12 The Cost of Financial Crisis: How Absent Management in Banking Became Costly

Meagher, Evan, Rebecca Frezzano, and David Stowell. 2008. Investment Banking in 2008 (B): A Brave New World. Kellogg School of Management, Northwestern

University, Illinois. Melvin, Sheila, and Ken Shotts. 2013. Barclays and the LIBOR: Anatomy of a

Scandal. Stanford Graduate School of Business: Stanford. Nakamoto, Michiyo, and David Wighton. 2007. Citigroup Chief Stays Bullish on

Buy-outs. Financial Times, 9 July 2007. Parliamentary Commission on Banking Standards. 2015. An Accident Waiting to

Happen: The Failure of HBOS. London. Pozen, Robert C., and Charles E. Beresford. 2010. Bank of America Acquires

Merrill Lynch (A). Boston: Harvard Business School. Rodionova, Zlata. 2010. Deutsche Bank and Credit Suisse to Pay $12.5bn in US

Fines Over Role in 2008 Financial Crisis. Rose, Clayton S., and Aldo Sesia. 2010. Post Crisis Compensation at Credit Suisse (A). Boston: Harvard Business School. Rose, Clayton S., and Aldo Sesia. 2014. Barclays and the LIBOR Scandal. Boston:

Harvard Business School. Rose, Clayton, and Aldington Sesia. 2011. What Happened at Citigroup (B)?

Boston: Harvard Business School. SWI. 2013. Buy Buy Bad Bank. www.swissinfo.ch/eng/business/bye-bye-badbank_swiss-bank-bailout-turned-poison-into-profit/37218080 (2013). The Independent. 2016. Deutsche Bank, Credit Suisse, Barclays Pay US Fine. The

Independent, December 23. https://www.independent.co.uk/news/business/news/deutsche-bank-credit-suisse-barclays-banks-pay-us-fine-2008-financial-crisis-housing-market-a7491901.html. UBS. 2008. Shareholder Report on UBS’s Write-Downs. Zurich. Wikipedia. 2010. List of Write Downs Due to Subprime Crisis.

CHAPTER 12

The Cost of Financial Crisis: How Absent Management in Banking Became Costly

Absent management need not be costly. Sometimes an organisation, even a bank, carries on without management but does not fail. In rare cases, it is even successful, such as when RBS made a hostile bid for NatWest and took it over without more due diligence than the publicly available information.

Absent management in banking becomes costly when it is the cause of a bank failing. When a bank fails this absence causes costs to customers, owners, employees and suppliers. If the bank needs support from government this support has an associated cost that is ultimately borne by the taxpayer. When absent management causes a bank to fail, that in turn causes or worsens a financial crisis, this absence can become enormously costly.

Before considering the cost of a financial crisis, the cost of the failure of a single bank can be serious enough. The customers, private and corporate, can lose their deposits in the bank. In many, particularly developed, countries private deposits are protected by the government up to a certain level. In the United Kingdom private depositors are protected by the Financial Services Compensation Scheme up to £85,000. Before the banking crisis in 2007 this protection was only £31,700 per person. Where the government is unable to recover compensation made to depositors the banking industry is responsible for making up the difference. The British banks had to fund a shortfall of over £500 million that the Financial Services Compensation Scheme was unable to recover from three failed Icelandic banks operating in the United Kingdom in 2008. In the United

© The Author(s) 2020 C. Dinesen, Absent Management in Banking, https://doi.org/10.1007/978-3-030-35824-2_12 227

States the Federal Deposit Insurance Corporation now insures all deposit accounts up to $250,000 per depositor, per insured bank. When established after the Great Depression in 1934 it was $2500. In between the Depository Institutions Deregulatory and Monetary Control Act of 1980 increased the insured amount from $40,000 to $100,000 (FDIC 2019).

Depositors withdrew over £12 billion from Northern Rock in the second half of 2007, estimated at two-fifths of the bank’s total deposits (Arnold 2017). To stem the run on Northern Rock, the British government guaranteed all private deposits in this institution on 17 September 2007. This guarantee was subsequently withdrawn and aligned with the protected £85,000 limit for all banks on 24 May 2010.

