Quora Response: Why does a financial crisis happen?

(Original: https://www.quora.com/Why-does-a-financial-crisis-happen)

Before becoming a venture capitalist a few years ago, I spent a good chunk of my career as an investment banker focused on providing strategic advice to financial institutions. Much of my time on Wall Street was spent working on bank restructurings and recapitalizations around the world. First, I spent a lot of time in Malyaisa and Thailand in the late 1990s after banks in South East Asia were hit with a wave of non performing loans when their currencies collapsed. Many of these institutions failed, were merged and or recapitalized.

Next came Japan. Several large banks failed, underwent temporary nationalization, some were sold to PE buyers, and then restructured. The banking crisis in Japan came about with the bursting of Japan’s epic economic bubble earlier in the decade. At that time, it was the largest banking collapse in history.

While still in Japan, I was in the center of the storm when the institution for whom we worked was now itself caught up in the Global Financial Crisis of 2008 (only the Great Depression was more severe in modern history). Each of us at the firm then did our part to help see our company through the other side. In sum, I have a fair bit of experience in the the trenches and on the front line as it relates to financial crises.

In my view, financial crises typically start with the systematic mis-pricing (i.e., underpricing) of risk. The underpricing of risk, results in a significant misallocation of capital that if unchecked can lead to speculative bubbles in asset prices, whether that be the prices of tea, tulip bulbs, real estate, or Internet stocks (all of which, by the way as happened).

Often, banks find themselves in the center of financial crises. Why? Because they play a significant role in capital formation and allocation. Given the interconnectedness of the capital markets and economies around the world, risk can be distributed throughout the world — when it’s priced correctly that’s a good thing, when it’s not all sorts of adverse consequences can unfold. Banks also by definition hold credit risk. If risk has been systematically mis-priced, then banks will be holding copious amounts of risk.

Also, keep in mind that banks are highly leveraged, and kept in business solely by the confidence that they have (or don’t have) with their creditors — namely their depositors. Because they are responsible for capital flows, Banks’ primary activities are the lifeblood of the global economy.

When those in a position to control capital flows — i.e., large institutional investors, banks, governments — find that there is a risk of correction in asset prices, the markets can move in a dramatic fashion, but often slowly at first. As asset prices unwind, more and more investors become skittish and if the unwinding of risk becomes uncontrolled (as is often the case) panics can ensue. That’s when you see massive sell-offs in the capital markets, the most recent being in 2008 and 2009 from the Global Financial Crisis.

As the appetite for risk is taken out of the market, investors seek safe havens like cash or gold. In seeking liquidity, banks can find themselves in the crosshairs. Remember, only confidence on the part of a bank’s creditors can keep a bank in business. Without depositor / investor confidence, runs on banks can occur and that’s what typically see during a panics, like in 2008 during the Global Financial Crisis, the Japanese financial crisis at the start of the millennium, and banking collapse in South East Asia a few years before the unwinding in Japan.

Now, I’m not that old, but in my working career I have lived through five major corrections in the market, each bigger than the last — the Asian financial crisis, the Japanese economic collapse, the Russian / emerging market correction precipitated by the collapse of the hedge fund LTCM, the first tech bubble bursting, and the Global Financial Crisis.

If you’re still reading my post, you may now be wondering how to prevent what we saw in 2008 and other financial crises from happening again. My views on this topic, which I share below, will likely be found by many reading this post to be (highly) unsettling.

My personal view is that I think it impossible to legislate, regulate or mandate away the risk of another financial crisis. There is, and always will be, a non-trivial risk that this happens again. To be clear, I’m not saying that regulators and industry participants shouldn’t do all that they can to prevent another calamity in the markets or in the banking system again. Nor am I saying that much progress hasn’t been made on all fronts since 2008. However, in my view, there is always going to be risk inherent in the banking system and in the capital markets. We don’t often know we are in a bubble until it bursts.

Now that markets are truly interconnected, banks have operations around the globe, risk has been partitioned and multiplied in the form of derivative contracts, and an even greater and unquantifiable amount of risk has been spread around to every nook and cranny of financial services.

What may seem like small problem of an isolated nature in some inconsequentially small country may in fact prove otherwise when you’re taking about banking crises. There is a reason, for example, that regulators and those in the know, held their breath when banks in Greece and other emerging markets started to falter a couple of years ago. It was a close call.

Many of the European banks remain undercapitalized. While some want to criticize the regulators in the US for not doing all they could of to prevent the Global Financial Crisis of 2008 — it’s just not that simple — the fact is that the US banks have taken the painful steps to restructure, including raising much needed equity capital. But other geographies lag behind. Many European banks have not and have a long way to go. (Note what’s happening in Italy and has happened in Germany.)

I can’t tell you when the next banking scare or financial crisis will happen, but it will. History has a way of repeating itself. My personal fear that risk in the capital markets has yet again been systematically mis-priced since the Global Financial Crisis of nearly a decade ago. (In the US, I worry about the leverage in the system at the municipal level and the explosion in student debt.)

Central Banks and Governments around the world had no choice but to flood their respective encomies with cheap liquidity in order to avert another Great Depression. This, in my view, has once again led to the underpricing of yield that leads to speculation in asset prices. Further, weening the capital markets off of monetary stimulus in the form of cheap credit and quantitative easing is like weaning a user off of herion. Over time, more and more stimulus is needed to have the intended effect, but in the end the user is left in tears.

It’s not going to be pretty when the ultra-loose monetary policies of the industrialized world comes to an end, but it eventually will and with it another storm. Brace yourselves.

PS: For those who want to learn more about the modern banking system read “Lords of Finance: The Bankers Who Broke the World” by Liaquat Ahamed. It’s about the forming of the modern banking system after World War I. If you do read the book, you will see that every policy failure that led the Great Depression was repeated decades later and that lead to the Global Financial Crisis of 2008.

Written by Simon Yoo