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Lessons From the Financial Crisis

Published September 04, 2018

Jay Hooley, State Street CEO
Ron O’Hanley, President and COO
Andy Kuritzkes, Chief Risk Officer
Cyrus Taraporevala, State Street Global Advisors CEO
Rick Lacaille, Global CIO
Lori Heinel, Deputy Global CIO

As investors weigh up the factors that could extend or curtail the current cycle, now the longest in history, senior leaders at State Street discuss their memories of the Lehman Brothers’ collapse, the lessons learned from the financial crisis and what might cause the next downturn.

Below is a snapshot of the discussion in which the following took part: from State Street, CEO Jay Hooley, President and COO Ron O’Hanley and Chief Risk Officer Andy Kuritzkes; and from State Street Global Advisors, CEO Cyrus Taraporevala, Global CIO Rick Lacaille, and Deputy Global CIO Lori Heinel.

To read the Lessons From the Financial Crisis discussion in full, please click here.

Q: In the wake of Lehman’s collapse, did you think the system as a whole might fail?

Jay Hooley: It was a dramatic and traumatic week. The system seized up very quickly after Lehman and we spent the next weeks figuring out how to continue funding major financial institutions. It was very hectic, especially after the Reserve Primary money market fund “broke the buck” (i.e., the net asset value or NAV of the fund fell below $1) within days of the Lehman failure.

Ron O’Hanley: Money markets started gumming up almost immediately in a quite unanticipated way. My biggest concern was about potential cascading effects and the belief that a failure of a money market fund would create even more systemic problems and cause a self-reinforcing downward spiral. It was in fact a classic example of behavioral finance: if you believe things are bad, then they become bad; and if you believe they will get worse, they do get worse.

Q: What finally restored stability?

Andy Kuritzkes: We came very close to a financial meltdown. The light at the end of the tunnel came with the Troubled Asset Relief Program (TARP) that was signed into law on October 3. The stress tests for the banks had to be coupled with an equity bail-in with the TARP in order to stabilize the system.

Q: What were the most important lessons you learned both professionally and personally?

Rick Lacaille: One of the main lessons learned was that if you have to achieve a return target and can do so only by levering up small incremental returns, you have a big problem. We are much more conscious now of the interaction of leverage, volatility and liquidity.

We also learned the importance of having truly independent control functions and cultural guardrails. You have to be very careful of where and how people accumulate power within an organization. We saw examples in the run-up to the crisis where certain individuals became overconfident about their market expertise and because their business line was commercially successful, they brooked no opposition. Overconfidence with economic power, because a particular strategy or product is profitable, can be very dangerous.

Cyrus Taraporevala: The value of liquidity was one of the most important lessons. Liquidity is like water to a fish. You don’t know how good it is until you no longer have it. In a crisis there is nothing like dry powder, and one of the abiding lessons is that, when appropriate in extreme market conditions, investors should find the intestinal fortitude to keep cash on hand and ignore the warnings of “performance drag.”  We should not subscribe to the false notion that “there is no alternative.” The crisis reminded us of first principles: buy only what you understand, don’t get greedy and overstretch, and ask the hard questions about what might go wrong.

Q: Ten years on, are there areas of concern about what might cause the next crisis?

Ron O’Hanley: Overall, I think the U.S. regulators have done a good job of lowering systemic risk, though I do worry that they have inadvertently diverted some of the risk to less transparent parts of the system. Second, no matter how much you think the system is only about data and analytics, there are always human beings behind the decision-making and one needs to understand the behavioral biases that drive those decisions. Third, we need to have a much better understanding of the secondary and tertiary risk exposures in the system, the so-called daisy chain effect. In terms of what might cause the next crisis, I can’t be sure, but I know it won’t be what caused the last one. We are better prepared, but we are not perfectly prepared. We need to remain vigilant about risk in all of its potential forms.

Jay Hooley: I also worry about the potential instability caused by high-speed algorithmic trading. As we become more digitalized, in theory, we have a better ability to manage information, but the pace of digitization and high-speed trading is accelerating. I am not sure we completely understand the overall effect on the system. Obviously cybersecurity is another area where we need greater transparency and collaboration among large financial institutions and the government, and we are part of multiple industry efforts to improve that.

Lori Heinel: In terms of the resiliency of the banking system, I think we’re absolutely in a better place today than we were 10 years ago. The challenge, though, is you don’t really know where the new risk might come from. Now that governments are increasing their leverage in places like China, where we have seen aggregate credit growth exceed GDP growth by three times, that is worrying.  For me, though, the real lesson of 2008 is how much of pricing is a confidence game. Part of what happened in 2008 was that you had enormous opacity and investors were fearful of everything because valuations became completely unanchored from fundamentals. For example, in the U.S. you had municipal bonds trading above Treasuries although there was no basis for that in the fundamentals. Valuations just broke down because you didn’t know who was levered or presented a major risk. The question today is: where else could confidence be breached?

Disclosures

The views expressed in this material are the views of Jay Hooley, Ron O’Hanley, Andy Kuritzkes, Cyrus Taraporevala, Rick Lacaille and Lori Heinel through the period ended 08/31/2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

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