In addition to the loss of deposits a failed bank also ceases to provide services of which one of the most important is lending. Private and corporate customers depend on banks to be able to finance purchases beyond their accumulated savings or corporate capital. When a single bank fails, customers are often able to borrow from another bank, so the loss may be more of a temporary inconvenience than a long-term problem. However if more than one bank fails the lack of available and affordable finance can become problematic. Private customers will be less able to make larger purchase, such as cars and houses, affecting their lives and possibly causing the prices of exiting assets, particularly property, to fall.

Businesses can become less able to expand or just refinance their existing borrowings leading to lower earnings, possible reduction in staff and even failure. A reduction in bank lending can be particularly problematic for small- to medium-sized companies and organisations. This is because they lack the size and name recognition to seek alternative finance such as from debt and equity capital markets. In the second quarter of 2008, industrial and commercial lending in the United States peaked at $1700 billion falling by a quarter to below $1300 billion in the third quarter of 2010. Lending took a long time to recover and did not exceed $1500 billion until the beginning of 2013 (U.S. Department of the Treasury 2013).

Bank employees will often lose their employment when a bank fails. The vast majority of them would not have been managers but been as diligent and hard working as in other industries and organisations. They would have played no role in the possible absent management that may have been the cause of the failure of the bank. In the 2008 financial crisis, the hostility felt towards senior bankers in failed banks, all of whom should have been managing the banks, also affected other bank employees. Because banks were seen as instrumental in the crisis, these former employ-

ees may have found less sympathy for the loss of their employment amongst the rest of society than was the case when non-banks failed and laid off their employees. In a buoyant economy, many employees of a failed bank should be able to find other employment. In the case of single bank failure, the failed bank is often taken over by another bank, such as was the case when Barings was taken over by ING in 1995. In such a case, only few employees may lose their jobs. In a situation where more than one bank fails, and particularly if the economy is negatively affected by numerous bank failures, finding new employment can be extremely difficult.

Banks use a wide range of suppliers, from paper to information technology to professional services, such as for example auditors. A bank failure means reduced income for the bank’s suppliers. More than one bank failure can be serious, particularly for suppliers heavily dependent on not just one bank but also on the banking sector.

Bank owners often lose everything when a bank fails. ING paid £1 for Barings, a bank that had once been the second largest in London. The Baring family was the majority owner at the time of the bank’s failure and lost their investment. For banks listed on the stock exchange, a failed bank causes loss to shareholders. This loss will range from what the shares can be sold at to a possible acquirer to a total loss if the shares have no value. While Lehman Brothers’ shares were worth nothing on 17 September 2008, Merrill Lynch was sold to Bank of America for $29 per share. Had Bank of America decided to buy Lehman Brothers instead of Merrill Lynch, the loss to the respective shareholders would have been different, if not perhaps completely opposite, depending on what Bank of America might have paid for Lehman Brothers. AIG’s shares were widely held by pensioners who lost part of their pensions when AIG’s market capitalisation of $140 billion in 2007 fell to almost nil.

Some customers are also owners of their banks. When mutual or savings banks demutualise, the issued shares are generally distributed to depositors and other customers. This was the case with Northern Rock, which demutualised in 1997. More than 100,000 smaller shareholders lost their investment when the bank was nationalised in 2008. An action group is still pursuing the British government for compensation.

In other cases banks encouraged their customers to invest in the bank’s shares only for the customers to lose their investment when the bank failed. From 2000 onwards the Danish Roskilde Bank raised DKR370 million in equity capital from its customers with the majority of these investments being financed by loans from the bank. This amounted to

margin lending as seen prior to the Great Depression. When the bank failed in 2008 the customer investors lost their investments with the total loss to all shareholders being DKR7 billion. The management was found not to be personally liable for the losses in a compensation trial. The judge said that the court had found that the bank had in some instances been managed irresponsible. Irresponsible management is not really management at all, particularly for a bank, and is close to absent management. And shareholders lost their investment.

A particular unfortunate group are those employees who lost both their job and the value of their shares. Northern Rock employees were often also customers, so received shares upon demutualisation and lost both their employment and the value of these shares. Only months before the government had to take over RBS in 2008, employees were still being offered shares at £2.20 per share in a £12 billion capital raising exercise. Ten years later, a compensation of £0.82 per share was offered.

The deposits of corporate customers are generally not protected by the government. This means that any organisation, including for example charities and local councils, need to weigh up the risk of bank failure when placing their deposits. Kent Council in the United Kingdom was one of 125 local councils with deposits with one of three Icelandic banks with operations in the United Kingdom. Kent Council fully recovered its deposits of £50 m plus interest after ten years, but many other councils did not. For these councils, the result was either a need to cut expenditure or to increase council tax where allowed by central government.

