In economics, the haunting question ‘What is the use of economics?’ has been raised in the aftermath of the crisis. Diane Coyle (2012) has introduced a Vox debate on the use of economics, and how we should teach it to the next generation. Finance has been less introspective after the crisis. Most textbooks have added a chapter on the causes and consequences of financial crises (see, for example, the widely used text of Mishkin and Eakins 2014).
We think that the leading theoretical concepts such as the ‘efficiency’ of financial markets and the merits of financial innovation need a critical examination (see De Haan et al 2015). The next generation of students should learn about the strengths as well as the weaknesses of the financial system. Finally, the financial system has undergone structural changes after the crisis.
The main idea before the crisis was that markets are efficient. Arrival of new information is ‘efficiently’ incorporated in the prices. Financial markets are thus self-equilibrating. But the financial instability hypothesis of Minsky (1986) has regained prominence after the financial crisis. It shows that the financial system is inherently instable. More formally, Allen and Gale (1998) have developed a formal model to show how cyclical fluctuations in asset values can produce bank runs. Reinhart and Rogoff (2009) have documented the history of banking crises over eight centuries.
What should be the policy response? Borio (2014) has introduced the concept of the financial cycle, which measures growth in credit and house prices. Depending on the phase of the cycle (e.g. building up of imbalances in the financial system), the macro-prudential authorities should take action. Borio is one of the founding fathers of macro-prudential policy, which focuses on the financial system as a whole (Schoenmaker 2014). It complements and partly overrules the prevailing micro thinking according to which the financial system will be stable as long as its individual components are healthy. The subprime crisis has shown what happens if the big picture is ignored. So, the macro-prudential approach should be part of the new teaching (see De Haan et al 2015).
Another theoretical concept under fire is financial innovation, the act of creating and then popularising new financial instruments, as well as new financial technologies, institutions and markets. Before the crisis, it was thought (and taught) that financial innovation would enhance the efficiency of the financial system, and thus fosters growth and economic prosperity. The crisis has shown that new financial instruments can be fragile. Gennaioli et al (2012) highlight the tail risks of new debt securities. New securities may be a cheaper substitute for traditional securities, but at some point news may reveal that the new securities are vulnerable to some neglected risks. A prime example is the securitisation of subprime mortgages, which were sold as triple A-rated centralised debt obligations (CDOs). When house prices declined (the neglected risk), these CDOs dropped in value.
The crisis has also revealed some structural weaknesses in the structure of the (European) financial system. An emerging view in the banking versus markets debate is that a healthy mix of bank-based and market-based financing provides the optimal financial structure for the economy. Banks and markets play complementary roles in the financial system. Langfield and Pagano (2015) argue that Europe is ‘overbanked’ and, at the same time, has ‘less developed markets’. They argue that bank credit was more volatile than market financing by corporate bonds (mostly held by institutional investors) in the direct aftermath of the crisis. Figure 1 shows that banks deleveraged during the crisis both in Europe and the US. The net financing became negative, as the amount of amortised loans exceeded new loans. At the same time, net corporate bond financing (labelled debt securities in Figure 1) was more stable and remained positive throughout the crisis. Table 1 shows that the shift from bank to institutional intermediation is already underway, but has not yet run its course in Europe. The share of banking is well above 70%, while it is 30 to 50% in the US, Canada and Japan.
Figure 1. Non-financial firms’ financing in loans and debt securities
Note: The figures plot the year-on-year change in non-financial corporations’ outstanding external liabilities (broken down as loans and debt securities) divided by nominal GDP.
Source: Langfield and Pagano (2015).
Table 1. Bank and institutional intermediation ratios (in %)
The euro sovereign debt crisis has also had some positive fall-out. While many academics have already argued for a long time that a Monetary Union would also need centralised supervision, we had to experience the diabolic loop between national banks and sovereigns (showing the inter-linkages between the solvency of banks and that of sovereigns) before we moved to Banking Union (BU). The establishment of the European BU creates a large banking market comparable to the US banking market (De Haan et al 2015).
The BU entails a paradigm shift for banks and policymakers. Policymakers have to design their policies at this wider geographical level. For banks, the home market expands from their country to the wider BU. Figure 2 shows the geographical segmentation of the top 20 banks in three regions (EU, BU, and US). The large BU and US banks have just over 70% of their assets at home (i.e. the BU and the US). The rest of the region (i.e. the rest of Europe and the rest of North and South America) accounts for 11%. The share of the rest of the world amounts to about 18%. The large EU banks are more international. They have not only a smaller home base (one country), but they also have more business in the rest of the world. Examples of major global banks outside the BU are HSBC, Barclays and Standard Chartered from the UK. This new data shows that the BU is, like the US, a relatively closed banking system, with limited inward and outward expansion.
Figure 2. Geographic segmentation top 20 banks in the EU, BU, and US (in %)
Source: de Haan et al (2015).
The financial crisis has led to many changes, both in research and policy. We believe it is important that students of both economics and finance are taught the lessons drawn from the crisis.
Allen, F and D Gale (1998) “Optimal Financial Crises”, Journal of Finance, 53: 1245–1284.
Borio, C (2014) “The financial cycle and macroeconomics: What have we learnt?”, Journal of Banking and Finance, 45: 182-198.
Coyle, D (2012) “What’s the use of economics? Introduction to the Vox debate”, VoxEU.org, 19 September.
de Haan, J, S Oosterloo, and D Schoenmaker (2015) Financial Markets and Institutions: A European Perspective, Third edition, Cambridge University Press, Cambridge.
Gennaioli, N, A Shleifer and R Vishny (2012) “Neglected risks, financial innovation, and financial fragility”, Journal of Financial Economics, 104: 452-468.
Langfield, S and M Pagano (2015) “Bank bias in Europe: Effects on systemic risk and growth”, Economic Policy, forthcoming.
Minsky, H P (1986) Stabilizing An Unstable Economy, Yale University Press.
Mishkin, F and S Eakins (2014) Financial Markets and Institutions, 8th Edition, Prentice Hall.
Reinhart, C M and K S Rogoff (2009), This time is different: Eight centuries of financial folly, Princeton University Press.
Schoenmaker, D (2014) Macroprudentialism, Vox eBook, CEPR, London.