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Don't blame bankers for the financial crisis and its aftermath

It wasn't them

If you're the kind of person who thinks that the neo-liberal agenda is to blame for the world's ills and that capitalism should be abolished, you could claim that Adair Turner is an insider and apologist whose defense of bankers' role in the financial crisis is an inevitability. After all, Turner spent three years working for Chase Manhattan (now part of J.P. Morgan), six years working for Merrill Lynch, and 12 years working for McKinsey & Co. - You don't get much more insider than that.

However, to dismiss Turner as an apologist is a simplification. He's the man, after all, who famously said in 2009 that many of banks' activities were "socially useless." He's also the man who joined the UK Financial Services Authority as chairman five days after the collapse of Lehman Brothers in 2008, and who has spent much of the past seven years trying to put the financial system to rights.

Now Turner has written a book, 'Between Debt and the Devil,' which lays out his conclusions about the causes of the financial crisis, about how to palliate its aftermath, and how ensure it never happens again. For people who think bankers are a scourge on society, it makes challenging reading.

Don't blame the bankers, blame the system

Bankers were "irrelevant" to the crisis, argues Turner, provocatively. "Yes, many individual financiers were greedy or incompetent, and we should punish fraud severely and increase the penalties for reckless behaviour," he says. "- But if we think the crisis occurred because of individual "bad apples" who corrupted the system, or because of badly designed incentives and inadequate sanctions, we will fail to make adequately radical reforms.”

From Turner's perspective, the cause of the financial crisis wasn't greedy bankers, or bankers' incompetence, or even inadequate risk controls - it was out of control credit expansion. Most importantly, it was out of control credit expansion funneled towards the real estate sector.

The fundamental problem wasn't bankers' greed, it was lending to buy real estate assets 

As he scrutinized the causes of the crisis, Turner says he was increasingly led to the conclusion that, "the most fundamental problems of financial and economic instability are created not by economic activities that we would be quite happy to see disappear entirely [like so-called 'casino banking' or proprietary trading] but by activities such as lending money to someone to buy a house – which in moderate amounts are clearly valuable but on an excessive scale can cause economic disaster."

In other words, the problem was, and is, house prices.

While banks theoretically exist to make loans to businesses and to allocate capital efficiently to entrepreneurs, Turner says the reality is very different.  In advanced economies, banks' main purpose is instead to channel money into both the residential and commercial real estate markets - into mortgages for homes and commercial buildings.

He figures to back-up his assertion. In 1928 real estate lending averaged 30% of all bank lending across 17 advanced economies; by 1970 it was 35%; by 2007 it was closer to 60%. In the UK, residential mortgages accounted for 65% of bank loans in 2012; business-related non-real estate loans accounted for just 14%.

Turner says there are two good reasons why so much credit is funneled into real estate. One is down to bankers' preferences, the other, to borrowers.

Banks like to lend against real estate because such loans are 'easy,' suggests Turner. Compared to a business proposal, real estate assets are tangible and simple to value. And real estate losses, so far, have been minimal. Admittedly, in the US, total mortgage loan losses reached 7% after 2008, but in the UK, losses on mortgage loans are running at less than 1%. This encourages banks to lend against real estate: it's seen as a safe bet.

At the same time, Turner says people like to buy real estate not just because they need somewhere to live but because in a world where digital products can be replicated for little or no marginal cost, real estate is in finite supply and is therefore a store of value. House prices rise as a result:  "If the supply of desirable locations is scarce, and the land on which desirable real estate is, is irreproducible, the only thing that can adjust is the price.”

For this reason, Turner says real estate prices in advanced economies will always increase irrespective of credit-fueled lending - but that credit-fueled lending makes those price rises worse. Mortgage credit moves in line with house prices: between 2000 and 2007, US mortgage credit increased by 134% and house prices by 90%; in Spain, the increases were 254% and 120%; in Ireland, they were 336% and 109%

When it becomes apparent that too much credit has been extended against house prices, the bubble bursts. The result is a financial crisis, a debt overhang and a recession or depression. Debt markets are susceptible to sudden stops, notes Turner. From 2004 to 2008 credit in Ireland grew by 20% a year; from 2009 to 2013 it contracted by 1.3%.