The biggest debtors of a bank are often other banks. Some banks, for example investment banks, often deposit surplus cash with other banks. Much more important is that banks lend to each other. This creates a dependency of one bank on other banks. In the case of Bear Sterns and Lehman Brothers, the dependency on very short-term, often overnight, financing with other banks was so high that the refusal of other banks to continue the financing triggered these two investment banks’ failures.

When a bank fails, other banks may not be able to recover their outstanding lending. In the case of Northern Rock, around one-quarter of all its financing was loans from other banks, with deposits making up another quarter and securitisation in the form of mortgage-backed securities being by far the largest at half the bank’s total financing.

One way a bank failing can cause a wider crisis is when a run on a single bank causes runs on additional banks. This happens when the lack of confidence by its customers in one bank leads to a loss of confidence in

other banks by their customers. Some banks have been able to stop bank runs by returning deposits to customers until the confidence returns. This was Washington Mutual’s approach in the Great Depression. This approach requires that the bank has enough liquid assets to pay out deposits until confidence returns. If the bank has lent out or invested too much, it may run out of liquid assets before confidence can be restored.

Alternatively the government can step in and support the banks such as by guaranteeing deposits. This requires that the government is trusted to be able to support the guarantees in what can become very substantial amounts.

One of the ways a single bank failure can cause a wider banking crisis, and become a lot more costly, is when the run on one bank causes runs on other banks. The British government action on guaranteeing the private retail deposits of Northern Rock was critical to avoid the first run on a British bank in 140 years spreading to runs on other banks. Northern Rock was mostly considered a unique case, including by parts of the media. The guaranteeing of deposits of this one institution by the government avoided the crises spreading by runs on other banks. The customers of other British banks had enough confidence that Northern Rock was unique. In case it was not, customers probably believed that their deposits in other banks would also be guaranteed by the government.

So it is not difficult to see how the failure of one, possibly unmanaged, bank can cause problems and failures of other banks. This can happen through a widening loss of confidence or because a failing bank can cause losses to other banks due to being unable to repay loans or to financing them.

Another cause of wider financial crisis by bank failure is the disruption of debt markets in which banks finance themselves. The disruption of the new highly complex part of the debt market made up of mortgage-backed securities, credit default swaps, collateralised debt obligation and so on was possibly the single most important reason for the 2008 bank crisis spreading so quickly and so widely.

The German bank IKB was one of the first banks outside the United States to incur losses from its investments in these complex debt instruments. The disruption of the mortgage-backed securities market, following the problems at the IKB and BNP Paribas in 2007, was the single most important trigger for Northern Rock to need rescuing. This was because Northern Rock had developed a dependency on this complex debt market amounting to half its financing.

It is not just banks that swim naked, governments do so as well. When debt markets are severely disrupted, this makes it more expensive, even difficult for governments to refinance themselves. Sometimes the link is direct between the debt issued by banks and those of the government of the country of the banks. One of the earliest analysis that identified problems banks might have to refinance themselves prior to the 2008 financial crisis was the case of Icelandic banks in March 2006. This analysis identified potential problems the three largest banks might have to refinance debt that in total was larger than the gross domestic product of Iceland during 2007 (Thomas 2006). The banks eventually did refinance themselves during 2007, but after the collapse of Lehman Brothers in September 2008 and the severe disruption of debt markets, all three large banks were taken over by the Icelandic government in October 2008. On 24 October, Iceland then requested a rescue package from the International Monetary Fund to stem the banking crisis that had become a currency crisis. The currency had collapsed from around Icelandic Krona100 to the Euro to more than Krona300 during the month of October.

Whether and how a banking crisis becomes a wider financial crisis, a currency crisis, a sovereign crisis and finally causes an economic recession or depression are complicated. There are times when factors outside banking cause economic conditions that are detrimental to banks and may cause some banks to fail. The plague in Europe in the fourteenth century that caused the failure of the predecessors banks of the Medici, the European structural imbalance of money flows in the fifteenth century that made the Medici’s business so complicated, wars and revolutions that created problems for the Rothschilds in the nineteenth century and the two Oil Crises of the 1970s that caused recessions across the globe, were all examples of economic crises not caused by banks. But many are.

