Misaligned internal incentives. Judging from headline-grabbing incidents of inappropriate behavior and processes in recent years, the sticks and carrots in place in some financial institutions need work. These institutions still contain pockets of improper risk-taking and other unsuitable conduct, as well as excessive short-termism in compensation payouts and managerial tolerance for actions that are too close to the line that separates permissible from non-permissible activities.
A scarcity of “patient” balance sheets. Putting challenged and damaged securities in ring-fenced balance sheets was key to containing the huge financial disturbances. This involved reliance on large public balance sheets, though their use was increasingly met by social and political pushback. Concerns about distributional effects, including favoring corporate profits at the expense of wages, Wall Street at the expense of Main Street, and the rich at the expense of the poor, have added to what is now a reduced availability of these tools for use in future crises.
Unintended consequences:
The big got bigger and the small got more complex. Although more progress has been made on what to do when a bank fails, especially when it is large, the market structure that emerged from the financial crisis involves significantly larger institutions, particularly U.S.-based ones. The same phenomenon of the big having gotten bigger can be seen in asset management. It has come at the expense of a gradual hollowing out of the middle of the distribution of financial firms. Meanwhile, the other end of the size distribution consisting of small institutions has been increasingly populated by the proliferation of fintech activities that, for the most part, haven’t been tested through a cycle downturn.
Risk has morphed and migrated to underregulated areas. This change in market structure is connected to another phenomenon: the morphing and migration of risk to non-banks. This dynamic is particularly notable in the extent to which, benefiting from years of ample global liquidity and unusually low financial volatility, there has been an over-promising of liquidity provision and excessive volatility-selling in its many forms. And part of this has been embedded in the structure of the system through product proliferation, including the growing number of exchange-traded funds that implicitly promise instantaneous liquidity in market segments that are structurally subject to repeated pockets of illiquidity.
Reduced policy flexibility. There is limited “dry powder” to rely on in the event of a crisis because interest rates are still floored at zero or below in much of the advanced world outside the U.S., central banks’ balance sheets are already large, and debt levels are significantly higher than before the global financial crisis. This suggests that, even if there is sufficient political will, the ability to crisis manage and recover may be diminished compared to 10 years ago.
Those of us who navigated the global financial crisis first-hand, managing assets and liabilities in the private sector during exceptional market turmoil, saw unprecedented unpredictability turn what had previously been unthinkable into reality with unsettling regularity. We readily recognize how much was done to prevent an awful situation from severely damaging current and future generations, and also the important steps taken to reduce the probability and severity of another global crisis.
But that does not mean all is well. Renewed efforts by both the public and private sectors are needed to deal with longstanding challenges that received inadequate attention in the aftermath of the crisis, and to understand and address some of the major unintended consequences of 10 years of crisis management and prevention. Fortunately, we know a lot more about both. The biggest challenge is to get the political process to address their importance when there is no actual or looming crisis in the advanced world to focus minds.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. His books include “The Only Game in Town” and “When Markets Collide.”