A year ago, the British government was faced with the prospect of runs on some of the country’s largest banks and riots in the streets if these banks failed.
The possibility of violence linked to bank failures is not far fetched. Violent protests erupted in Iceland for months after the government was forced to nationalise some of their largest banks. The entire recovery – if, in fact, it is a recovery – in the financial system is a result of billions of dollars of public money being force-fed into the system. Notwithstanding the bulky bail-outs, credit markets are still ceased up.
The problem was not as simple as policymakers and central bankers had hoped. They may have saved the banks that, they believed, were too big to fail but they have not saved their economies. Banks may have survived and restructured. Bank executives may still be getting oversized bonuses, but most households and businesses are struggling. Job losses around the world may have slowed, but they are still increasing. Home foreclosures and car repossessions continue. Commercial property foreclosures are climbing. Investment levels remain low. The shortage of available credit is hurting and governments cannot pour enough money into the system to adequately improve it. One reason is that increased use of new financial instruments, such as derivatives and securitisation of debt, have changed the operation of global credit markets.
A significant change in the financial systems of most countries is how the role of banks in our economies has changed. Banks, especially those in developed countries, have shifted their functions from financial intermediation to earning fees. They earned billions in fees on originating loans and then repackaging them for sale to third parties. The growth of securitisation markets in the US and elsewhere has totally changed credit markets. Much debt issuance has become tied to securitisation.
A recent New York Times article stated that securitisation was the source of about 60% of all credit over the past few years. The subprime crisis and subsequent events have scared investors off securitised debt and similar financial assets. The securitised-debt market is depressed because investors have lost their trust in these markets. The New York Times article said that the US markets were working only because of all the money government is putting into the markets. The poor performance of securitisation markets means that the reco- very would be slower, if not delayed. It also makes decisions by governments to phase out bail-out funds more difficult.
The complexity resulting from the increased role of markets for securitised debt in countries such as the US is important to understand. First, it provides one with a good sense of how important the changes in the financial system over the past decade or two were for the global economy – not just for financial markets.
The ability to consume, buy homes, invest in businesses and to get cash for the day-to-day operational cost of running businesses depends on liquid credit markets. Of course, it was not only the securitisation of debt that grew in popularity. All kinds of derivatives became commonly used in day-to-day financial operations of corporations. The notional size of outstanding over- the-counter derivatives reported by the Bank for International Settlements at the end of 2008 was $592-trillion. Most corporate debt issuances in developed economies were done using derivatives of different sorts.
An important characteristic of the financialistion of economies is that the day-to-day operations of businesses have become tied to financial markets and the increased use of derivatives. There has been increased financial speculation in all aspects of business. A real solution to the financial crisis and lasting stability in financial markets have to deal with the changes in financial markets.