Each bank has management. Management has choices. That is why not all banks fail due to circumstances outside the control of the management of banks. The management of some banks chooses and implements a strategy that avoids failure when external pressure is applied. There are exceptions where all banks do fail. The circumstances can be so overwhelming that no bank can survive. This was probably the case in plague-ridden Europe in the fourteenth century. In the Great Depression, it is often emphasised that thousands of banks failed and rarely noted that the majority of banks did not fail. Those that did not fail must have taken or avoided action that contributed to their survival. Those that did fail must have

taken, or avoided, action that contributed to their failure. Some of them were not managed and were so absorbed by growth, by lending more, that their absent management contributed to their failure.

But it is complicated to which extent bank crises cause wider and more costly crisis. Fortunately, most banking crises do not cause either a currency crisis or a sovereign debt crisis. Of 146 banking crisis since 1970, a fifth was followed by a currency crisis within three years. A currency crisis is where a country’s currency depreciates by at least one third against the United States dollar and by a tenth more than it depreciated the previous year (Laeven and Valencia 2012). This is not meant to imply that these 34 bank crises all caused a currency crisis. Other economic factors would have contributed.

Nineteen bank crises were followed by a sovereign debt crisis (Laeven and Valencia 2012). A sovereign debt crisis is where there is either a default of the sovereign debt, or a restructuring of the debt causing loss to investors. Again other economic factors than the bank crisis could have contributed, for example the disruption of debt markets, which could affect the ability of sovereigns to refinance and issue additional debt.

The individual complexity of each banking crisis and the additional complexity of whether it caused a currency or sovereign debt crisis are beyond the scope of this book. Perhaps a future book will be titled “Absent Containment of Banking Crises”. Instead, the rest of this chapter will explain some of the costs of the most recent banking crisis that did become the 2008 financial crisis, both currency and sovereign crises, and is now referred to as the Great Recession.

The 2008 financial crisis, still felt in some countries, affected at least 25 countries (Laeven and Valencia 2012). This book has primarily focused on the Anglo and American banks but also considered French, German and Swiss Banks and mentioned banks from other countries.

Governments have a very complex decision to make when a bank fails. The government can allow a bank to fail or it can decide to support the bank. The United States government decided to support Bear Stearns by providing $29 billion of guarantees to J.P.Morgan that took over Bear Stearns. It rescued Fannie Mae and Freddie Mac as well as AIG. The government did not support Lehman Brothers, which then failed.

Second guessing the United States government action after the event is not the purpose here. Considering the cost of absent management in banking is. When government supports failing banks, there are three important ways for a government to pay for this, being increased borrowing

and taxation and reduced expenditure. It may be necessary for the government to do all three.

Rescuing banks is expensive. About 11,000 banks failed in the Great Depression between 1929 and 1933. One billion dollar of public money was injected into the 6000 of the remaining 14,000 banks that had not failed. One billion dollar was equivalent to about a third of the equity capital on the total United States banking system. Importantly 8000 banks not only did not fail but also did not receive public money. Not all banks fail in a crisis. Those 11,000 banks that did fail and those 6000 that did require public money probably had a higher rate of absent management than the 8000 that neither failed nor received public money. But absent management is not easy to identify based on statistics.

The United States Troubled Asset Relief Program (TARP) had injected an astonishing $238 billion into banks by March 2009. Four years later, an even more remarkable 99 per cent of this had been paid back to the government with only $3 billion outstanding (U.S. Department of the Treasury 2013). One estimate of the truly astonishing cost of the Great Recession in the United States is an estimated $13 trillion in extraordinary government assistance allocated to struggling businesses and households. Had the country averted the financial crisis, these funds, belonging to the United States taxpayer or raised in debt on their behalf, would not have been deployed or been at risk of deployment. Without a financial crisis debt levels might still have risen, but much less. With no financial crisis these funds could have been deployed to improve society, for example in education or infrastructure (Atkinson et al. 2013). One of the costs of a banking crisis is the lost opportunity of not investing elsewhere in society. This lost opportunity cost will always be difficult to estimate. That does not mean that it was not very large and the impact of its absence not profound for society.

