Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

How was this possible? It was easy enough to understand how China acquired claims on the United States. It had a gigantic trade surplus, the dollar

proceeds of which were bought up by its financial authorities and invested in US Treasurys, giving rise to Larry Summers’s scenario of a “balance of financial terror.”

The Europeans did not peg their currencies against the dollar.

So how did European banks end up owning such a large slice of American mortgage debt?

The answer is that European banks operated just like their adventurous American counterparts.

They borrowed dollars to le...

And the scale of this activity is revealed if we look not at the net flow of capital in and out of the United States (inflows minus outflows), which has its counterpart in the trade deficit or surplus, but at the gross flows, which record how many assets we...

by far the largest purchasers of US assets, by far the largest foreign lenders to the United States prior to the crisis, were not Asian but European. Indeed, in 2007, roughly twice as much money f...

By contrast, the financial flows between Europe and the United States made up a financial circulatory system quite independent of the trade connections between the two.

Across the Pacific, from Asia to the United States, money flowed one way. In the North Atlantic financial system it flowed both ways, both in and out of the United States.

the market-based model of banking. You borrowed the dollars on Wall Street to fund your holdings of mortgages from all over the United States.

ABCP

ABCP conduits organized bundles of securitized assets from the United States and Europe.13 With those securities as collateral they then issued short-term commercial paper, which was bought by the managers of cash pools in the United States. In 2008, $1 trillion, or half of the prime nongovernment money market funds in the United States, were invested in the debt and commercial paper of European banks and their vehicles.

But if we map not annual flows but cross-border banking claims, this gives further proof of how one-sided the Sino-American view of the buildup to the crisis was. The central axis of world finance was not Asian-American but Euro-American. Indeed, of the six most significant pairwise linkages in the network of cross-border bank claims, five involved Europe. European banking claims on the United States were the largest link in the system, followed by Asian claims on Europe and American claims on Europe. European claims on Asia exceeded the much commented upon Asian-American connections. Indeed, West European claims on emerging Eastern Europe alone were more than three times the size of American claims on Asia. It was also noticeable that oil- and gas-rich Middle Eastern investors preferred to channel their funds through Europe rather than directly to the United States. This was a pattern already established in the 1970s and only reinforced by the aggressive politics of Bush’s “War on Terror.” The European financial centers offered a safe channel through which funds from Asia and the Middle East were then sluiced into more speculative investments in the United States. It was not for nothing that China preferred to channel many of its claims on the United States through Belgium. In the process, the European financial system came to function, in the words of Fed analysts, as a “global hedge fund,” borrowing short and lending long.

What this suggests is a further crucial development of the argument. If it is misleading to construct our image of financial globalization around the Sino-American trade balance, to imagine it as centered on US securitization with outsiders being “sucked in” misses the point too. In fact, the entire structure of international banking in the early twenty-first century was transatlantic. The new Wall Street was not geographically confined to the southern end of Manhattan. It was a North Atlantic system. The second node, detached from but integrally and inseparably connected to New

York, was the City of London.17 In the nineteenth century, in the age of the gold standard and the British Empire, London had been the capital of global finance in its own right. From the 1950s, the City of London made a new role for itself as the main hub for offshore global dollar financing.

In the aftermath of World War II, the Bretton Woods monetary system had sought to restrict speculative capital flows. This gave the US Treasury and the Fed controlling roles. The aim was to minimize currency instability and to manage the global shortage of dollars. But it meant that the US authorities had to operate the kinds of controls that we now associate with China. This was a fetter on private banking. From the 1950s, with connivance of the UK authorities, the City of London developed as a financial center that sidestepped those constraints.18 British, American, European and then Asian banks too began to use London as a center for unregulated deposit taking and lending in dollars. Among the first to avail themselves of these “eurodollar” accounts were Communist states that wanted to keep their export earnings safe from meddling by the US Treasury. They set a trend. By the 1960s eurodollar accounts in London offered the basic framework for a largely unregulated global financial market. As a result, what we know today as American financial hegemony had a complex geography. It was no more reducible to Wall Street than the manufacture of iPhones can be reduced to Silicon Valley. Dollar hegemony was made through a network. It was by way of London that the dollar was made global.19 Driven by the search for profit, powered by bank leverage, offshore dollars were from the start a disruptive force. They had scant regard for the official value of the dollar under Bretton Woods...

