David McWilliams: Seven rules of life to avoid a financial crisis

On this day 10 years ago, Katy Perry's I Kissed a Girl was hurtling up the charts almost as quickly as deposits were hurtling out of the Irish banks. Within a few weeks, Ms Perry would go on to sell millions, and the Irish banks go on to lose billions. Yet, even in late July, when they could see what was happening, those in the regulator's office were still bleating that the fundamentals were sound and the banks were well-financed. That they believed it is one of the most difficult aspects of the sorry saga to digest.

But they weren’t alone. From New York to Frankfurt, from Dublin to Dubai, banks went to the wall in the biggest boom/bust credit cycle the world has yet experienced. It was on the same scale as the 1929 crash, with the added complication of enormous inter-country leverage, implying that the crash was viciously contagious, jumping not just from bank to bank but from country to country.

The defence of the central bankers and Treasury officials was that no one saw this coming, which we all know to be not true. The question is, if the people who were paid to see 2008 coming didn’t see it, are you irresponsible to trust them this time around? Be warned: when it comes to global economics the past is a good early warning system.

To misquote Oscar Wilde, to lose money once in a crisis can be viewed as a misfortune, to do so twice is careless

Ten years on, has the world learned anything from the crash which was caused by over-lending and over-borrowing? If you are worried, are there any rules of thumb that you can deploy to spot a financial crisis before it engulfs you? There are; but before we go there, the state of play should make you a bit fidgety.

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Tailspin

Hard as it might be to believe, global debt levels are actually higher than they were when too much debt sent the world into a tailspin. The world's $164 trillion debt pile is bigger than at the height of the financial crisis a decade ago. Half of this is accounted for by three countries: the US, Japan and China. Worldwide borrowing is more than twice the size of the value of goods and services produced every year and at 225 per cent of global gross domestic product, is 12 percentage points higher than during the peak of the previous financial crisis in 2009. China alone has been responsible for more than 40% of the increase in global debt since 2007. Debt levels across emerging markets as a whole now average 50 per cent of GDP, their highest level since the 1980s, the decade marked by the Latin American debt crisis.

The global picture is not pretty and, if we look at the US, we see that a small number of big banks are involved yet again. Concentration remains an issue: of the total assets held by the top 100 US commercial banks, 55 per cent is in the hands of only 10 banks. Furthermore, the big three credit-rating agents who were supposed to police the system and failed miserably a decade ago – S&P, Moody's and Fitch – still dominate the market. Those three account for more than 94 per cent of revenue in that industry.

Given this backdrop, how do you protect yourself? To misquote Oscar Wilde, to lose money once in a crisis can be viewed as a misfortune, to do so twice is careless.

We need to separate myth from reality and give ourselves a few rules of thumb to help us spot a banking crisis to protect against, say, an interest rate rise or some other unexpected shock to the global system.

It is a myth that these crises are hard to forecast and here are some rules of thumb.

Be very afraid when the swaggering CEO gets invited to speak at Davos. This is clue that the wheels may be coming off

Rule Number 1
One thing we know about banking since the first Venetians started lending money on Rialto Bridge is that the easiest way to rob a bank is to run one. Banks are robbed from the inside by their own executives. In the past, the image of bank robber was a thief in the night with a bag of swag. These days the robber wears Prada. He/she is a boss in the bank.

Banks go bad from the inside out, and the rot starts deep within the management structure of the banks themselves. This is why the concentration of banking activity in a few huge banks is worrying.

Rule Number 2
If a bank starts growing very quickly, you should start to get nervous. These are low single-digit businesses so if they are growing quickly something is wrong. If a bank's share price takes off, worry! If it starts lending a great deal, this is not a sign of strength, but recklessness. Typically, in the growth phase, it will fail to set aside loans for bad loans.

Rule Number 3
Don't rely on the financial market to tell you things are becoming riskier. You would think that financial analysts would spot the reckless lending and mark down the share price. Unfortunately, the opposite happens! As the bank takes more risk to generate more return, the share price doesn't fall, but the market gets giddy at the growth and drives the prices through the roof. As a result, the market sends you all the wrong signals. This is the structural fault deep in our financial system. The things that are supposed to protect you, in fact imperil you.

Rule Number 4 
This is the Davos rule. Be very afraid when the swaggering CEO gets invited to speak at Davos. This is clue that the wheels may be coming off. Across the water, the signal is awarding the CEO a knighthood. The more awards, the bigger the impending catastrophe.

Rule Number 5
We never learn from our mistakes. Just because we have more regulators it doesn't mean the financial precinct is safer.

The free market system encourages bad behaviour and rewards reckless carry on. And it’s infectious. Once the CEO sees everyone else making money, it encourages risk-taking.

Rule Number 6
The nub of banking failures and systemic collapse is ethics at the top.

Bad ethics drive out good ethics. Great frauds start deep within the bank. Executives convince themselves that their behaviour is okay – and then convince others. When there’s so much money sloshing around, this is human nature.

Katy Perry’s world tour continues tonight in Perth, which was one of the most over-leveraged property markets in the world, where property prices soared but are now down 25.5 per cent since the peak.

Rule Number 7
This time it's different.