As an advisor to your individual and business clients, you’re probably sick of hearing about when or if the next financial crisis will happen. Unfortunately, the outlook is still cloudy.
The Challenges Facing the Current System
According to a recent article, Columbia University law professor Kathryn Judge believes the necessary protections still aren’t in place to protect the financial system, although it’s been a decade. While the banks are stronger than they were 10 years ago “and meaningful steps [have been] taken to prevent a precise replay of the last crisis,” she writes, “the next crisis will inevitably look different than the last, and the structural deficiencies revealed in the last crisis have not gone away.” That’s because of several challenges, she believes, a key one being a fragmented regulatory structure.
The U.S. currently has three federal bank regulators, two federal market regulators and numerous state and federal regulators, some of whom compete instead of cooperate. They are also limited in the information they can share, she states, adding that there is no one specific oversight regulator.
The landmark Dodd-Frank Act tried to mitigate the challenges by requiring the heads of the major financial regulators to also serve as members of the Financial Stability Oversight Council. But that group’s powers are limited, according to Judge, “and the agency heads remain far more concerned with furthering their individual missions than addressing systemic risk.”
According to Judge, a second key challenge is complexity. In other words, the U.S. financial system is a maze of links, connections and banks that have perhaps thousands of separate legal entities, all of which are spawning new financial instruments.
“As we learned the hard way with securitization, even useful financial innovations can pose unforeseen hazards,” Judge states. “The rise of fintech only accentuates the rate of change and possibility of disruption. Post-crisis reforms have reduced the complexity of layering of securitization structures, but they have not halted the trend toward increasing complexity and the massive information gaps it creates.”
The complex and continually evolving financial system with its fragmented regulatory structure was the root of the last crisis, she says. “These challenges remain, and could well lead to another crisis sooner than anyone would like.”
The Dangers of the Shadow System
On the flip side, Moody’s Analytics’ chief economist, Mark Zandi, believes the financial system is on firmer ground and unlikely to go through another crisis on the same scale.
“The financial system is in a much better place than it was 10 years ago, and the next crisis appears a long way off, but regulators will need to be vigilant as the nightmare of the financial crisis fades and risk-taking increases,” he says.
If another crisis does materialize, Zandi predicts it likely will begin in what he calls the “shadow system,” in which banks, facing higher capital requirements and increased liquidity, shift risks to the less regulated and more “opaque part of the financial system.”
Zandi doesn’t specifically point to the PR Newswire release about National Advisory in June, which notes, “Nationwide Advisory Solutions added nine new funds to Monument Advisor, the industry's first and only Flat-Fee Investment-Only Variable Annuity (IOVA). A leading distributor of tax-advantaged investing solutions for Registered Investment Advisors (RIAs), fee-based advisors and [their clients], the company continues to offer the industry's largest lineup of investment options, including the most alternatives such as real assets, trading assets, and liquid alternatives utilizing strategies like those favored by hedge funds and elite institutional investors.”
Crises Will Happen, But Protections Are in Place
He does, however, cite a few key safeguards. Federal regulators, for instance, can use “macroprudential” tools to address issues developing in the financial system. In fact, regulators issued guidance to banks cautioning them about their lending practice on multifamily projects because of concerns about overbuilding.
The Consumer Financial Protection Bureau, which was created by the Dodd-Frank Act, keeps an eye on consumer and mortgage lending tactics, Zandi notes. He points out that the combination of new rules that makes it more difficult to lend to people who can’t afford the loans also makes it tougher to make bad consumer lending decisions.
Still, there will be more crises, and one is forming in leveraged lending to non-financial businesses, Zandi states. “These highly indebted companies will likely navigate the next recession, and the resulting bankruptcies and losses will stress the economy and financial system. Regulators appear to be on increasing alert to this problem, and may utilize macroprudential steps to address it.”
From advisors’ perspectives, a change in client mentality since the Great Recession has most (61 percent) of advisors believing that investors are better prepared if there’s another market drop, according to a Financial Planning article that is partially based on a national poll.
The poll found that advisors say 74 percent of investors now are more likely to work with financial professionals, 90 percent are more likely to take their advice and 84 percent are more willing to make a financial plan and stick to it – a problem for many investors a decade ago, says pollster Craig Hawley, president of Nationwide Advisory Solutions.
Not sticking to a plan was the undoing of many investors during the crisis. “From the late 90s to the financial crisis, there were a lot of advisors that were trying to pitch alpha, their ability to outperform, and they were sort of selling performance,” Hawley says. “Then the market crisis comes and I remember there being stories about buy-and-hold is dead. That makes no sense anymore.”
That, in fact, is the key message in the MarketWatch article by Howard Gold about the best strategies used by investors to weather the last crisis: It’s all about buy and hold.
“We’ve [U.S. journalists] had lots of articles about how the economy has changed, whether the financial system is safer, how the housing market compares with what it was like before the crash, where the next crisis might come from, and whether the financial crisis led to the rise of populism in Europe and the United States,” writes Gold, a retirement planning advisor and the founder and editor of GoldenEgg Investing. “But there hasn’t been much about how investors have done. The answer, it turns out, is they did pretty well, if they stuck to their plans.”
In fact, the “‘dumb’ plodders who held on have had the last laugh over the ‘gurus’ who outsmarted themselves,” Gold states. “The big takeaway from Lehman’s fall was don’t panic and stay the course.”
About Terry Sheridan
Terry Sheridan is an award-winning journalist who has covered real estate, mortgage finance, health care, insurance, personal finance, and accounting and taxation issues for newspapers, magazines, and websites. A Chicago native and former South Florida resident, she now lives in New England.