Banks Have No Plan For New Financial Crisis: Harvard's Rogoff

The shares of big U.S. banks have been surging on growing optimism about profits, making the financial crisis of 2008 a distant memory for many investors. Nonetheless, economics professor Kenneth Rogoff of Harvard University is concerned. Though he does not feel that a new crisis is building at least right now, he recently warned attendees at the World Economic Forum (WEF) in Davos, Switzerland that central banks are unprepared to deal with one, CNBC reports. "If we have another financial crisis, there isn't even a plan A," Rogoff said, per CNBC. 

Rogoff makes these sobering comments as the biggest U.S. banks have posted major gains in the past year, per CNBC, with JPMorgan Chase & Co. (JPM) up 36.7%, Bank of America Corp. (BAC), 42.4%, Wells Fargo & Co. (WFC),19.3%, Citigroup Inc. (C), 41.0%, Morgan Stanley (MS), 36.4%, and even lagging Goldman Sachs Group Inc. (GS) posting a 11.5% increase.

While these robust stock price gains reflect investor confidence that banks have fully recovered, Rogoff is clearly ambivalent. "We're still coming out of the last financial crisis," he said per CNBC, adding, "but I'm kind of optimistic going forward with where the world economy is at the moment. Could there be a financial crisis? Of course." 

Rogoff advises banks to be cautious, and sees a growing risk from "debt rising at an aggressive pace," as CNBC quotes him. This is bound to push up interest rates, and thus may trigger a stock market selloff. "It is not hard to imagine a stock price collapse--it's built on price growth but also very low interest rates," he said per CNBC.

Moreover, a global uptick in central bank interest rates that slash U.S. stock prices may originate elsewhere around the world. Rogoff suggested that a widespread increase in interest rates may start in countries that already have significant debt burdens, such as Japan, Italy, and various emerging market economies. (For more, see also: How The Fed May Kill The 2018 Stock Rally.) Rogoff is well-known for his provocative comments on the the economy and financial system. Investopedia talked to Rogoff in an earlier interview about how young investors should factor in rising interest rates into their portfolio strategy. (Click here for Rogoff video).

Rogoff's analysis reflects a gloomy December report from an independent research arm of the U.S. Treasury, the very department that managed the bailouts of big U.S. banks during the financial crisis. The report found that, despite all the measures taken to prevent or at least mitigate a new financial crisis, big banks still pose a major risk to the financial system. In particular, the report concludes that regulators would be overwhelmed if more than one systemically important financial institution (SIFI) were to become insolvent, or teeter on the brink of insolvency, at the same time.

Today, systemically important U.S.-based banks include not only the six listed above, but also two lower-profile institutions that provide vital infrastructure and support services for the financial system. These are Bank of New York Mellon Corp. (BK) and State Street Corp. (STT). (For more, see also: Big U.S. Banks as Risky Today as 2007.)

Key events in the financial crisis of 2008 were the failures of two leading investment banking firms, Bear Stearns (acquired at a fire sale price by JPMorgan Chase) and Lehman Brothers (which was not rescued). Merrill Lynch was on the verge of insolvency when bought out by Bank of America. Wachovia Bank was near failure when acquired by Wells Fargo. American International Group Inc. (AIG), a major player in the derivatives markets, also was in danger of bankruptcy, saved by a federal bailout under the Troubled Asset Relief Program (TARP).

In response to the crisis, the Federal Reserve responded with an aggressive policy of quantitative easing that sent interest rates near zero. With rates still near historic lows, this policy lever has diminished efficacy today. Meanwhile, the TARP program, which injected capital into troubled financial institutions, was a one-off response to the 2008 crisis authorized by an Act of Congress. Whether Congress would vote similar emergency measures in a new crisis, and in a sufficiently rapid fashion, is anyone's guess.

If a similar crisis happened today, it's unclear how early or quickly the Fed and other central banks would be willing to move to stanch the bleeding. And it's also unclear whether U.S. taxpayers would be willing to fund hundreds of billions of dollars of bailouts  - if needed.