Unprecedented state assistance helped avert global meltdown

ANALYSIS:THE ROLE of the state has been of paramount importance to the development of modern financial systems, writes CHARLIE FELL

Financial systems evolved during the early modern era in tandem with the emergence of nation states. This is hardly surprising, given that governments needed large-scale finance long before private economic entities. Those needs arose from the ambition of governments to solidify their power and wage war against competing states. The history of modern banking is intertwined with that of nation states and war.

A symbiotic relationship between banks and the state can be observed from the 12th to the 19th century. The availability of ample funds enabled ambitious nation states to fund their military exploits and, in return, financiers could expect attractive trading privileges that allowed them to consolidate their own positions. However, sovereign borrowing needs were highest during times of war and defaults were common.

Sovereign default was the biggest risk faced by merchant banks. It contributed to the demise of the great Italian banking families. The Bardi, Peruzzi and Acciaiuoli banks all failed in the 1340s following defaults by Edward III of England and King Robert of Naples; the Mannini were forced to liquidate their business in 1399 when Richard II of England fell from power; and the Medici floundered during the latter half of the 15th century as a result of ill-advised loans made to Charles the Bold, the last of the great dukes of Burgundy, and his brother-in-law, Edward IV of England.

The symbiotic relationship still exists, but the roles have reversed and the state has become the provider of last-resort financing to the banks. The state has repeatedly provided life support to the banking system since Henry Thornton set out the definitive analysis of last-resort lending in 1802.

The safety net has since expanded to include bank recapitalisation programmes and deposit insurance. All three insurance devices have been provided at some point since the long financial boom began three decades ago, but the current crisis has required state assistance on an unprecedented scale.

European and US governments have provided more than $15 trillion (€10.4 trillion) in guarantees, cash injections and other supports, or an amount equivalent to almost a quarter of world gross domestic product. But while a repeat of a 1930s-style meltdown has been averted, it is too early to break open the champagne.

Decisive action has been lacking as the political clout of major financial institutions has enabled Wall Street to return to business as usual. The excessive risk-taking that precipitated the crisis has not been addressed. If anything, the distorted incentives have been exacerbated by the bailouts and forced consolidations of financial institutions deemed “too big to fail”.

The Federal Reserve Bank of New York brokered the sale of Bear Stearns to JP Morgan Chase in spring 2008, and this was followed by government-brokered deals including the sale of Merrill Lynch to Bank of America, Washington Mutual to JP Morgan, and Wachovia to Wells Fargo.

Government action saw the three largest US institutions capture more than a third of the insured deposits held by all commercial banks during this year’s first quarter, up from a one-fifth share before the crisis erupted in autumn 2007. The leading 10 financial institutions now hold almost half of commercial bank deposits, an increase of 30 percentage points over the past three decades.

It would appear to be ludicrous that the large financial institutions that helped precipitate the crisis would become even greater in size, but this is exactly what government policy promoted, and their “too- big-to-fail” status has been rewarded by the markets through a reduction in their funding costs relative to their smaller brethren.

The moral hazard created by the repeated bailout of ailing banks through liquidity support or increasingly asymmetric monetary policy during Alan Greenspan’s tenure at the helm of the Federal Reserve has been exacerbated by executive compensation practices that have seen senior management participate fully on the upside, and walk away with generous golden parachutes on the downside. Stanley O’Neal, former chief executive of Merrill Lynch, walked away with close to $160 million when he was forced out in October 2007. Chuck Prince quit Citigroup a month later with roughly $100 million.

Even the top executive teams of the defunct Bear Stearns and Lehman Brothers were able to profit handsomely from the reckless risk- taking that brought down their firms. The top executive teams of these failed entities derived cash flows of roughly $2.5 billion via cash bonuses and stock sales from 2000 to 2008, an amount that substantially exceeded the value of their worthless equity holdings.

Unprecedented state assistance has prevented a collapse of the financial system, but a second act cannot be ruled out in the years ahead, as excessive risk-taking incentives have not been addressed. Another systemic threat could prove disastrous as governments in the developed world have all but used up their spare fiscal capacity.