PREFACE
The New World of Banking
Banking after the Global Financial Crisis

The global financial crisis of 2007-2009 will shape the ways banks are managed for many decades to come. It will also continue to affect the ways that politicians, regulators, analysts, and the general public think about banks and behave toward them.

Banking crises are not unusual. The Argentinian currency revaluation in 2001 led to a crisis for its banks, the Asian financial crisis of 1997 led to the insolvency of many of the region's banks, Sweden suffered a banking crisis in the early 1990s, and in the mid-1970s many second-tier British banks suf­fered huge losses as a result of a collapse in property prices.

Yet the 2007-2009 global financial crisis stands out from other banking crises due to its global extent, its impact on economic growth, and the far-reaching policy responses that have followed it. In all three respects, what happened in 2007-2009 resembles the financial crash and economic depres­sion of the late 1920s and early 1930s more than it does any of the other banking system crises of more recent years.

The events of 2007-2009 challenged many of the widely held assump­tions about how banks and banking systems worked. In simple terms, many things that would have been dismissed as unthinkable a few years before actually happened.

For example, it had always been assumed that banks and other commer­cial institutions would invariably make liquidity available to other financial institutions even if they charged very high rates for it. Yet during the days that followed the collapse of Lehman Brothers in September 2008, short-term financing markets dried up as banks refused to extend liquidity at any price. The level of uncertainty in financial markets was such that banks did not want to increase their exposure to anyone else, however strong they seemed to be.

Among the other ideas challenged by the crisis was the distinction between off-balance-sheet and on-balance-sheet items, the value of credit rat­ings, and the ability of many new capital instruments to absorb losses.

More generally, the long-term trend toward deregulation of financial markets that had begun in the 1970s and gathered pace during the 1990s fell out of favor. The belief that bankers themselves best understood the risks that they were taking was discredited. Politicians who had to explain to their voters why the failure of private sector banks had led to higher unemploy­ment and public sector wage freezes wanted to exert control over the way banks operated in the future to try to ensure that a similar global crisis could not reoccur.

As a result, the level of regulation and public scrutiny of banks is far greater today than it has been for many decades, and this is unlikely to change in the near future.

Although the crisis was global in the sense that banks and economies throughout the world were affected, some were affected more than others. Emerging market banks that did not rely on global funding streams and had little exposure to assets and financial instruments originated in Western economies were barely affected. For example, in 2007-2009, the perform­ance of Egyptian banks was driven more by the progress of their central bank's domestic financial reform program than by events in global financial markets.

Nevertheless, the fact that it was banks and economies in developed mar­kets, particularly the United States and Europe, that were most affected has had far-reaching consequences for banks everywhere. Officials from North American and European countries and from the developed economies of Asia dominate bodies such as the Basel Committee on Banking Supervision that set standards for international banks and other financial institutions. It was banks from these countries that were most affected by the global financial crisis, so officials from these countries have been determined to put in place new standards-for example, on minimum capital levels and corporate gov­ernance-that they hope will reduce the possibility of another global finan­cial crisis happening.

The standards that are set by bodies such as the Basel Committee are applicable to banks worldwide. So, for example, Egyptian banks may have been minimally affected during the financial crisis, but they are now judged against new international standards on bank capital and liquidity just like everyone else.

THE EUROPEAN FINANCIAL CRISIS OF 2009-2013

European banks and financial markets were badly affected by the global financial crisis, but from early 2010 European financial markets suffered additional problems specifically related to economic trends in Europe. These problems particularly affected the Eurozone-the group of 17 countries that had adopted the euro as their currency and whose monetary affairs were therefore governed primarily by the European Central Bank.

The difficulties experienced by European financial markets over this time were the result first and foremost of a sovereign debt crisis arising from unsustainable spending and borrowing by some governments. However, one of the features of the crisis was the close connection that emerged between the sustainability of government finances in a particular country and the health of that country's banking system.

The response to the crisis has had far-reaching consequences for the way in which banks are regulated and supervised in the European Union (EU)- for both Eurozone and non-Eurozone countries.

Ireland was the first EU country to need financial support from the European Union and the International Monetary Fund, although Ireland's problems arose from problems in its banking system that became apparent in 2007-2008, rather than from budgetary difficulties. As a result, the Euro­pean crisis is deemed to have begun with Greece in 2009.

In late 2009, concerns began to grow that the Greek government would not be able to repay its debts, and in February 2010 the European Union announced a financial support package for Greece that was coupled with requirements that the Greek government drastically reduce public spending. Over the course of 2010, new figures revealed that the Greek government's financial situation was even worse than expected, and further support from international bodies was provided.

Although the Greek crisis originated with problems in the Greek govern­ment's finances, it quickly became clear that Greek banks would be affected. Most obviously, they held large amounts of their own government's bonds, and the government's ability to repay these bonds was now in doubt. Fur­thermore, as investors worried about the ability of the Greek government to repay its debts, they pushed up the cost of new borrowing to Greece and this in turn led to higher funding costs for Greek banks. More generally, the Greek government's budgetary crisis revealed broader mismanagement within the Greek economy, including state-owned enterprises that were not servicing the loans that they had received from banks.

As the problems in Greece unfolded, analysts turned their attention to other Eurozone countries that had been running large budget deficits, such as Portugal, Spain, and Cyprus. Although the fundamental problems lay with government budgets, banks based in these countries also experienced diffi­culties either as a result of their direct exposure to their governments, because international investors were refusing to provide funds to any institutions in that particular country, or because the problems at the government level were symptomatic of broader economic mismanagement whose full extent only came to light as a result of the crisis.

The difficulties of resolving the European financial crisis were exacer­bated by a lack of clarity over who was responsible for solving the problems. It was clearly in the interest of the Eurozone as a whole to prevent financial collapse in any member country, but some countries were reluctant to commit their own taxpayers' money to resolve problems in other countries that had been caused by years of overspending. These issues have now been largely resolved though the implementation of a "banking union" among Eurozone countries, with a central fund to support troubled banks and centralized supervision conducted by the European Central Bank.

The European financial crisis illustrated not only how budgetary prob­lems at the government level lead to problems for individual banks, but also how lack of clarity over who is responsible for resolving banking crises can result in those crises deepening and becoming more widespread.

THE RISE OF SHADOW BANKING

Until recent times, the provision of credit and the collection of deposits were performed almost exclusively by banks that were regulated by a central bank or an equivalent institution, and these banks could expect to receive support from their central bank in the event that they ran short of liquidity. In the mid-1980s in the United States, and shortly after that in other developed financial markets, a variety of nonbank institutions and investment vehicles began to conduct many of these banking activities alongside the traditional banks. This network of nonbank institutions and vehicles is known as shadow...