Most banking crises are difficult to quantify in their early stages, because key variables such as property prices are changing as events unfold. But the current crisis is big.

The problems that started last August in the US sub-prime market have so far generated potential losses totalling around $200bn. But the damage will swell if house prices plunge further and if the economic downturn is particularly severe.

Mounting losses are spreading to credit card debt and car loans, while commercial property and debt insurers are also threatened. Total banking sector losses could reach $500bn over the next few years.

Spiralling out of control
The biggest threat is the emergence of a vicious circle, where losses destroy bank capital and worsen the credit crunch, which, in turn, cause new and bigger losses leading to a slump. We have so far escaped this predicament and we should avoid it altogether. But, even if the crisis is contained, it will cause significant damage to the global economy. While outright recession is unlikely, we will see a bigger slowdown in global growth than would have occurred without the banking crisis.

Forecasts for 2008 have been cut for all the major economies. GDP growth is set to plummet to below 2% in the US, the eurozone, Japan, and the UK. The immediate risks are most acute in the US, where the financial crisis could unleash recession and higher unemployment. Europe and Japan are less exposed than the US, but will also record marked economic slowdowns. Even China and India will grow at a much slower pace than in 2007. Asia will expand relatively strongly when compared with the West, but hopes that 2008 will see significant “decoupling” from the US may be disappointed. While big interest rate cuts, especially in the US, will help to alleviate the pain, they cannot offset the damage inflicted by recent big losses on the banks’ ability to lend.

The banking crisis has also given impetus to the shift in global economic and financial power towards Asia and the oil exporters. Injections of capital from Asian and Middle Eastern sovereign wealth funds, and other state investors, into major Western banks totalled more than $60bn in recent months. The providers of funds came from economies with big surpluses and large forex reserves, such as China, Singapore, Abu Dhabi, Kuwait, Saudi Arabia, and Qatar. The recipients were top-tier international banks, such as UBS, Citigroup, Merrill Lynch, Morgan Stanley, Barclays, and Bear Stearns. The new money alleviated the damage to banks, but also raised other concerns.

Most fears focused on the risk that state-owned sovereign funds would not be guided by normal commercial considerations, but by ulterior political and possibly even sinister objectives, such as gaining control over strategic sectors in western economies. There were also concerns over the secrecy and lack of transparency of many sovereign funds, and by the lack of reciprocity, since our investors are often barred from investing in their countries on an equal footing. These fears have generated hostile protectionism, particularly in France and Germany, which are often more suspicious of foreign investment than the US and the UK.

Western economies must accept new economic realities and global players such as China must be allowed to participate on equal terms in global trade and investment. But the new emerging powers must accept standards of transparency and reciprocity. Western nations must avoid blatant protectionism, while protecting genuine strategic interests linked to national security.

Unacceptable risk
The banking crisis has also raised uneasy questions about the role of banks in our economy. Low interest rates have encouraged excessive bank lending during the boom. But banks have clearly engaged in irresponsible mispricing of risk. The standard practice of securitising and distributing loans, thus moving risks off their own balance sheets, has encouraged banks to boost lending and incur unacceptable risks. This temptation to act recklessly has been magnified by a misguided bonus system, which rewards traders and bankers for short-term returns, but does not penalise the subsequent long-term losses.
If other businesses make disastrous mistakes they go bust. But, as Northern Rock has shown, governments are effectively obliged, politically, to guarantee bank deposits.

Resolving the dilemma is extremely difficult. Over-regulation would be self-defeating, but we cannot afford to persevere with a system that will inevitably cause recurring costly crises. There will have to be some major changes in our banking system to make the banking sector less inclined to take irresponsible risks, perhaps by making bonuses less short-termist or making the minimum capital rules more counter-cyclical. But political pressures to satisfy populist clamour for quick action may, in fact, trigger damaging over-regulation.