For many of the most fast-paced global transactions, it was London, not Wall Street, that was the location of choice. By 2007, 35 percent of the global turnover in foreign exchange, running at a staggering $1 trillion per day, was conducted between computer systems in the City of London.22 European banks were the biggest players in the business. London was also the hub for the over-the-counter (OTC) interest rates derivatives business, a means of hedging against the risk of interest rate fluctuations and an essential complement to repo deals. Of an annual turnover in interest rate derivatives in excess of $600 trillion, London claimed 43 percent, to New York’s 24 percent.

Tony Blair’s New Labour government set about further streamlining the City’s regulatory system.24 Nine specialist regulators were combined into a single agency, the Financial Services Authority (FSA). It set a new low bar for financial oversight. Tony Blair’s chancellor, Gordon Brown, boasted that the FSA offered “not only light but limited regulation.”25 The FSA was mandated to achieve its “goals

in the most efficient and effective way.” “[N]ot damaging the competitive position of the United Kingdom” was its top priority.26 The FSA was required to apply cost benefit analysis to its own interventions and benchmark its operations against other countries.27 Perhaps not surprisingly, given this mandate, the FSA’s staff was a fraction of that of its US counterparts. As Howard Davies, the FSA’s first chair, put it in the libertarian language of the day: “The philosophy of the F.S.A. from when I set it up has been to say, ‘Consenting adults in private? That’s their problem.’”28 The sort of thing that you could do in London but not in New York is exemplified by “collateral

rehypothec...

reverse repo?

In the UK there was no limit on rehypothecation.

a result, according to investigations by a team of analysts from the IMF, the City of London came to function as a “platform for higher leveraging not available in the United States.” The scale of this activity was enormous. According to the IMF team, trading in and out of London the main European and US banks achieved a collateral multiplication of 400 percent, amounting to roughly $4.5 trillion in additional funding, effectively out of thin

The UK’s liberalization not only freed up UK markets but acted as a crowbar to dislodge regulation worldwide. A transatlantic feedback loop drove regulation down on both sides.30 The notorious US deregulation decisions taken by the Clinton administration in the late 1990s, which overturned the last remaining financial restrictions of the New Deal era, were not taken in a vacuum. The 1999 law was not called the Financial Services Modernization Act for nothing. There was a distinct vision of modern finance that the US industry was chasing and it was defined by global competition, above all by the City of London. In promoting the legislation, Senator Charles Schumer (D-NY) insisted “the future of America’s dominance as the financial center of the world” was at stake. If Congress did not pass the bill, London, Frankfurt or Shanghai would take over.31 New York, certainly, stood to benefit,

No one had been more active in shaping the global marketplace in London than expat American bankers working for the London offices of the major Wall Street firms.

Nor was it only Americans in London. European politicians and cultural critics might be skeptical of freewheeling “Anglo-Saxon” finance. But this downplays the extent to which Europeans coconstructed global finance. From the 1980s onward, Swiss, German, French and Dutch banks began to buy into the City of London with aggressive acquisitions. It was, more often than not, their springboard for a venture into US markets. In 1989 Deutsche Bank acquired Morgan Grenfell Group before buying Bankers Trust in the United States in 1999, and Scudder Investments, a US asset management firm, in 2002. Shortly thereafter, Germany’s leading bank declared English to be its official working language. Credit Suisse was unusual in starting with the acquisition of First Boston in 1990 before reorganizing itself as CSFB in 1996–1997, the same year that it acquired the London firm BZW from Barclays. Germany’s Dresdner Bank bought Kleinwort Benson in 1995 before buying the small but highly influential New York investment bank Wasserstein Perella in 2001. In the 1980s City of London insider Hoare Govett sold out to Security Pacific before being snapped up by the expansive Dutch bank ABN AMRO, which would become the leading European issuer

