Executive MBA Videos

Christopher Kobrak: Financial Crisis: A history in 5 crises.

European Executive MBA Faculty member and ESCP Europe Finance Professor Christopher Kobrak’s historical perspective of the current financial crisis demonstrates how lessons could have been learned from 5 previous economic crises.

Financial Crisis: Learning from 5 historical examples

My name is Chris Kobrak, I’m a professor of finance at ESCP Europe and I’ve been asked to give you a talk about the history of finance and financial regulation. The idea is: what could we learn about some of the crises of the past?

Quite frankly, I’m convinced that most financial actors have very little sense of history and that that has contributed to our crises. And some others have a tendency to focus on one period, one crisis, instead of looking at a broad range of them. I’m not sure that we’re able to find any broad generalisations about crises of the past but I think there are some lessons that might be learned from them. I have chosen five from America’s history. Quite frankly, all of them had worldwide implications but the epicentre was in the United States.

The first started virtually 100 years before the recent crisis that we’ve had. It was called the Bankers’ Panic, which tells you a lot about it already. They panicked, they got very nervous about counterparty risk. There was a bubble in commodities prices and perhaps most importantly an upsurge in a whole bunch of new financial institutions, that were pretty unstable and not well-regulated. Some natural disasters also occurred around them, some people think that the earthquake in San Francisco contributed to it. It had, as I mentioned, worldwide repercussions, but it was really very focused in the United States.

There was one big difference between that crisis and the one we’ve just been going through and still are going through, and that is that bankers themselves stepped in and solved the problem. They took responsibility for what they had been doing. And J.P. Morgan, the most important banker in the United States, got together with the biggest bankers in New York, and that is the biggest bankers in the United States, and said: “Guys, we’ve got to put up some money and save this system. And they did that, they lent some of the other institutions more money. They looked at the institutions that were very shaky and what they did with them was they merged several of them. They closed others. And they put out a lot of bulletins saying: “We have it in hand. This is a serious problem, but we’re going to take care of it.” And, in fact, it shows that bankers can take personal responsibility for their actions.

Now, the next big crisis is much more associated with continental Europe than the United States, but the truth is, the origin of it was probably the United States. It is the banking crisis that most people look at, it is the 1931 banking crisis, the classic worldwide banking crisis, where there were failures in good portions of the developed world. It was probably the worst handled of all the crises that I’m going to talk about. In fact, instead of adding liquidity, the system, the bankers, the central bankers of the world took it away, which exacerbated the deflation that was already occurring and made the depression worst, created more of a tendency of governments to become autarchic and contributed to World War II, which followed a few years later.

Now, it is the crisis that Bernanke knows the most about. He is one of the great experts about it and it is my feeling that he’s focused almost exclusively on that banking crisis, and does not want to see the same mistake of moving credit from the system happen, and removing America’s role as banker of last resort, contributing liquidity to other countries. He doesn’t want to make those mistakes. And he’s right not to make those mistakes. But there are some very big differences between that crisis and the ones we’re having. There was no deposit insurance then, we have no gold standard now, which caused some of the problems in 1931. There was no prior crash leading up to September 2008. And we had increase in commodities prices before, and instead of that in the 1920s they were decreasing ones. So perhaps the lesson here is that we should not focus too much our policies on any one crisis and look for some distinctions, because we may overreact to what’s going on.

Now, for me, one of the most interesting periods is Bretton Woods and I’m not going to say a lot about it because it is kind of complicated to describe the whole Bretton Woods system. But in 1971, the system that had been established after World War II, that had stable foreign exchange rates, low inflation, high increases in trade, broke down because lots of countries, primarily the United States but other countries as well, lost some of the required discipline for that system. What’s interesting for me is that in the 10 years that followed August 1971, we had relatively high inflation, actually very high inflation, and relatively little growth, and some of that may have been caused by the uncertainty of the actors, financial and others, looking forward at a system that they had no idea how it was going to evolve. It’s the basis of the system we have today. But they haven’t lived through the gold standard and then the inter-war period and the Bretton Woods system. They really had no idea how the new market based system was going to work. And that uncertainty slowed growth a great deal. And the other thing was that inflation was very high in part because of all the steps taken by governments to ease the pain. And perhaps we ended up having to have the most severe recession up until this one to wring out that inflation to get the system back into some sort of reasonable equilibrium afterwards.

Next crisis is the savings and loan crisis in the United States. It had a lot of similarities to what we’ve been going through in that it was also associated with a real estate bubble. There was poor deregulation of the banking system, allowing small banks to start investing in things that they probably had no business investing in, using funds that they got by deposits guaranteed by the Federal government. For years and years, American governments postponed dealing with it and it made it worse. Once they did deal with it, they dealt with it in a very serious way – they closed down a lot of banks, merged a lot of banks. And because of that very focused effort, it ended up costing a lot less than it would have otherwise.

The last crisis I want to mention I can only describe as a wake-up call to what we experienced in 2008. In the mid-1990s, the best and the brightest of American finance got together and created a hedge fund. They had two of the three people who had created the most famous model in finance, the Black-Scholes-Merton model. They had the best traders from Salman Brothers. They went into a hedge fund for a while, they made tons of money and finally people copied them, finally they got over-leveraged and finally markets moved in ways that were not in their models and the whole thing collapsed. The Fed came in, Greenspan organised a bail-out with private banks coming in. And with that bail-out, they were able to rescue the system, and most of the assets of long-term capital management. The bad thing about it is they looked at the experience afterwards and said: “We don’t have anything to worry about, see, one of these institutions goes belly-up, we’ll come in and we’ll organise a bail-out and everything will be honky-dory. What was forgotten was that the total assets of long-term capital management were $100 billion. Citibank alone in 2007 had $500 million of these shaky assets, hard-to-price, hard-to-market, illiquid assets and liabilities. And that’s one bank of twenty mega-banks in the world. So the lesson that they forgot is that once you allow lots and lots of people to be doing this, it may not be so easy to control the next time around. That’s all I wanted to say. I hope it was interesting. Thank you!

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