The biggest economic puzzle of the past few years is why the recovery has remained so weak. The underlying cause of the 2007-2009 recession was the bursting of the real estate bubble. But it was the banking crisis resulting from the drop in home prices that actually sent the U.S. tumbling into the worst economic downturn since the Great Depression. Continuing problems in the banking industry have been among the chief factors holding back the recovery. The key question now is whether the banks have finally tackled their problems, so that the economy can start to grow more robustly.
It certainly seems as though the banking sector should be on the mend. Home prices have turned up after hitting bottom early last year. And other borrowers are in better shape, too. Corporate profits have rebounded powerfully, and consumers have got their household debt under control. So you might think that banks would be in a stronger position to finance economic growth. The reality, however, is more complicated. The losses banks suffered because of falling home prices exposed a host of fundamental problems in the industry. Here’s a look at what needs to be addressed to get the financial system back to full strength:
Regulation. There are two key types of regulation. The first limits the amount of risk a bank can take. Only trouble is, it’s hard for regulators – or anyone else – to monitor the riskiness of bank portfolios. Indeed, the major credit-rating agencies have come under sharp criticism for failing to recognize the risk of some sophisticated investments. The second type of regulation separates aggressive forms of banking from more mundane lending for mortgages, businesses, and consumer finance. That prevents speculative losses from leading to a cutback in credit available for ordinary business activities. A provision known as the Volcker Rule restricts banks from making risky investments with the same capital that they use to make loans to clients. But the rule does not require the nearly complete separation of commercial and investment banking that the old Glass-Steagall act did. Moreover, financial firms already seem to be finding ways to get around the complex provisions of the Volcker Rule.
Credit quality. Looser regulation wasn’t the only thing that led to risky investing before the recession. Federal Reserve Chairman Alan Greenspan pursued an easy-money policy that encouraged banks to lend as much as possible. And since the number of high-quality borrowers is always limited, expansive lending led to a decline in creditworthiness and an increase in so-called subprime real estate lending. Today banks are more cautious. But the Fed is still very expansive, so the potential for speculation remains.
Sophisticated investments. What sent risk levels into overdrive prior to the recession was the growth of sophisticated investments – sometimes known as derivatives – that repackaged mortgages and other loans so that they could easily be bought and sold. These vehicles increased the scale of potential losses if loans went bad. They also made it difficult for outsiders – and sometimes even for banks themselves – to gauge how risky their portfolios were. Although the volume of derivatives outstanding has declined a bit recently, it still remains very high by historical standards.
Transparency. The difficulties outsiders face in trying to figure out the true risks in bank portfolios is analyzed in a recent Atlantic cover story. According to the article, the biggest cause of panic during the financial crisis was that “it was impossible to tell, from looking at a particular bank’s disclosures, whether it might suddenly implode.” The article goes on to conclude that the situation is not much different today.
Some top banking analysts say that the worst has passed, that the banking industry has reformed, and that the outlook can only improve from here. Prices for bank stocks are still far below their pre-recession highs, and if the industry really has fixed its problems the shares look like terrific bargains.
I’m not so sure. Even at banks with the best reputation, internal risk management seems insufficient. J.P. Morgan Chase’s own investigation into its $5.8 billion dollar trading loss last year concluded that management didn’t fully understand the trading strategies, didn’t provide effective oversight, and basically had no idea how much money was at risk. As a conservative investor, I’ve steered clear of financial stocks. At today’s prices, they may be good buys for aggressive investors, but I’ve been able to find plenty of high-yielding retirement investments among oils, pharmaceuticals, telecoms, utilities, and some other industrials.
(MORE: Disabled Kids Get in the Game)
As for the bigger question, the banking sector won’t be able to boost the economic recovery as long as key challenges remain unresolved. It’s necessary to regulate the industry without stifling it, to encourage lending without risking a deterioration of credit quality, and to keep up with global financial innovation without creating additional uncertainy. One thing does seem clear, though. Banks need to be a lot more forthcoming with analysts and investors. Striving for transparency will not only increase confidence in the industry, it will also encourage banks to recognize the risks they’re taking and manage them better internally.