of how it all began. The trigger was the pricking of the American housing bubble. But the underlying cause was a fatal collapse in bank lending standards in the years before the summer of 2007.

A few years ago, Wall Street investment banks began buying up the risky loans made to poor Americans and packaging them into opaque financial instruments known as collateralised debt obligations (CDOs). They would then sell these CDOs on to private investors, or simply add them to their own balance sheets. The theory was that the risk was so diffused as to make the investment rock-solid. Wall Street big names, such as Merrill Lynch and Bear Stearns, were at the forefront of this business. But our own high street banks, from the Royal Bank of Scotland to Barclays, joined in. Some less prudent European banks became involved too.

The problem was that this business model was only sustainable so long as house prices were rising. As soon as they went into reverse, CDOs collapsed in value. They turned out to be full of risk after all. In fact, they were even riskier than normal loans. Because there were so many of these poisonous products in the global financial system, no one knew exactly which banks or investors had lost money. And because these instruments were so opaque, no one could accurately gauge the scale of anyone's losses. The banks panicked and abruptly stopped lending to each other. They also cut back their lending to ordinary customers. The credit crunch had begun.

For the past year, banks around the world have been writing off billions in bad debts and raising new capital to repair their balance sheets. But it has been a slow process. And still no one knows the full extent of the losses because house prices in America, to which the value of these toxic investments are mostly linked, continue to fall. Confidence has yet to return.

There are some who argue that little can be done about this sort of thing; that banking crises are inevitable in free markets and that it is futile, even counter-productive, to try to prevent them. This is misguided for several reasons. One is the involvement of the taxpayer in sorting out the mess. We have seen with the nationalisation of Northern Rock, and the Federal Reserve's rescue of Bear Stearns, that governments have no choice but to support banks when they are in danger of going under. Even relatively small financial institutions are "too big to fail". But this support comes with a price tag. Taxpayers are being forced to bear some of the costs of the bad lending made by banks. A system in which the banks earn huge profits from dodgy lending and the public picks up the bill when things go wrong is – or should be – politically unsustainable.

Another compelling reason for reform lies in the impact on the real economy. Banks are the beating heart of our economic system. When they stop pumping money around the system, limbs are prone to start falling off. Industry and retailers need capital to operate. We cannot tolerate a system in which the banks can suddenly shut off the supply of funds to the economy – particularly in a downturn of the sort we are experiencing at present.

So what should be done? The fatalists have half a point. Regulation by national or international bodies can never be perfect. Each banking crisis tends to be different from its predecessor in some way, which makes pre-empting trouble difficult. But what links these periodic crises is a general collapse in lending standards and a mass mispricing of risk. Financial institutions and their employees have a tendency to succumb to a state of financial euphoria in which they assume asset prices will carry on rising forever. For some, a downturn had never been part of their experience. In such circumstances, judgement became sloppy. Greed takes over.

What the international finance system needs is a regulatory framework that checks what John Maynard Keynes termed the "animal spirits" of lenders and large investors. We need a debate about how this framework ought to be constructed. Any reform needs to curb excesses, without damaging the flow of credit to businesses and sound borrowers. It will be anything but simple. But we cannot allow our economies to be periodically jeopardised by the excesses of the financiers. One year on from the start of the credit crunch, it should be clear that we cannot simply shrug our shoulders and wait for history to repeat itself. That would be the height of irresponsibility.

React Now

Latest stories from i100
iJobs Job Widget
iJobs General

Recruitment Genius: Home Care / Support Workers

£7 - £10 per hour: Recruitment Genius: This care provider is looking for Home ...

Recruitment Genius: Web Team Leader

£30000 - £35000 per annum: Recruitment Genius: One of the UK's leading web des...

Recruitment Genius: Client Manager

£27000 - £35000 per annum: Recruitment Genius: A growing, successful, friendly...

Recruitment Genius: Property Negotiator - OTE £20,000+

£16000 - £25000 per annum: Recruitment Genius: This family owned, independent ...

Day In a Page

Read Next
Separate lives: Boston’s streets illustrate the divide between the town’s communities  

Migrants have far more to offer than hard work and wealth creation, yet too many exist in isolation from the rest of society

Emily Dugan
Harper Lee's To Kill a Mockingbird has sold 40 million copies  

Go Set a Watchman: Harper Lee’s new novel is more than just a literary event

Joseph Charlton
The Greek referendum exposes a gaping hole at the heart of the European Union – its distinct lack of any genuine popular legitimacy

Gaping hole at the heart of the European Union

Treatment of Greece has shown up a lack of genuine legitimacy
Number of young homeless in Britain 'more than three times the official figures'

'Everything changed when I went to the hostel'

Number of young homeless people in Britain is 'more than three times the official figures'
Compton Cricket Club

Compton Cricket Club

Portraits of LA cricketers from notorious suburb to be displayed in London
London now the global money-laundering centre for the drug trade, says crime expert

Wlecome to London, drug money-laundering centre for the world

'Mexico is its heart and London is its head'
The Buddhist temple minutes from Centre Court that helps a winner keep on winning

The Buddhist temple minutes from Centre Court

It helps a winner keep on winning
Is this the future of flying: battery-powered planes made of plastic, and without flight decks?

Is this the future of flying?

Battery-powered planes made of plastic, and without flight decks
Isis are barbarians – but the Caliphate is a dream at the heart of all Muslim traditions

Isis are barbarians

but the Caliphate is an ancient Muslim ideal
The Brink's-Mat curse strikes again: three tons of stolen gold that brought only grief

Curse of Brink's Mat strikes again

Death of John 'Goldfinger' Palmer the latest killing related to 1983 heist
Greece debt crisis: 'The ministers talk to us about miracles' – why Greeks are cynical ahead of the bailout referendum

'The ministers talk to us about miracles'

Why Greeks are cynical ahead of the bailout referendum
Call of the wild: How science is learning to decode the way animals communicate

Call of the wild

How science is learning to decode the way animals communicate
Greece debt crisis: What happened to democracy when it’s a case of 'Vote Yes or else'?

'The economic collapse has happened. What is at risk now is democracy...'

If it doesn’t work in Europe, how is it supposed to work in India or the Middle East, asks Robert Fisk
The science of swearing: What lies behind the use of four-letter words?

The science of swearing

What lies behind the use of four-letter words?
The Real Stories of Migrant Britain: Clive fled from Zimbabwe - now it won't have him back

The Real Stories of Migrant Britain

Clive fled from Zimbabwe - now it won’t have him back
Africa on the menu: Three foodie friends want to popularise dishes from the continent

Africa on the menu

Three foodie friends want to popularise dishes from the hot new continent
Donna Karan is stepping down after 30 years - so who will fill the DKNY creator's boots?

Who will fill Donna Karan's boots?

The designer is stepping down as Chief Designer of DKNY after 30 years. Alexander Fury looks back at the career of 'America's Chanel'