He says bashing individual bankers is not the solution: "It was mistakes in policy, economic theory, and in the overall design of the financial system, that led to the crisis of 1929. The same is true of our latest crisis.”

What the banking system did wrong

While Turner absolves bankers, he doesn't absolve the banking system or the complex financial products that fueled credit growth in the run-up to 2008.

Securitization, credit default swaps, and collateralized debt obligations, all theoretically benign, were not. "Credit structuring enabled investors to choose the precise combination of risk, return and liquidity that best matched their preferences," says Turner. Long term, however, he says the effect of such structuring was, 'strongly negative.'

Similarly, Turner sees little value in the complex trades between banks that contribute to the instability of the system: "Left to themselves, free financial markets will generate far more intra-financial system trading than is socially optimal.” Nor does he see much value in things like high frequency trading: “Financial participants may devote large resources to predicting movements in price minutely ahead of the rest of the market, in ways that may be profitable for the individual firm, but cannot possibly increase the size of the overall economic cake.”

He also notes that risk management innovations like mark to market pricing and Value at Risk were sadly inadequate, but adds that better risk controls aren't the whole of the answer: the banks that dealt with risk well during the crisis simply offloaded their positions onto banks that didn't deal with risk well (think RBS), and thereby contributed just as much to the instability of the whole system as those who managed their risks badly.

The debt hangover

Where does this leave us? Turner says the advanced world is still afflicted by the hangover of highly indebted households. When a credit bubble bursts, "highly leveraged households focus strongly on reducing their debt levels.” The economy shrinks and so the decline becomes self-perpetuating.

It is this shrinkage which Turner argues is responsible for increasing government debts - not the cost of bailing out the banks in 2008: "In the UK the total net costs of bailing out the banks – including equity injections, guarantees, and central bank liquidity support – have amounted to about 1.3% of GDP, but public debt as a share of GDP has soared from 44% in 2007 to 92% in 2013."

Turner's solution is not necessarily to encourage government spending to fill the gap - this simply shifts the debt from one place to another and is unsustainable. He does note, however, that while the UK government is committed to austerity, it's also relying upon increased private indebtedness to keep the economy afloat. The Office for Budgetary Responsibility (OBR) is predicting that UK private household debt, which fell by 22 percentage points between 2010 and 2014, will rise by 40 percentage points through to 2020. As a result, the UK could end up more exposed to a future crisis than ever.

The cure

For Turner, the cure is not to restrict bankers' pay (although he's not averse to this), nor to break up big banks, or even to to insist upon new risk systems. While all this might be desirable, he thinks none of it will solve the real cause of financial crises: housing bubbles.

Instead, Turner suggests that policy makers need to go for the jugular: housing loans need to be curtailed by supply side measures like strict loan to value and income to value ratios, houses need to be taxed more highly, land needs to be taxed more highly, house price appreciation needs to be taxed more highly. At the same time, the supply of homes needs to increase. He posits innovative products like 'shared risk mortgages' in which mortgage lenders receive lower payments if house prices fall, meaning that household consumption doesn't fall as dramatically when a housing bubble bursts.

This is not to say that Turner's vision is favourable for the average banker. He supports a Financial Transaction Tax. He thinks banks need to increase leverage ratios (the amount of equity capital they hold relative to the loans they've made) far above the levels prescribed by Basel III. He also (seems to) support capital controls, which would dramatically reduce the size of the global banking system. And, he's not averse to debt amnesties, or to printing money to reduce debts - along the lines of quantitative easing advocated by economist Steve Keen.

However, Turner also thinks that in a properly regulated system, bankers and traders are both valuable and misunderstood.

“Liquid markets can facilitate capital investment and help to ensure well–informed capital allocation. And liquid markets in turn require market-makers who are willing to sell when investors want to buy, and buy when they want to sell – but that requires position taking, and position taking is a form of betting," says Turner. "A financial system that performed only socially useful functions would still be one in which man firms and individuals earned large incomes from trading activities whose value will seem to many people mysterious.”

Try telling that to the next person who says all 'bankers' are pointless parasites.

Photo credit: Chris Brown

AUTHORSarah Butcher Global Editor

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