Lessons learnt from the GFC and how to heed them

Boards’ inability to effectively self-regulate firms

Prior to the GFC, poor regulation by boards left financial institutions vulnerable to economic downturns. Short-term profits and market share were the primary concern of banks, with Chuck Prince, former CEO of Citibank, declaring “while the music is playing, you have to dance”. [1] Boards were wrong in rewarding executives for short-term profits, especially if attaining this profit involved excessive risk taking that left the firm exposed. [2] In 2008, despite posting last quarter losses of US$15bn, Merrill Lynch paid executives US$4-5bn in bonuses. [3] Boards need to ensure that executives are held accountable for any excessive risk-taking, by linking their remuneration to long-term performance. Firms could also hire a chief risk officer to conduct their risk management processes, improving transparency and better preparing themselves for future economic downturns. [4]

Financial institutions need to guarantee that their board has a good understanding of the firm’s products, so that they can ensure it is operating legally and ethically. Regulation changes have proven to be too slow in the past – in order to maintain peak performance and maximise shareholder wealth, firms must conduct regular audits and implement changes based on their findings. [5]

Failings of Financial Regulators

Regulators were unable to keep up with evolving financial markets, allowing firms to operate with minimal supervision. Regulators failed to foresee future sources of financial instability, and instead focused on monitoring previous sources to ensure they were kept in check. [6] This lack of foresight may be due to regulators having little experience in the private sector. For example, the last three RBA governors and deputy governors have all spent their entire careers in regulation, government and academia. Potential solutions for regulators include recruiting staff who have held senior positions at financial institutions, as well as placing staff on assignment within financial institutions. [7]

One of the most pressing issues emerging from the crisis is regulatory arbitrage, where firms knowingly change their activities to avoid unfavourable regulation. Pre-GFC, there were many financial regulators, each monitoring a small segment of the market. Firms took advantage of this by shifting their operations to fit the market segment with the most favourable regulator. [8] For instance, investment banks faced less regulation relative to commercial banks, so commercial banks established new investment banking entities to conduct their riskiest activities. [9]

As many financial products are global products, there is a need for global rules to minimise arbitrage opportunities. In an attempt to reduce cross-border regulatory arbitrage, the Basel Accord for Bank Supervision was created, which drew up international accounting frameworks Basel I and Basel II. These frameworks are an admirable attempt at cross-border regulation, however they need to be constantly revised and expanded. Basel III is a noticeable improvement with new capital asset ratio and liquidity requirements, however many argue that it still allows banks to operate with too much leverage. [10] Another attempt to reduce cross-border regulatory arbitrage is shifting focus from the G7 to the G20, to involve more of the world’s most important economies. Such efforts must be continued if the global severity of the next crisis is to be reduced.

Lessons for Governments and Central Banks

The Global Financial Crisis served as a wake-up call for governments and central banks to review their macroeconomic policy framework. Central banks pre-GFC predominantly viewed the money supply as a determinant of interest rates, and ‘inflation targeting’ as the method of conducting their operations. However, central banks need to follow the lead of Fed Chair Ben Bernanke, by separately targeting money supply growth to keep the banks both operating and in check. They should also inject liquidity into credit markets in general, rather than into specific institutions, to avoid contagion. However, they must be careful to not inject too much liquidity and encourage excessive risk-taking. [11] [12] [13] In a similar vein, there was a belief that central banks were only to worry after asset price bubbles burst, but not to worry about asset price rises or counteracting the growth of these bubbles. Central banks need to take greater responsibility for monitoring and acting on asset price changes during time of regular market operations, rather than only when a bubble has burst. If central banks fail to respond in time, then the next bubble will be even larger than the one that brought on the GFC. [14]

Governments were irresponsible in allowing banks to become ‘too big to fail’. If financial institutions are experiencing an illiquidity crisis due to capital mismanagement, then it is not the government’s duty to bail out these banks. By declaring some banks ‘too big to fail’, the government indirectly declares others ‘too small to succeed’. Such banks must be allowed to fold, allowing new ones to take their place and sending a warning of the consequences in irresponsibly taking on too much risk. If this does not occur, banks in the future could become ‘too connected to fail’ and able to hold the government hostage, over a bailout, under threat of contagion. [15]

If firms, regulators and governments fail to heed and implement the key lessons from the 2008 Global Financial Crisis, then the next crisis could be even more severe.

Nicolas is a Commerce/Economics student and the current Director of Publications at ESSA’s Monash branch.

[1] Cheung, S. (2011). Fingers burnt, lessons learnt?. Keeping Good Companies (14447614), 63(2), 89-91.

[2] Kumar, N., & Singh, J. P. (2013). Global Financial Crisis: Corporate Governance Failures and Lessons. Journal Of Finance, Accounting & Management, 4(1), 21-34.

[3] Cheung, S. (2011). Fingers burnt, lessons learnt?. Keeping Good Companies (14447614), 63(2), 89-91.

[4] Kumar, N., & Singh, J. P. (2013). Global Financial Crisis: Corporate Governance Failures and Lessons. Journal Of Finance, Accounting & Management, 4(1), 21-34.

[5] Hilb, M. (2011). Redesigning corporate governance: lessons learnt from the global financial crisis. Journal Of Management & Governance, 15(4), 533-538. doi:10.1007/s10997-010-9131-8.

[6] Edgar, R. J. (2009). The Future of Financial Regulation: Lessons from the Global Financial Crisis. Australian Economic Review, 42(4), 470-476. doi:10.1111/j.1467-8462.2009.00567.

[7] Ibid

[8] Ibid

[9] Issing, O. (2009). Some Lessons from the Financial Market Crisis. International Finance, 12(3), 431-444. doi:10.1111/j.1468-2362.2009.01250.

[10] Elson, A. (2015). What Have We Learned From the Global Financial Crisis of 2008-09 and its Aftermath?. World Economics, 16(2), 23-46.

[11] Ibid

[12] Kantor, B., & Holdsworth, C. (2010). Lessons from the Global Financial Crisis (Or Why Capital Structure Is Too Important to Be Left to Regulation). Journal Of Applied Corporate Finance, 22(3), 112-122. doi:10.1111/j.1745-6622.2010.00295.

[13] Issing, O. (2009). Some Lessons from the Financial Market Crisis. International Finance, 12(3), 431-444. doi:10.1111/j.1468-2362.2009.01250.

[14] Ibid

[15] Ibid