Question

How does the pending financial crisis because of Covid-19 differ from that of previous financial crisis?

Answer 1

Comparison between the coronavirus crisis and the global systemic crisis of 2008 is inevitable, but seen through the lens of exogenous and endogenous risk they are quite different.

Exogenous risk arrives to the financial system like an asteroid might hit earth – it comes as a surprise, there is nothing we do to precipitate its arrival, and it can cause enormous damage. To the financial system, the coronavirus shock is purely exogenous.

The crisis event in 2008, at its core, was caused by the interaction of market participants, who came to doubt assumptions that had previously usually been made almost without question.  The result was synchronised decisions to sell similar assets and to avoid the same exposures, causing an acute lack of liquidity.

The crisis preyed on the weaknesses of the financial system: ill-advised and poorly risk-assessed structured credit products, extreme maturity mismatches, illusionary bank capital, regulatory fragmentation, extensive regulatory arbitrage and large off-balance sheet liabilities.  The process was primarily endogenous.

2008 was a global systemic financial crisis fuelled by the endogenous interactions of market participants. The forces of the crisis fed on deep weaknesses in the financial system that had built up out of sight.

COVID-19 is an exogenous shock to the economy, and the question is whether there are sufficient latent weaknesses for it to prey on. We think this unlikely. Instead, the locus of the problem lies outside the financial industry, in a real economy in which shops, services and business are being closed by state fiat, and the income of employees involved is collapsing.   

In turn, that means the appropriate policy response cannot be limited to reducing interest rates or purchases of corporate or sovereign bonds on the open market, but should also encompass forbearance and targeted help and similar policies.

With the most vulnerable part of the financial system – the banks – in much better shape now than in 2008, we feel that this is not the real problem and that any solution focused primarily on the financial system would fail.