The government of the United Kingdom reduced overall government spending by around 5 per cent and increased taxation by around 1 per cent of national income. It still saw borrowing increase by 7 per cent by 2014. This policy of austerity intensified with a change of government in 2010 and spending on public services in the United Kingdom was over 9 per cent lower in 2014–2015 than it had been in 2010–2011 (Bozio et al. 2015). Only in 2018, 11 years after the nationalisation of Northern Rock, did the government propose to bring austerity to an end.

The Irish government reduction in expenditure was three times as severe as that of the United Kingdom. Ireland had experienced one of the worst banking crises of any country in 2008 and in history. Irish govern-

ment expenditure was cut by over one-tenth, taxation increased by over one-twentieth and borrowing increased by close to a quarter. In sharp contrast, Germany did not reduce expenditure, did not increase taxation and only marginally increased borrowing. Germany had a very strong economy and comparatively low importance of banking sector relative to other services and industry. This meant that the rest of the economy could provide substantial support to banks with relatively limited impact on government borrowing, taxation or expenditure.

Within the European Union, member states are not allowed to support private corporations such as banks without authorisation from the European Commission. This is to avoid governments providing their own corporations with an unfair competitive advantage. Between September 2008 and December 2010, the Commission authorised support for 215 financial institutions. The overall authorised amount was a staggering €4.3 trillion equivalent to one-third of the total production or gross domestic product of the European Union. The amount actually used to support financial institutions was about one-third, which is still an enormous amount of €1.2 trillion, equivalent to one-tenth of the European Union gross domestic product. Again more than half of this amount was in the form of guarantees granted that were not necessarily paid out. So actual amounts within the European Union from 2008 to 2015 were over €466 billion for recapitalisations of financial institutions and €187 billion to buy impaired assets (Millaruelo and del Río 2017).

Banks are very important for all societies and the more so the more developed an economy is. Borrowing to finance investment has become one of the key drivers of economic growth, particularly since the Industrial Revolution from the second half of the eighteenth century. A reduction in lending by banks is likely to have a negative effect on economic growth. If banks fail and need rescuing, the cost of this rescue, from increased government borrowing, increased taxation and reduced government spending, is likely to affect economic growth negatively. The exact effects on economic growth of a banking crisis are extremely complex to estimate. This is where economic history is helpful because it takes a view over a historical period rather than on one particular crisis. The median loss of output in 146 banking crises between 1970 and 2012 has been estimated at close to a quarter of the annual gross domestic product of the country suffering the crisis (Laeven and Valencia 2012). But the worst crises are far more costly than that as was the case of Ireland. Managing banks rather than not managing them, so that bank failures are less likely, seems a good

idea against such a reduction in growth from the average banking crisis. Given how much effort it takes to achieve any economic growth, even one or two percentage points, this is a strong indication, if not perhaps conclusive proof that banking crises are best avoided. And even if there are economic crises not caused by banks, bank crisis makes economic crisis worse.

Ireland probably experienced the most costly banking crisis in 2008 and onwards, estimated at a loss of more than its total gross domestic product in one year. This is equivalent to the country producing nothing in a whole year. Ireland’s direct support of its financial system was an amount equal to almost half its gross domestic product. Ireland’s sovereign debt increased by an amount equal to nearly three-quarters of its gross domestic product. This may have made Ireland the costliest banking crisis since the Great Depression relative to the size of the country’s economy. In Ireland the Anglo Irish Bank was fully nationalised at a cost of €23 billion in January 2009, while the Irish Government took a stake of over one-third in Bank of Ireland at a cost of €3.5 billion and close to two-fifths in Allied Irish Bank for a similar amount. Iceland also spent amounts close to half its domestic product on supporting its financial system and experienced a similar increase in its debt of nearly three-quarters (Laeven and Valencia 2012). All the three Icelandic banks mentioned in that early analysis in March 2006 were nationalised by October 2008.

Governments also have to support banks with increased liquidity. This can be essential to enable banks to repay depositors. From 2008 banks in the United States and United Kingdom were supported by close to onetwentieth of total deposits. The support was much higher in the Eurozone amounting to over one-seventh of total deposits.

The longest monetary effect of a banking crisis may be the increased government debt. Unless the economy recovers quickly and strongly and there is a political mandate and will to reduce government borrowing, the increased government debt effectively shifts the cost of a banking crisis to the next generation. Government debt has been estimated to rise by over two-fifths in the three years following a bank crisis (Reinhart and Rogoff 2009). Some of this debt is reduced over time, but some remains. Overall the increase in government debt from banking crises between 1970 and 2012 has been estimated at above one-tenth.

