Nick Martindale 8 May 2017 10:00am

The legacy of the global financial crisis

Ten years on from the global financial crisis, the world is still wrestling with the consequences, with implications for politics, business and the accountancy sector. Nick Martindale traces its origins and both current and possible future impacts

Caption: Like most major historical events, the causes of the crisis were complex, with a mixture of short and long-term factors.

For many people alive today, the global financial crisis, which started almost a decade ago, may well represent the most tumultuous economic period of their lives. Like most major historical events, the causes were complex, with a mixture of short and long-term factors.

John Hawksworth, UK chief economist at PwC, suggests the underlying cause was imbalances in the global economy, linked to the rise of China. “China became a significant player in terms of global trade, particularly selling large amounts to the US and Europe, and built up a large trade surplus that really was a reflection of the fact their savings were higher than their investment,” he says.

This was mirrored in countries such as Japan and Germany, while other countries – including the UK and US – developed a culture of borrowing. “A combination of very low interest rates, optimism that house prices were a one-way bet and relatively relaxed regulation made it easy to offer sub-prime mortgages in the US,” he says. “Those were then sold on in various derivatives in complex matrices to all sorts of investors right across the world, but particularly in Europe.” Once people realised just how risky these debts were, there was a wider reluctance to lend, and the whole system failed, he adds.

There were also failings, with the benefit of hindsight, in the financial sector itself. “The minimum capital requirements for banks set in the Basel Accord proved to be too liberal, and the repeal of the Glass-Steagall Act allowing commercial banks to undertake more speculative activity probably also served to heighten risk,” says Geraint Johnes, professor of economics at Lancaster University Management School. “Derivatives allowed risk to be piled upon risk, with little transparency about the real extent to which various investments were secure. When the market turned south, the house was built of cards.”

Remuneration in the sector also helped to encourage a risk-taking culture that still exists today, says Ismail Erturk, senior lecturer in banking at Alliance Manchester Business School, and author of The Routledge Companion to Banking Regulation and Reform. “We have a banking business model where the remuneration mechanisms favour volume,” he says. “In investment banking the remuneration is based on net revenues, and the usual rule is investment bankers get 50% as compensation. That encourages irresponsible risk taking by driving volume.” Executive success, meanwhile, is measured by return on equity rather than an institution’s stability.

Ansgar Walther, assistant professor of finance at Warwick Business School, says there are two schools of thought around just how much the banks knew about the risks they were taking. “There are those who think that the crisis was due to bad incentives and that banks did not internalise the downside of the risks they were taking in the sub-prime mortgage market,” he says. “Others think that it was due to irrational exuberance; banks genuinely thought that sub-prime was safe. Academic research has uncovered evidence consistent with both theories but the jury is out as to which one is quantitatively more important.”

Drawing on insight gleaned from a series of international events with various stakeholders held during and in the aftermath of the economic crash, Robert Hodgkinson, executive director, technical, at ICAEW, suggests the crisis was a symptom of, and served to highlight three forces, an underlying tension between national interests and those of businesses or capitalist market forces, which has been compounded by an inability of international institutions to reconcile these, ultimately leading to the rise of nationalism as seen in movements such as Brexit and the election of US president Donald Trump.

Just 10 years after the credit crunch, we cannot return to the days of compromising economic sustainability for short-term political popularity. (Sam Tate, director at Exiger)

“There is a continuing issue which people are still grappling with, which is how you balance and reconcile those three forces, and you could say that what happened last year politically represents national interest and popular opinion triumphing over the forces of international markets and institutions,” he says. “That combination of business and international institutions almost defines the problem in a lot of people’s eyes.”

The financial crisis certainly had the effect of uncovering a number of issues and imbalances that had been allowed to build up unchecked during the boom years of the early 2000s, suggests Hawksworth, particularly the issue of stagnating real incomes in a global economy. “That credit bubble papered over the cracks because it made it seem like low-to-middle earners could still buy a house and have a reasonable standard of living through borrowing,” he says. Many people who lost previously secure jobs have also found it hard to find work, in both the US and UK, he adds, creating a swathe of people who feel disenfranchised and let down.

