It may seem surprising that big global banks couldn't do anything to protect themselves from failure even after more than a year since the credit crisis started. When the market turns exuberant and runs ahead of regulatory structures and systems, crisis follows. By Shivshanker Verma

Like the hurricanes in the Atlantic, the global credit crisis hardly appeared threatening in the beginning.

Now more than a year we have all been sufficientlu enlightened in considerable detail about the US housing market, where a decline in home prices led to defaults in what they call sub-prime home loans. That was no big deal, but what followed definitely was.

We were told that these bad home loans were sliced, packaged and sold to investors as far away as China and Norway and therefore all those investors ended up with losses. The big global banks who had large chunks of these securities announced huge losses on asset write-downs. Too bad for them, we thought, now the end is sight, we reassured ourselves.

Credit spreads surged and credit availability shrank, forcing central banks to step in and pump liquidity. Even then, the first global credit crisis since the Asian financial crisis of the late '90s appeared to be only a tropical storm and not yet a hurricane.

The proactive central banks managed to cool down the credit markets for a while. Just when the worst seemed over and we were all distracted by the big surge in crude oil prices, credit markets were nearing an even deeper precipice. As asset prices declined across the board, financial institutions roiling under heavy losses found it increasingly difficult to raise additional capital and strengthen their balance sheets. Suspicions about each other's balance sheet made banks cautious about lending to other banks, which in turn pushed the weakest among the lot to the brink of bankruptcy.

When investment bank Bear Stearns was about to go under a few months back, the US Fed stepped in and brokered a takeover by JP Morgan (see: US Fed bails out Bear Sterns through JPMorgan Chase)  Then came the de-facto nationalisation of home loan refinance companies Fannie Mae and Freddie Mac, with combined liabilities of more than $5 trillion, by the US treasury (See:US Fed bails out Bear Sterns through JPMorgan Chase) The authorities backed away when big investment banks Lehman Brothers and Merrill Lynch were staring down the barrel, forcing the former to go bankrupt  (See: Lehman Brothers heads for Chapter 11 as Barclays walks away) and the latter to be taken over by Bank of America (See: Bank of America buys Merrill Lynch) Just when everyone thought US regulators were done with bailouts, the Fed took over insurance giant AIG to avert a collapse and market panic that would have followed (See: $85-billion bailout for AIG)

It is a full blown crisis now, a financial hurricane, the like of which the world has not seen since the first half of last century.

How did it come to this?

To the rest of the world, it seems quite incredible that the 'masters of the universe' in the financial services industry didn't foresee this crisis. Even as late as last year, the big Wall Street firms were doling out huge bonuses to their employees. Annual bonuses at Goldman averaged more than $300,000 per employee and totalled over $12 billion last year. Top management compensation at each of the top five Wall Street firms and most big commercial banks ran into tens of millions of dollars per executive last year. During the first half of this year, all the top investment banks were busy hiring management graduates - including many from IIM's - at very attractive pay levels.

Even more surprising is the fact that these venerable institutions, several of which have been around for around a century, couldn't find a way to bail themselves out of total collapse even after more than a year since the crisis started.

This financial crisis is no different from the boom-bust stories that have been repeated time and again. When the boom is on, it appears like a brave new world of limitless opportunities in perpetuity and unbound confidence. This confidence later turns to irrational exuberance that leads to excesses. When the unavoidable crash comes, everyone stares at the destruction in utter shock and disbelief, wondering how they could have been so naïve in the first place!

The spectacular growth in financial services over the last decade has brought about significant changes in the way the banking industry is structured and functions. Until a decade back, traditional commercial banks performed the routine banking functions of accepting deposits and extending credit. Investment banks limited themselves to offering broking and corporate advisory services.

With the rapid growth of securitisation, or packaging financial assets like home loans into tradable securities, the boundaries between traditional and investment banking blurred. The investors who put their money into these derivative instruments were not very different from traditional bank depositors, except that they sought higher returns than what traditional banks offered on deposits.

The complex structuring of these securities and the high credit ratings given to them by reckless rating agencies fooled investors into believing that such securities are no less secure than traditional deposits or high quality bonds.

Traditional bank depositors are protected by the bank's capital base and by deposit insurance in the event of a bank run. But, investors in derivative securities are directly exposed to the default risks which unfortunately they were not aware of or believed will never happen. When housing prices started falling in the US and the home loan borrowers defaulted, these investors were caught completely unawares.

Financial sector regulation and the systems in place to absorb credit losses were designed for traditional banking models. For instance, until recently only traditional banks which accepted deposits from individuals were allowed to borrow from central banks like the US Fed to tide over liquidity problems.

To protect against default risks, investors in derivative securities could buy credit default swaps, but they are worthless when the issuing institutions are under financial stress. Also, financial institutions other than traditional banks are not subject to capital adequacy or solvency norms and their activities are not monitored by regulators. By the time central banks and regulators woke up and extended distress lending to all financial institutions, it was too late.

Financial securitisation has undoubtedly helped overall economic growth by increasing accessibility to cheaper and easier credit for millions of retail borrowers. But too much of a good thing can be really harmful, especially when the environment turns for the worse. Securitisation helps spread credit risk among a large number of investors, which pushes down the risk premium demanded by lenders and hence overall lending rates go down. However, when investors are loaded up on these securities, their aggregate risk levels are no less especially when credit defaults happen across the board. Also, the lower risk perception encouraged most financial institutions to be less conservative with capital adequacy levels. So when the crisis hit, they were all unprepared and under-capitalised.

During the early days of the crisis, banks could raise additional capital as sovereign wealth funds were flush with money and looking for opportunities. With oil and other commodity prices under pressure and higher risk perceptions, such investors are now very cautious. Lehman Brothers was in negotiations with many sovereign funds, including South Korea, but nothing happened. The US Fed was forced to take over AIG after the insurer failed to attract private investors. When fear rules, capital disappears and financial crises become worse.

It is still too early to say the worst is behind us, especially since the global economy is slowing down and the crisis can easily spread in a weak environment. But, it is certain that it will be a while before stability returns to the world of finance. By then the sector would have seen a complete restructuring and tighter regulations will be in place. Hopefully, it will take much longer before the financial wizards become exuberant again and bring us another crisis.

(Also see: The financial world reels)