A decade of de-risking banks has made financial markets more risky
Risk is energy, and it’s now moving from banks to money markets: The shadow of the financial crisis is looming over the covid-19 fallout as efforts aimed at making banking safer “may instead have conspired to make it more brittle,” Robin Wigglesworth writes for the Financial Times. Since the big banks were bailed out during the 2008 crisis, policymakers vowed not to do it again. Regulators instead imposed stricter capital requirements on banks, limiting their ability to engage in “proprietary” trading, or buying and selling equities and bonds using their own money to build up capital in the economy.
As a result, the role of banks as market makers started to diminish, and they began looking up to brokers, who are particularly astute in their ability to make a quick buck. While this shift made banks less exposed, it was accelerated by digitization and algorithms and quickly transferred risk to the now liquidity-starved global financial markets.
Market watchers have previously warned: The shift in the role of banks from institutions that help others raise financial capital to mere intermediaries will amplify any post-2008 economic crisis, says a 2018 piece by Wigglesworth and FT banking editor Ben McLannahan. This is because frantic attempts to eliminate leverage from the economy
The situation may be described by future economists as a modern-day “cobra effect,” which is quite the anecdote for why well intentioned economic policies could have a few undesirable side effects, says Wigglesworth. The cobra effect was coined in a 2001 book by German economist Horst Siebert, which uses a story from British colonial rule in India. Back then, the ruling class in Delhi attempted to counter an outbreak of cobras by paying out cityfolk for every snake head they delivered. This led the locals to start breeding snakes as a side hustle, which resulted in an even larger cobra infestation when the British called off the scheme.