ABCP

before being acquired and dismembered by a pan-European consortium. The Swiss bank UBS-SBC acquired S. G. Warburg in London in 1995. In 1997 it followed this with the purchase of Dillon, Read & Co., an investment bank in New York. After abortive merger talks with Merrill Lynch in 1999, UBS bought out the asset manager PaineWebber. With its fixed-income and currency businesses booming, in June 2004 UBS’s CEO, Marcel Ospel, announced that his ambition was to make the Swiss bank into...

giant Connecticut-based office did manage to make the bank into the...

CDO

MBS

after Merrill and Citigroup, and the leader in the riskiest me...

All told, in 2007 the City of London was home to 250 foreign banks and bank branches, twice as many as operated out of New York.33 But the European footprint in Wall Street was very substantial. Of the top twenty broker-dealers in New York, twelve were foreign owned and held 50 percent of the assets.34 These were the competitors in the top tier. But European financial adventurism came in all shapes and sizes. And it was not confined to the City of London–Wall Street axis. From the 1980s ...

A case in point was the German bank Depfa. Founded in 1922 at the time of the Weimar Republic by the government of Prussia to make subsidized housing loans, Depfa moved to Dublin’s International Financial Services Center in 2002 to take advantage of Ireland’s welcoming tax laws. Depfa soon became known across the world as an adventurous financer of infrastructure, providing credits to the Spanish city of Jerez, giving financial advice to Athens and financing a conference center in Dublin and a toll road between Tijuana and San Diego. The Irish-German bank invested the retirement fund of the teachers of the state of Wisconsin, as well as funding Vancouver’s Golden Ears Bridge project. By the time of the crisis, Depfa’s total assets as reported by credit-rating agency Moody’s had sw...

It borrowed to lend. And it made handsome profits doing so. So much profit, in fact, that it attracted the attention of Hypo Real Estate, the Munich-based mortgage lender. Hypo was looking to diversify its risk profile and in July 2007 finalized plans to buy out Depfa, taking t...

For the resilience of a bank in the face of losses on its loan book, capital is the crucial criterion. The more capital a bank has, the more it is able to absorb losses. However, the larger a bank’s book of loans relative to its capital, the higher the rate of return it will be able to offer investors. That was the point of the elaborate legal structures designed to hold securitized assets off balance sheet, to minimize the capital invested and to maximize its leverage. Capital ratios were, therefore, one of the neuralgic points of bank governance. After years of deadlock, in September 1986 the Fed and the Bank of England reached a deal, which in July 1988 finally brought the Basel Committee to agreement on what was known as the Capital Accord, or Basel I. Henceforth, the minimum level of capital that a large international bank should aim to hold against normal business loans was set at 8 percent.

Almost as soon as the standard was set, the argument over its definition, implementation and consequences began. If the 8 percent rule had been imposed as a simple percentage, the effect would have been to encourage banks to make the most high-risk investments available in a frantic attempt to milk every cent of profit from every dollar of capital. It would have incentivized risk taking. So the Basel Committee provided for a basic system of risk weights, requiring no capital to be held against the low-risk, short-term debt of governments that were members of the OECD,

the exclusive club of rich countries.39 Mortgages and mortgage-backed securities were also favored with low-risk weights. But at the margin, the system continued to encourage risk taking. Furthermore, the lax provisions of Basel I enabled banks to hold substantial parts of their portfolio off balance sheet in special purpose vehicles (SPV) financed by ABCP. This was one of the main reasons why European banks were so active in ABCP. Their national regulators interpreted Basel I in such a way as to allow them to hold hundreds of billions of dollars of securities and fund them with short-term commercial paper, without needing to commit much of their capital. Not only was their capital stretched thin but the maturity mismatch was terrifying.

