Executives around the world still feel the effects of the 2008 financial crisis. One such executive is Anil Chaturvedi, a long-time banker whose career dates back to the early 1970s when he got his start at the State Bank of India.
Today, Mr. Chaturvedi serves as the Managing Director of Hinduja Bank in Switzerland. Fortunately, by leveraging Anil Chaturvedi’s years of experience and first-hand knowledge of the financial crisis, we can make sense of this post-2008 international banking community.
In this article, we’ll first review what went wrong in 2008 and the years leading up to it. Then we’ll use insights gleaned from Chaturvedi’s experience to understand the current state of affairs.
What Happened in 2008?
The story of the financial crisis of 2008 and the ensuing global recession truly began years before 2008. In reality, the convergence of several factors that played out over time, beginning in the United States and reverberating throughout the world, led to the crisis.
Essentially, banks made loans to homebuyers, then sold those loans to hedge funds. The hedge funds then turned around and “securitized” those loans, meaning they bundled several loans they’d purchased and sold that bundle to investors. These investors included huge financial institutions like the Lehman Brothers, Citibank, and Bear Stearns. The “bundle” that those investors bought is called a mortgage-backed security.
Homebuyers made their payments through the bank they’d borrowed from, even though that bank no longer owned that loan. The payments, minus the bank’s fees, then went to the hedge fund, which also took a cut, and then finally to the investors.
Think of a mortgage-backed security like common stock in a company, except that, instead of investing in a company, you invest in the revenue generated by a bundle of mortgages.
The risk you’re taking when you own a mortgage-backed security is that, if the borrowers default on their payments, that security is more or less worthless. Investors compensated for this risk by purchasing credit default swaps.
A credit default swap is basically an insurance policy. Investors, like Lehman Brothers and other large banks, bought these credit swaps in case the mortgage-backed securities they’d purchased went into default. Third parties, often large insurance companies like AIG, were the ones who sold these credit default swaps.
Where it Went Wrong
In the investment world, purchasing mortgage-backed securities covered by credit default swaps became a very popular investment strategy. People were making lots of money, and they wanted more. Plus, once the banks had sold off the mortgages they’d made, they had capital that they needed to place. As Anil Chaturvedi can attest, banks generally don’t want to sit on a pile of cash; they’re in the business of making loans. So banks, to remain competitive, were strongly incentivized to keep making loans. The problem is that there are only so many quality borrowers. Banks were under lots of pressure to keep loaning money, so they started loosening their borrowing standards, opening the door for people they never should have approved for a loan.
While home prices were rising, everything was fine. But because of the ridiculously hot market for housing, homebuilders overbuilt. That meant there was a huge supply of homes but not enough buyers. As a result, home prices faltered.
Usually, that wouldn’t be a huge deal. However, many homeowners had adjustable rate loans on homes they could barely afford to pay off. So, when their rates increased and home prices dropped slightly, people could neither sell their homes to pay back their loans nor make payments long enough to benefit from price appreciation. Millions of people defaulted on their loans, causing reverberations all the way to Wall Street and around the globe.
The payments on mortgage-backed securities stopped. Investors who’d bought credit default swaps tried to cash out, but the third parties who’d insured these mortgage-backed securities didn’t have the money to cover all the swaps. There was no money.
As a result, several huge financial institutions faced bankruptcy. The economy restricted, banks stopped making loans, businesses stopped investing, and demand for imports stopped. Many international banks suffered because they’d taken part in the real estate investment flurry. Moreover, demand from the United States, the world’s largest economy, nosedived. The result was a prolonged global recession.
How Banking Has Changed
A major regulatory overhaul ensued in the years after the global recession. Basel III in Europe and the Dodd-Frank Act in the United States were among the most notable regulatory frameworks passed as a direct result of the financial crisis. Both enacted strict rules for how much liquid assets banks had to hold in case of another crisis.
However, many of these regulations made it much harder for banks to make money, as Anil Chaturvedi and his colleagues have experienced. The regulations make it so that banks have to limit their investments, both regarding how much they invest and into what types of assets they can invest.
And the numbers back this up. According to the Harvard Business Review, “these changes have diminished the profitability of investment banks. Combined revenues are down 25% — the equivalent of $70 billion. On average, their returns on equity have been halved, to just 10%.”
Conclusion: An Ending Yet to be Told
The banking industry—while forever changed—is alive and well. Anil Chaturvedi and the tremendous growth he’s overseen throughout four decades in the banking industry are proof of that. However, the true result of regulation is yet to be seen. We won’t know whether the increased restriction on banks is worth it until we face another crisis.
For now, it’s clear that regulation is costly. Large banks, like the one Anil Chaturvedi helps run, spend a fortune on compliance alone. And that’s not to mention the new restrictions on their investment activities. Moreover, a less profitable bank means fewer loans and less credit available for business growth.
But perhaps the price of compliance and slower growth is well worth it if it can prevent us from experiencing another global recession.