TalkingPoint : The most important lesson from the crisis

written by TalkingPoint on 09/12/2011

Professor Moorad Choudhry is Head of Business Treasury, Global Banking & Markets, Royal Bank of Scotland.

Students of economic history will know that crashes are endemic in free markets. The natural order of capitalist economics dictates that financial markets regularly have booms followed by busts and back to boom again. An automatic reaction to a financial crash is increased risk aversion: in the aftermath of a severe market correction individuals cut spending, institutional investors withdraw to safe havens and companies put off capital intensive projects, or worse still lay off staff. This is expected behaviour during, and immediately after, a recession.

In such an environment, it is almost universally agreed that a more conservative approach to liquidity and capital management in banks is the correct thing to do. Few people would argue against this logic. The important thing however, is to ensure that this thinking is not pushed back once the immediate memories of the recession are forgotten.

A paper written by John Boyd and Mark Gertler and published by the Federal Reserve Bank of Minneapolis in 1994, entitled The Role of Large Banks in the recent U.S Banking Crisis, is well worth reading because it is a perfect illustration of how history repeats itself. The authors, surveying the 1981-82 bank crash in the United States, note the errors made in the lead-up to that crisis and make recommendations about liquidity management in banks that remain relevant, word for word, in 2011. Commentators have remarked that it needs to be “back to basics” for banks, but that is too simplistic. Rather, what is important is that the more effective approach to liquidity risk management that is accepted as good practice today remains accepted practice tomorrow and through the business cycle, even as economic conditions improve and the market becomes bullish. In other words, banks need to ensure that the robust principles being enshrined in policy now are not watered down once credit spreads reduce and GDP growth resumes.

And that is the most important lesson to be learned from the crash of 2008. Not becoming risk averse, reining in outlier business projects, or strengthening balance sheets by raising capital ratios – vital as these may be. No, the most important lesson to be learned from the downturn is to ensure that we maintain the sensible approach to risk management that is accepted by everyone today but (as history tells us) is invariably diluted and then forgotten altogether once the economy has recovered.

As Boyd and Gertler noted in 1994 and numerous other authors have opined since 2008, if we strip the causes of the crash down to one over-riding issue, it is essentially that market participants repeat the mistakes of their predecessors. The imperative now is to try to break this cycle and remember the lessons of 2002-2008, and ensure we maintain sound banking principles over the long term. That would be to take away the principal lesson learned from the financial crisis.