The obvious inadequacies of Basel I set in motion the search for a new framework that finally emerged in 2004 with the Basel II accord. But the transition from one regime to the other was telling. Whereas Basel I had been a conventional regulation aiming to impose standards on the industry from the outside, the chief ambition of Basel II was to align risk regulation with “best business practice” as defined by the bankers themselves. Basel II did require off balance sheet risks to be brought onto the banks’ own accounts. But at the same time, they were encouraged to apply their own risk-weighting models to those assets to decide how large their capital buffer needed to be. Far greater reliance was placed also on the credit evaluations issued by the private credit rating agencies.40 Though Basel II notionally maintained the 8 percent capital requirement, once the big banks applied their proprietary risk-weighting models, they found that they could sustain larger balance sheets than ever before. Under Basel I mortgage assets had been rated as relatively safe and counted only 50 percent for purposes of calculating the necessary capital. Rather than tightening those regula...

One method of massaging the figure down was to purchase default insurance against risky assets in the portfolio. The key supplier of default

insurance for “regulatory capital relief” was the American insurance giant AIG and its Financial Products offices in London and Paris. By the end of 2007 it was providing insurance for $379 billion in assets held by major European banks, led by ABN AMRO ($56.2 billion), Danish bank Danske ($32.2 billion), German bank KfW ($30 billion), French mortgage lender Crédit Logement ($29.3 billion), BNP Paribas ($23.3 billion) and Société Générale ($15.6 billion).43 AIG’s insurance allowed them to save a total of $16 billion in regulatory capital, further increasing leverage, profits and bonus payments.

Rather than imposing intrusive inspections and external audits, Basel II placed heavy emphasis on self-regulation, disclosure and transparency. “Well-informed” market judgments would do the work of oversight better than “arbitrary” regulatory decisions. After all, rational investors could have no interest in exposing themselves to the risk of catastrophic loss, or so the reasoning went. They would price bank shares accordingly, sending a clear signal as to which banks were safe and which were not. The regulators were utterly subservient to the logic of the businesses they were supposed to be regulating. The draft text of what would become the Basel II regulations was prepared for the Basel Committee by the Institute of International Finance, the chief lobby group of the global banking industry.

Nor was the Basel framework well designed to drive standards upward.

The FDIC’s chair, Sheila Bair, an outspoken midwestern Republican appointee, was incredulous that big banks were effectively being given license to “set their own capital requirements.”48 It would give them a huge competitive advantage over their smaller competitors. The FDIC estimated that the introduction of Basel II would permit big banks to reduce their capital by 22 percent.

It was not that the key players were completely oblivious to risk. But they believed in their capacity to manage it and were totally committed to maximizing the rate of return. So every regulation and every restriction on leverage was subject to second-guessing and subversion by the overwhelming force of competition and the unfettered movement of capital that had been gathering steam since the 1960s.

Would Europe’s central banks have the dollar reserves necessary to backstop the European financial system?

But when the question was put by analysts from the BIS, the answer was sobering. In the balance sheets of the European banks at the end of 2007 there was a mismatch between dollar assets (lending) and dollar liabilities (funding by way of deposits, bonds or short-term money market borrowing) of $1.1–1.3 trillion.

It is telling that no one troubled to ask the question of what the adequate level of reserves would be for a European country with a gigantic globalized banking system. As it turns out, given the scale of the banking business in their jurisdictions, the level of foreign exchange reserves held by the Swiss and British central banks

was astonishingly low—less than $50 billion each. To backstop the sprawling banking system of the eurozone, the European Central Bank had little more than $200 billion on hand. What did this say about their assumptions about both financial risk and financial sovereignty? When asked later how he justified such minimal reserve holdings prior to the crisis, one of the most outspoken central bankers of the period paused for a minute, smiled at a point well taken and then said quite simply: “Given our long history of relations with the Fed, we didn’t expect to have any difficulty getting hold of dollars.” In other words, there was a presumption that collaboration would be forthcoming and in an emergency the Fed would provide Europe, and London in particular, with the dollars it needed. Given the scale of the offshore dollar business there could be no other answer. But for that same reason, it was also an astonishingly audacious assumption, an expectation so exorbitant that it was better left unspoken.