Changes in banking in the run-up to the crisis
In the years preceding the global financial crisis that started in 2007, the landscape of banking had undergone major changes. Global financial institutions had grown ever bigger in size and scope and their organizational complexity had increased, adding to their opacity. They had become strongly interconnected via increasingly long chains of claims as well as correlated risk exposures, arising from increasingly similar investment strategies. Their leverage had strongly increased and the average maturity of their own funding had shortened.
Behind these trends were forces that intensified competition in banking; technological development and deregulation. Advances in information technology as well as in investment theory and practice meant that commercial banks faced increasing competition on both the liability side and the asset side.1
New savings alternatives to bank deposits, such as money market mutual funds, proliferated and new opportunities for borrowing, in addition to bank loans, emerged. In fact, an entire shadow banking sector developed, comprising a chain of non-bank institutions which were able to provide similar financial intermediary services as traditional banks.
In this environment, deregulation was partly a response to the aforementioned changes and enabled banks to cope with the increasing pressure from non-bank competitors. In the United States, the gradual unwinding and the ultimate repeal of the Glass-Steagall Act in the late 1990s made it possible to reunite investment banking and commercial banking, which had been separated since the crisis of the 1930s.2
In Europe, the universal banking model already had a longer history of combining commercial banking and investment banking under the same roof. However, there was a trend before the crisis, among the biggest European banking institutions, to strengthen their focus on investment banking, including trading operations, and to increase wholesale funding to the point of excess. Part of this trend was driven by the growing demand from non-financial firms for risk management services.
With more freedom to choose their business models, banks sought economies of scale and scope and strived to take advantage of diversification benefits from multiple sources of income. Commercial banking moved increasingly away from customer relationship-based banking where loans are granted and then held until maturity, to the ‘originate and distribute’ model where granted loans are pooled, then securitized and sold to investors. This shift in the business model increased traditional banks’ connections to the shadow banking sector and they became part of the long intermediation chains characteristic of shadow banking.3
The increasing influence of the investment banking-oriented management culture also spurred the focus on short-term profits in commercial banking, reinforced by short-term performance-based managerial compensation schemes. Investment banks in turn transformed themselves from partnerships into public corporations. This helped them grow but also provided them with incentives to take risks that partners would not have taken with their own money.