10 Years After The Financial Crisis: Organizations Turn To De-risking To Prevent A Repeat

We’re now 10 years on from the financial crisis of 2007-08, to the minds of many, the worst financial crisis since the Great Depression.

Since the crisis, regulations have been adopted to try to prevent a repeat, and banks do appear stronger as a result. In the face of the crisis, major central banks turned to tactics such as “quantitative easing” and low interest rates to provide economic stimulus, measures they’re now beginning to unwind. Elsewhere, organizations from government agencies to individual businesses have taken steps over the past decade to reduce their risks from a similar future crisis.

History suggests there will be another crisis. No one can say for certain what will cause it, but there are many potential trigger points, including emerging market banking systems, global corporate debt levels or rising US student debt burdens among them.

Gordon Brown, UK prime minister during the 2008 crisis, recently cited the risks posed by a “leaderless world” in which governments and central banks are ill-equipped to recognize escalating risks and would be incapable of working together to address a 2008-like crisis. He warns of the danger of sleepwalking into a future crisis.

In a memo looking back on the events of 2008, Jamie Dimon, chief executive officer of JPMorgan Chase, took a different tack, suggesting that lessons learned from the crisis include “the need for plenty of capital and liquidity, proper underwriting, and regulations that are constantly refined, fair and appropriate.” He suggested that regulators should “take a victory lap,” because regulations imposed over the past decade would make many of the financial institution collapses of 2008 impossible today.

Those regulations might have addressed some of the factors that contributed to the 2008 crisis. Still, drawing lessons from last decade’s financial crisis and wary of a repeat, many government agencies, financial institutions and other businesses are looking to “de-risk” – taking a variety of steps to reduce their exposure to the next crisis or the events that might trigger it.

A major factor leading to the crisis was the bursting of the US housing price bubble. Low interest rates that encouraged mortgage lending coupled with the rise of mortgage securitization and weak regulations led to homebuyers who previously wouldn’t have qualified financially frequently finding mortgage lenders eager for their business.

As more buyers entered the market, housing prices rose, leading many to borrow further against the additional value of their homes. When housing prices started to fall, mortgage delinquencies mounted, leading to a rapid drop in the value of mortgage-backed securities and other financial instruments. Collapses of major financial institutions – most notably Lehman Brothers – followed and, with them, a major global economic downturn affecting individuals, governments and businesses.

New Risks Emerge

Experts point to various developments as possible causes of the next financial crisis.

The rapid growth of banks in China or problems at banks in other emerging markets could be one problem spot, according to some experts. Chinese banks have grown dramatically, but they’ve also taken on large amounts of debt, introducing fragility to the Chinese banking system, according to Itay Goldstein, finance professor at the University of Pennsylvania’s Wharton School of Business.

The dramatic increase of student loan debt could be another potential issue in the US economy. Since 2014, US student loan debts have increased from $260 billion to $1.4 trillion. Large student loan debts limit many young workers’ ability to make major purchases such as cars or homes. Not surprisingly, as student loan debt has increased, so have delinquencies, unpaid loans that can be a burden on taxpayers.

The rise in corporate debt is another potential risk. Worldwide, corporate debt reached a record $237 trillion earlier this year, an increase of $21 trillion since 2016. The International Monetary Fund fears that riskier businesses are responsible for much of that new debt, and has cautioned that high credit growth accompanied by increased lending to riskier borrowers “is more likely to be followed by a severe downturn or financial sector stress over the medium term.”

The Drive To De-risk

The 2008 crisis and the increased recognition of the various risks it highlighted have led many organizations to engage in “de-risking,” taking steps to reduce their exposure to a future financial downturn.

Financial institutions and other organizations are reducing their risk in various ways, including limiting interactions with certain customers and enacting new capital requirements, often as a result of post-crisis regulations.

Participating on a panel reflecting on the events and aftermath of the 2008 crisis, Ruth Porat, former Morgan Stanley chief financial officer and now CFO of Google and its parent company, Alphabet, cited four lessons she learned from the financial crisis:

  • Every company and industry should identify its vulnerabilities and take steps to address them when times are good;
  • Build data analytics, strengthen risk measures and improve transparency;
  • Have the will and means to enact change;
  • Build a strong team.

(Re)insurers Role In Mortgage De-risking

Reforms following the 2007-08 crisis have reduced risk in the US mortgage market and increased transparency. Lending rules have become stricter and banks have become more risk averse. Mortgage delinquency rates have fallen since the financial crisis, showing the positive impact of the changes.

The insurance and reinsurance markets are also playing an increasing role in de-risking mortgage activity. “Insurance and reinsurance can reduce credit and counterparty risk exposures and provide certainty of coverage and improved liquidity in stressful environments,” said Aon’s Credit & Guaranty, and Government practice leader, Joe Monaghan.

Agencies such as Fannie Mae and Freddie Mac are now insured, using insurance and reinsurance to transfer some credit risk.

“Aon has seen a significant increase in the volume and magnitude of insurance and reinsurance transactions focused on credit exposures like US residential mortgage default risk,” Monaghan said.

For Governments, De-Risking Offers Tangible Benefits

Government-sponsored enterprises could also benefit from taking a de-risking approach to reduce their exposure to factors that precipitated the 2007-08 financial crisis. Efforts by Freddie Mac and Fannie Mae to transfer some of the credit risk associated with US residential mortgage defaults is just one example.

Governmental and quasi-governmental organizations like the Export-Import Bank of the United States, the US Federal Emergency Management Agency (FEMA) and the National Flood Insurance Program (NFIP) and the World Bank have also taken advantage of such de-risking opportunities. Earlier this year, the World Bank structured a nearly $1.4 billion catastrophe bond to manage the risk of earthquake-prone countries and FEMA announced the expansion of its reinsurance program in transferring $500 million in flood risk to capital markets. Both are examples of how new forms of capital, such as reinsurance, can add additional coverage to protect balance sheets in the face of large-scale catastrophes. Of the World Bank transaction, CEO of Aon Securities, Paul Schultz, states that the work demonstrates “the strategic partnership between nations seeking efficient sources of capital to fund emergency costs and investors seeking to invest in diversifying risks and support sustainable development initiatives.”

“The development of credit risk transfer solutions for government exposures has become an element of fiscal policy in the US and other countries,” said Monaghan. “There’s robust support in the insurance and reinsurance markets to assist in de-risking government and quasi-governmental loan guarantee and insurance programs.”

Such de-risking provides real benefits for governments and their taxpayers. It can transfer credit risk away from taxpayers, improve government agencies’ risk management and increase the likely sustainability of government policy objectives.

“De-risking increases the likelihood of sustainable support for government policy objectives throughout their life cycle,” said Aon’s global head of Strategic Growth and Development, Bryon Ehrhart.

De-risking can also provide real savings. “By using reinsurance to transfer flood risk FEMA and the NFIP saved taxpayers almost $1 billion,” Ehrhart said.

History Repeats, De-Risking Can Limit The Impact

The cause of any future financial crisis remains uncertain. But organizations that recognize history’s tendency to repeat have tried to learn the lessons from the 2008 crisis and are working to reduce their exposure in the future.

Identifying exposures and engaging in de-risking activities can help organizations prepare themselves for the next financial crisis. In many cases, those actions can pay immediate dividends as well.

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