High pre-crisis returns in the financial sector proved temporary. The return on tangible equity in UK banking fell from levels of 25%+ in 2006 to - 29% in 2008. Many financial institutions around the world found themselves calling on the authorities, in enormous size, to help manage their solvency and liquidity risk. That fall from grace, and the resulting ballooning of risk, sits uneasily with a pre-crisis story of a shift in the technological frontier of banks’ risk management.
In fact,
high pre-crisis returns to banking had a much more mundane explanation. They reflected simply increased risk-taking across the sector. This was not an outward shift in the portfolio possibility set of finance. Instead, it was a traverse up the high-wire of risk and return. This hire-wire act involved, on the asset side, rapid credit expansion, often through the development of poorly understood financial instruments. On the liability side, this ballooning balance sheet was financed using risky leverage, often at short maturities ...
If risk-making were a value-adding activity, Russian roulette players would contribute disproportionately to global welfare. And if government subsidies were the route to improved well-being, today’s growth problems could be solved at a stroke. Typically, this is not the way societies keep score. But it was those very misconceptions which caused the measured contribution of the financial sector to be over-estimated ahead of the crisis.
Bookmarks