Bubble Trouble: Could Banks Lead Us Into Another Financial Crisis?

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Financial crisis headlinesNearly five years out from the 2008 financial meltdown, many of us have seen our retirement accounts recover, and home values are headed in the right direction. But you know what would really help us relax? The assurance that a catastrophe like that could never happen again.

Unfortunately, despite new regulations and the recent round of bank stress tests, which determine whether banks would have enough capital on hand to withstand financial crisis situations, some critics warn that banks are once again taking on the kind of risks that could endanger the financial system. In fact, a new Senate report on last year’s $6.2 billion trading loss by J.P. Morgan Chase found that the company didn’t heed internal controls, manipulated documents and even withheld information from regulators.

Most surprising, some banks’ new risky behavior may be in reaction to government regulations aimed at aiding the recovery. We look at the current pressures on banks and explore whether our newly instated regulations are up to the task of preventing another financial crisis.

Risky Business

Banks’ standard method of making money is pretty simple: Borrow cash at one interest rate and lend it out at a higher one. The problem with that right now is that the Federal Reserve has kept interest rates so low—in its efforts to stimulate investment and job growth—that banks aren’t earning much on loans. As a recent report from Moody’s Investors Service put it, “Low interest rates are supportive to the economy, but undermine banks’ profitability.”

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Not only are rates low, but consumers and businesses are borrowing less, which further hampers business for banks. On top of that, complying with new regulations increases banks’ costs. And the new Consumer Financial Protection Bureau is investigating overdraft fees and the way they are charged—and any changes in those practices could limit banks’ future revenue.

All this pressures banks to find other ways to make money. Potentially risky bank behaviors that worry experts include:

  • Making higher-risk loans: “Banks have already begun to relax loan standards after they were tightened in response to the financial crisis,” Moody’s says.
  • Entering unfamiliar businesses for which they may lack appropriate control processes and expertise: A report by the Office of the Comptroller of the Currency, a Treasury Department bureau that regulates banks, says some of these businesses include commercial and industrial real estate, indirect auto loans, and oil and gas lending.
  • Investing in riskier securities in hopes of higher yields: Moody’s says banks are looking at investments that might be more profitable but also riskier—and that those risks may not become apparent until interest rates begin to rise.
  • Making bets on mergers and acquisitions: American Banker editor-in-chief Neil Weinberg, in a recent column calling out an increase in risky activities in the banking industry, said, “Three recent deals involved premiums of 32% to 83% above tangible book value, implying that buyers are willing to bet on the prospect that the targets will be worth more in the future than they are today.” Translation: Some buyers bought companies for more than they were worth, indicating that they were willing to bet that the investments would increase in value in the future—and as with all bets, these may not pan out.

“They’re reaching for yield and going out on the risk spectrum” by making loans to customers they wouldn’t normally lend to or charging rates that aren’t commensurate with the risks, said Rebel Cole, a professor of finance at Chicago’s DePaul University. Banks are taking investment risks too; the prime example being the J.P. Morgan Chase loss from last year. That kind of speculative trade mimics behavior leading up to the 2007-2008 financial crisis, when banks made investments in securities based on bad mortgages. When the true value of those mortgages were revealed, banks did not have enough money on hand to back up their bad bets. Could banks land in the same hot water now?

What About Those Regulations?

After the crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, a sweeping bill that calls for various government departments to write new rules limiting the risks banks can take, increasing transparency and protecting consumers. Some of the regulations called for in the law are still being written, so it’s hard to judge now what the full impact will be, but some critics already think it’s insufficient.

  • http://www.facebook.com/louey.bitler Louey Bitler

    I didn’t know we had left the first one

    • http://twitter.com/kgal1298 Suspicious ^^^

      As with any financial crisis regulations will ease up after a number of years. I think some people still feel a financial crisis, but others many are doing much better than they were when the issue first struck. At the same time the next financial crisis will most likely be brought on my student loan debt, which doesn’t get nearly as much attention as it should, but at least places like SoFi are trying to help in that situation.

  • LDutz

    So, if we are headed to trouble, what is the best way to protect ourselves? What steps can we take to minimize the negative impact of another crisis on our own finances?

  • damicol

    BancTrust Financial Group Inc DHS is going to open safety boxes. Clear them out now