In January 2008, the United States Congressional Budget Office forecast that the federal debt held by the public would be $6.7 trillion in 2012. The actual debt in that year was over $11 trillion or two thirds higher than estimated. Reasons included reduced government revenue

because earnings and related taxation were lower, the cost of government support for banks and the economy as well as tax cuts to stimulate the economy. It is not possible to attribute a precise number to the cost of the 2008 financial crisis. But without it the United States government debt would probably have been several trillion dollars lower. This additional debt burden will be passed on to future generations (Atkinson et al. 2013).

The increase in sovereign debt in the United States was close to one-third while the increase in the Euro area and in the United Kingdom was around one-quarter by 2012 (Laeven and Valencia 2012). From 2008 to 2015, overall government debt increased by two-fifths for the United Kingdom and one-third for Ireland, but less than one-tenth for Germany, having by far the largest European economy. Specifically related to financial sector interventions, the highest amounts were in Germany with €225 billion, the United Kingdom with €131 billion and Ireland with €58 billion. By 2015, the United Kingdom and Irish amounts had halved and Germany was reduced by two-fifths. Relative to gross domestic product the countries that saw the largest increase in government debt were Greece with over a quarter and Ireland just below one-quarter (Millaruelo and del Río 2017).

The United Kingdom increased taxation by around 1 per cent of national income. A new top income tax rate of 50 per cent was introduced on incomes over £150,000, later reduced to 45 per cent. The tax-free personal allowance was increased but removed for those with incomes above £100,000. The other major European countries, except Germany, all increased their main income tax rates by one or more percentage points, and Ireland did likewise. All the countries increased their sales tax rates with one or more percentage points with the United Kingdom increasing from 17.5 per cent to 20 per cent.

The United States took a different approach to taxation and implemented tax cuts of $188 billion to stimulate the economy, split about four-fifths to individuals and one-fifth to business (Blinder and Zandi 2010).

Whatever one’s political standpoint, an increase in taxation to pay for the support of the financial system is likely to result in reduced consumption and less economic growth. When taxation is increased due to a banking crisis it is also likely to cause resentment amongst a wide range of the population.

Another cause for resentment was the cost of reduced social expenditure. The United Kingdom reduced overall spending by around 5 per cent in addition to the increased taxation by around 1 per cent of national income. This is all in addition to the increased borrowing. Spending on

public services in the United Kingdom was nearly one-tenth lower in 2014–2015 than it had been in 2010–2011 (Bozio et al. 2015). Of the larger European economies only the United Kingdom financed the largest proportion of the costs of the financial crises with spending costs. Both the United Kingdom and Ireland protected spending on health and education (Bozio et al. 2015).

The impact on households in the larger European countries was reasonably similar across the different income groups with the important exception of the United Kingdom. Here the lowest five out of ten income groups saw an estimated reduction in household income from 4 per cent for the lowest income group to 1 per cent for the fifth lowest. The sixth to ninth income groups saw little change while the top tenth income group saw a negative impact of some 7 per cent by 2014. So even if the highest income group saw the largest reduction, the 2008 financial crisis contributed to increased income inequality.

In Ireland, as one of the worst-hit economies, the impact was around onetenth for most income groups with only the lowest seeing a 13 per cent reduction and the highest a 16 per cent reduction (Bozio et al. 2015).

In the United Kingdom it has been estimated, by a leading charity, that the poorest tenth of the population was by far the hardest hit, when all austerity measures are taken into account including cuts to public services and changes to taxes and welfare. According to this estimate, this part of the population experienced close to two-fifth reduction in their net income over the period 2010–2015.41 By comparison, the richest tenth lost the least, comparatively, seeing an only a 5 per cent fall in their income (OXFAM 2013).

Using a different measure for the United States, household net worth fell by a quarter from the middle of 2007 to the beginning of 2009 or by $16 trillion (OXFAM 2013).

Economic growth in the United States was negative in four of the five quarters from the beginning of 2008 until the third quarter 2009. The worst contraction was close to one-tenth of real gross domestic product in third quarter of 2008. Real gross domestic product measures total spending in the economy, consumer spending, industry investment, exports less imports and government spending adjusted for inflation.

