US subprime crisis, response offer lessons for China

By Alessandro Rebucci Source:Global Times Published: 2017/10/30 22:13:39

Illustration: Luo Xuan/GT


Last month marked the 10th anniversary of the collapse of US investment bank Lehman Brothers, which triggered the most acute phase of the subprime crisis. The US is still recovering from the great recession that ensued from this event, and its policymakers have spent the past decade reining an overgrown and overreaching financial system.

Over the past 10 years, in contrast, China's policymakers have worked toward getting the domestic financial system off the ground and connecting it with global capital markets. It is time to take stock of what lessons can be drawn for China from the US experience. 

In the US, an overly narrow regulatory perimeter around traditional banks gave pervasive incentives to shift banking activity and risks outside it. In the first part of the 2000s, the shift toward the "originate and distribute" banking model fueled less regulated and more dangerous shadow banking, especially in the form of legal vehicles supporting the spread and the growth of securitization.

In the past 10 years, shadow banking has exploded in China to circumvent strict regulation. Regulation of the banking system in China is tighter than in the US. An innovative, efficient financial system has grown and developed outside this perimeter. With it, risks and vulnerabilities have grown, the latest being the bubble in cryptocurrencies to avoid restrictions on capital outflows.

Real estate is the largest asset class for households, an important area for the financial business sector, and a key source of revenue for local governments in the US like in China. Once imbalances build up in residential or commercial real estate, they unwind only slowly, affecting consumption, investment, employment, and tax revenue for a long time. Crises originating in the real estate sector affect banks and take much longer to resolve than stock market or foreign exchange rate crises.

In China, real estate markets boomed during the past 10 years, fueled by rapid urbanization as well as abundant credit, lack of alternative diversification opportunities for households, and restrictions in municipal budgets.

A rapidly growing financial system also grows more complex. Complexity is difficult to evaluate and distorts the decisions of households, financial intermediaries and regulators. While the regulator may have a good idea of the total quantity of systemic risk, monitoring its distribution and concentration is nearly impossible. Complexity impedes the efficient intermediation of funds between households and companies and financial intermediaries and it may hurt liquidity. For instance, while there are enormous potential benefits and gains from the emergence of a thriving fintech industry, fintech increases the complexity of the financial system dramatically, making much of traditional regulation obsolete.

Financial crises are costly and these costs are not spread evenly in society. Financial crises hurt disproportionally young workers who have just entered the labor market and those close to retirement. Financial crises increase income inequality and hurt the poor disproportionately, who have worse access to insurance and risk-sharing mechanisms. Ultimately, financial crises can claim the jobs of policymakers and politicians at the helm. The new wave of protectionism and populism in the US and Europe owe much more to the global financial crisis than the merits of those economic and political ideas.

A government-run financial system is not immune from trouble. Using public financial enterprises to cushion the blow, like the US government-sponsored enterprises Fannie Mae and Freddie Mac, shields the national budget from the credit rating agencies, but it is shortsighted because it undermines the enterprises' long-term financial independence and support role for the efficient allocation of credit risk in the system.

Macro-prudential policy is not a silver bullet. In the presence of financial excesses, monetary policy might have to be tighter than what it would be based only on business cycle conditions. In theory, macro-prudential policy could target financial excess and monetary policy the business cycle, but it is hard to find effective macro-prudential instruments and difficult to know to adjust them. In the US the regulatory tools to moderate the financial cycle in the run up to the crisis were available, but were perceived to be ineffective.

Financial literacy and consumer protection are as important as financial innovation and development for efficient and safe intermediation. At the core of the US crisis there was also outright fraud and the financial illiteracy on which fraud thrives. Promoting financial literacy and protecting consumers from fraud and predatory lending is crucial in a fast-growing system like China's. 

When intermediaries are big, they are too big to fail. We don't know the optimal size of banks and financial intermediaries. Financial intermediation needs economies of scale to reduce costs and operate efficiently. But excessively large financial institutions are hard to liquidate in the case of insolvency, like Lehman Brothers, and create pervasive moral hazards. This challenge is compounded in the mushrooming fintech industry that is thriving in China.

If a crisis strikes, it needs to be resolved as quickly as possible. The speed, size, and momentum of the policy intervention matters for the final outcome. Crisis resolution interventions must be fast, larger than strictly necessary to resolve the problem, and sustained past the immediate urgency.

While the US monetary policy response to the subprime crisis has been very different from the Fed's response to the Great Depression of the 1930s, the fiscal policy response got stuck in the legislative process. The result has been an anemic recovery and lingering uncertainty of relapse that lasted well after the recession was formally over. In contrast, China's intervention in the equity and foreign exchange markets in 2015 was massive and decisive, which explains why it succeeded despite its shortcomings.    

No two crises are alike. But a financial system that is completely crisis-proof would be an excessively rigid one that cannot support growth and innovation. Fortunately, China can use the lessons learned from other countries and times, including the US 10 years ago.

The author is an associate Professor at the Johns Hopkins University Carey Business School.


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