Working Paper

The Persistence of a Reckless Banking System

Conference paper By

Download paper

The fall of 2008 was scary. For most people, the aftermath of Lehman Brothers’ bankruptcy resembled a major earthquake with strong aftershocks. Official narratives have promoted the image of the crisis as a rare, unpreventable and unforeseen natural disaster, the “100-year flood.” Policymakers emphasize the extraordinary measures they have taken to prevent the system from collapsing and to support recovery since.

Alas, they say, it was truly a disastrous event, but we are working on recovery, please be patient.

Citizens count on the government to take action when disasters hit. We want to believe that politicians, central bankers and regulators are doing all they can for us. Bankers, politicians and regulators may believe what they say. But in fact they advance false and misleading narratives. The result is to mask and divert attention from an unhealthy industry and from the continued failure by policymakers to protect the public from excessive risk in banking. The tolerance, and even implicit support and encouragement of reckless practices harms millions of innocent citizens.

The observation that financial crises are not like natural disaster has been made by many. At the conclusion of their book This Time is Different: 800 years of Financial Folly, Reinhart and Rogoff state: “We have come full circle to the concept of financial fragility in economies with massive indebtedness… . Highly leveraged economies … seldom survive forever, particularly if leverage continues to grow unchecked… . Encouragingly, history does point to warning signs that policy makers can look at to assess risk—if only they do not become too drunk with their credit bubble–fueled success.” In an article from 2000, the then-U.S. Treasury secretary Lawrence Summers, referred to “the increasing salience of long-standing financial-sector weaknesses, arising from some combination of insufficient capitalization and supervision of banks and excessive leverage and guarantee—the combination that, along with directed lending, has been captured in the term ‘crony capitalism,’ ” as a root cause of most crises. “Panics and runs,” continued Summers, “are not driven by sunspots: their likelihood is driven and determined by the extent of fundamental weaknesses.” He concludes that “preventing crises… will depend heavily on strengthening core institutions and other fundamentals.”

Conference paper By