In the United Kingdom economic growth was negative from the second quarter of 2008 until the third quarter of 2009, with the worst contraction being the last quarter of 2008 where the economy shrank by close to 3 per cent. In Ireland the economy shrank by around 4 per cent in 2008 and 2009. Germany only experienced one year of negative growth, 2009, when the

economy contracted by over 5 per cent. This was more of a result of reduced global demand for German exports than a direct effect of the 2008 financial crisis in Germany. For the European Union growth was negative from third quarter of 2008 until second quarter of 2010, with the first half of 2009 being the worst with contraction of over one-twentieth.

The United States Department of the Treasury estimates that nine million jobs were lost due to the 2008 financial crisis known as the Great Recession. Job growth in the private sector only exceeded job losses by the second half of 2010. Unemployment had been below 5 per cent in 2007, peaking at 10 per cent in October 2009 and was still above 7 per cent in 2013. Those out of work for more than 27 weeks had been below 1 per cent in 2007 rising to above 4 per cent in 2009 and remaining above 3 per cent by 2013 (U.S. Department of the Treasury 2013).

Unemployment in the United Kingdom had been just above 5 per cent in 2007 before the crisis, rising to over 8 per cent until 2013 and only reducing to precrisis levels in 2015. Irish unemployment had also been around 5 per cent before the crisis, doubling to over 10 per cent from 2009 to 2015 and trebling to over 15 per cent in 2012 and 2013. Precrisis levels have only been achieved in 2018. Iceland’s historically low unemployment rate of below 3 per cent reached almost 8 per cent in 2010–2011 before returning to precrisis levels in 2017.

Stress is perhaps the worst cost of a banking crisis, immeasurable, and even worse for that. The emotional cost can be terrible for the individual and detrimental for society. There were undoubtedly suicides as a result of stress caused by the absent management of banks.

Stress is often related to what is outside one’s control. Losing one’s job for reasons completely outside one’s control is a very stressful experience. Millions of people lost their employment because a few hundred did not do their job, which was to manage banks.

There are many additional sources of stress stemming from a financial crisis. The customers of Northern Rock lined up outside the branches to alleviate the stress related to the possible loss of their savings. This type of stress had not been seen in the United Kingdom for 140 years. Those with AIG shares in their pension fund saw their retirement income reduced, as did many investors and employees with Northern Rock, RBS and other bank shares as part of their savings.

Many businesses were lost, particularly small and medium sized, because they were unable to renew their borrowings as their bank had stopped lending.

Some of those depending on state support saw this cut including in the United Kingdom due to the austerity regime introduced to pay for the 2008 financial crisis.

The recent financial crisis has had a high cost in the loss of trust in Western government institutions and the capitalist economic system. The loss of income and household wealth was ascribed by many to inadequate regulation by governments. The bail out of banks, using taxpayer’s money for the last ten years and into the future, to pay for increased debt was seen as unfair. The need to rescue the financial system was often not well explained by government. One reason Lehman Brothers was not rescued and was allowed to fail and trigger the 2008 financial crisis, was public resentment of support for Bear Stearns. Bailing out another investment bank when hundreds of thousands were losing their homes to foreclosures was not considered politically explainable and acceptable, so Lehman Brothers failed, and the crises erupted.

The lack of actions against bankers seen to be responsible for the crisis was particularly resented by large proportions of the public. That many of those at senior levels were able to retain large bonuses for the exact business that caused the crisis was the result of inappropriate incentive structures. The resentment that almost no bankers went to jail was understandable but misunderstood. Bankers were not proven to have broken laws.

What should have been resented, and what this book hopes to contribute to the understanding of banking crisis, is that a few senior and very senior bankers did not do their job. They did not manage the banks they had responsibility for and that was a reason why many banks failed.

Financial institutions paid more than $150 billion in fines in the United States relating to the credit crisis. Bank of America paid $56 billion in settlements with state and federal regulators and the Department of Justice to cover its own mortgage sales and actions by two companies it acquired, subprime mortgage lender Countrywide and investment bank Merrill Lynch. J.P.Morgan paid the second-largest amount of $27 billion including an estimated $6 billion for Bear Stearns and $8 billion for Washington Mutual.