Dr Peter Bloom is senior lecturer and head of department of people and organisations in the faculty of business and law at the Open University. He believes the current trend towards nationalism and protectionism has its roots in the push towards a more global economy in the 1980s and 1990s, after years of industrial struggle in the 1970s. “We had a very strong and complete re-orientation of the national economy to meet the needs of being globally competitive, which meant being an export economy and doing things which were very pro-business,” he says.

“But we also had increasingly free movement of capital but not necessarily free movement of labour, which causes greater inequality. This global free trade created a competitive or problematic movement of labour that was very much a symptom of this broader global inequality.” This has led, argues Bloom, to what he terms “hopeful nihilists”, who are prepared to vote for movements offering the prospect of change simply because they want to try something else, rather than because they are genuinely believers in that cause.

The financial crisis has had other legacies, too, not least for organisations having to adapt to the new move towards protectionism. Hodgkinson gives the example of PSA Group’s move to purchase GM’s Opel and Vauxhall operations as a means of having manufacturing facilities inside the UK in the event of a “hard Brexit”, and suggests companies could even revert to more of a multinational business model rather than the global approach that has been ubiquitous in recent years.

“Business is like that; it’s adaptable,” he says. “Businesses used to have a different model where they could still share expertise and the power they get from operating in different markets but they don’t necessarily have globally integrated supply chains. It’s just a different model, and they could adapt to national regulation if that’s the way it’s going.” US businesses have also largely accepted the move to roll back international regulation, he adds.

Such a strategy would be inadvisable in the UK, however, says Hawksworth. “We don’t have a big enough domestic market and the only way we can really thrive after Brexit is by continuing to have strong flows of trade and investment with the rest of the world, particularly the fast-growing emerging economies like India and China, as well as the US,” he says. “The US has a bigger domestic market and could adopt a slightly more nationalistic approach, even though it would be damaging in the long run.”

Moving away from a more global model could also have implications in the finance and accountancy sectors, suggests Hodgkinson. “The accounting world hasn’t rammed international standards right down into the smallest business and we have quite a lot of national tailoring,” he says. “But in all kinds of areas there is an encouragement to think about how we might repatriate discretion or standard setting and regulation and there will be different dynamics in different sectors.

Everything is in play, which is different to the feeling you would have had 10 years ago when everything was in the direction of greater international co-operation and harmonisation. That presumption has been undermined.” International institutions also face an existential battle, he says, struggling to remain relevant in the wake of increasingly nationally-driven agendas.

Whether another crisis could erupt is conjecture but the accountancy sector has taken steps to help reduce the prospects, says Bob Dohrer, global leader, quality and risk, at RSM International. “There is a new commitment by auditors to provide greater transparency into the audit process and share more information with users of audited financial statements,” he says. “It is hard to think now but, before the financial crisis, there was no requirement for auditors to report ‘close calls’ with respect to the entity’s ability to continue as a going concern. New auditor reporting standards have resulted in the public having more information, making the entire financial system far more transparent.”

Walther, though, believes this comes down to which of the two schools of thought around the causes of the crisis is proved correct. “If bad incentives caused the crisis, then we have done a lot to mitigate the next one,” he says. “Bank capital and liquidity regulation has become more stringent, and governments have deliberately made it more difficult for themselves to authorise bailouts in the future, both of which should help to reduce risk-taking.

“However, if irrational beliefs caused the crisis, then it is unclear whether we can prevent the next one. There is always a strong tendency for everyone – including regulators – to believe that ‘this time is different’, and therefore regulators might not use their new tools at the right moment to avoid the next crash. Moreover, the next crash might well be triggered by geopolitical risks which are outside the control of financial regulators.”

There is also concern that regulation designed to prevent a repeat of the financial crisis could be rolled back, particularly in the Trump presidency. “The challenge for the next 10 years or more will be in examining carefully a growing US political will that has emerged since the new US president took office to roll back, all in the stated interests of stimulating economic growth, key tracts of financial regulation put in place in the wake of the last crisis,” says Sam Tate, director at financial crime, risk and compliance advisory firm Exiger.

“In reaction to the new US political mood to deregulate, deputy governor of the Bank of England Sir John Cunliffe warned in February that he was concerned about loosening many of the financial rules and regulations put in place in the UK since the financial crisis. He is right to be concerned. Just 10 years after the credit crunch, we cannot return to the days of compromising economic sustainability for short-term political popularity.”