The on-going effect of the financial crisis continues to negatively affect the public’s view of political institutions. The combined effects of what is seen as failed regulation, inadequate sanctions against bankers and severe economic costs and emotional hardship have had and may continue to have political consequences. It seems likely that the votes for new, alternative political parties and figures in a number of large Western countries as well as an element of protest votes have something to do with the public

resentment of the occurrence of the 2008 financial crisis and its consequences. Some consider the 2008 financial crisis to have contributed to political changes including the referendum on the United Kingdom leaving the European Union, the 2016 United States presidential election and the rise of populism as a political force in Europe (Stephens 2018).

The absent management in some banks and remedial austerity may be responsible for increased deaths in addition to suicides caused by stress. In some Western countries, the growth in longevity, how long people are expected to live, has reduced since 2010. One of the reasons may be reduced public medical and social expenditure. One study in the United Kingdom found that spending constraints between 2010 and 2014 were associated with over 45,000 higher than expected number of deaths compared to trends before 2010. If these findings were projected to 2020, the additional number of deaths would be above 150,000 (Watkins et al. 2017). The study finds association but not causation. So causes other than a banking crisis, austerity and reduced public expenditure on social and medical care may have been involved. But it is probably better not to risk this and to prevent another financial crisis.

A banking crisis affects a country’s relative strength in the world. Specifically, the United States had to consider the role of foreign investors of its Treasury Bonds and ensure that confidence was not lost in the United States ability to support its financial system. With China owning over $500 billion of mortgage-backed securities issued by Freddie Mac and Fannie Mae, the United States possibly felt forced to explicitly guarantee this debt to avoid raising questions about the financial standing of the United States. The increased debt levels of those countries suffering a banking crisis make the countries relatively weaker. Perhaps those countries not affected by the 2008 financial crisis and Great Recession will suffer their own banking crisis in due course. But until then those countries whose banks were unmanaged and failed have seen their relative position in the world weakened.

It is probably too early to judge how important the 2008 financial crisis was in affecting the relative strength of world powers. One indication is that the top four banks in the world, measured by the highest quality of capital, are now all Chinese, being ICBC, China Construction Bank, Bank of China and Agricultural Bank of China. The latter has seen the most phenomenal rise to one of the top four positions, having been outside the top 50 in 2007. In 2007 the highest ranked Chinese bank ICBC was only ranked seventh in the world.

J.P.Morgan is the largest non-Chinese bank and still the fifth largest as it was in 2007. In 2008, J.P.Morgan was the largest bank in the world, as it was at the beginning of the twentieth century, having taken over Bear Stearns and Washington Mutual. Three other United States banks, Bank of America, Citi and Wells Fargo, are next in the ranking. The first European bank HSBC is ninth having briefly been the largest bank in the world in 2007. French banks BNP Paribas and Credit Agricola have fairly similar places around 11 to 16 as have Santander, Goldman Sachs, Barclays and Deutsche Bank. The big loser is RBS having been the third largest bank in the world in 2007, it is now not in the top 25.

So China now has the largest banks in the world, although United States banks are still the largest international banks. Europe, and particularly the United Kingdom, has been relegated to third. This may be an indication of a future trend in world power although the Chinese banks will have to avoid a major crisis to maintain their leading positions. To do this Chinese banks will have to be managed.

A cost that will never be known is what would have been possible had the crisis not happened, the lost opportunity cost. What investments could have been made, what economic prosperity achieved, what personal stress and misery avoided.

Economist underestimated the impact of the 2008 financial crisis on the broader economy. The underestimation was of such magnitude that it implicated basic macroeconomics and requires some significant rethinking of standard economic models. One example was the severity and longevity of unemployment in the United States in 2009. This failure has been an important conclusion by the head of the Federal Reserve from 2006 to 2014 (Bernanke 2018). In other words we knew that banking crisis makes other crisis worse but we were unable to predict how costly a financial crisis would be (Reinhart and Rogoff 2009). And economics as a discipline requires fundamental rethinking before we will be able to estimate the cost of a financial crisis in the future. This is an indication that there is significant uncertainty of how costly the next crisis will be.

Bank crisis can be expensive, really, really expensive. They can cause incalculable costs and human misery. Economics fundamentally failed to predict how costly the 2008 crisis would be. There were no banking crisis between 1945 and 1970 so they are not part of an economic cycle, nor should they be considered either acceptable or inevitable. If we can contain medical epidemics we should also be able to prevent bank crisis. With this in mind, the next chapter is about what has changed since the last banking crisis.

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