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Podcast Résonance - 2008: the sub-prime crisis – Episode 5/6

Listen to our podcast on the subprime crisis and its ongoing impact on today’s society, presented by Belgian business columnist Salma Haouach and enhanced by the views of Etienne Planchard, member of the Executive Committee and Head of Risk Management.

Welcome to Résonance, the Banque de Luxembourg podcast (in French) that takes a look at the major events of the past 100 years and shares our insights into how they have impacted modern society. How can these past milestones prepare us for the financial challenges of the future?

This is part of a series of six podcasts presenting a positive analysis of the major changes born of past crises.


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The regulations are exactly in line with the cautious approach we have always taken. Etienne Planchard, Head of Risk Management

Podcast summary

Today, anyone over the age of 20 probably recalls the feeling of relief at the start of the new millennium that everything didn’t collapse after midnight on 31 December 1999 after all.

The ‘new economy’ and the digitisation of information gave the impression that there were no limits. It was as if the perception of limitations, and thus risks, shrank as accessibility to information grew. The economy was on a roll, with GDP growth rates reaching 5%. But in 2001, the dot-com bubble burst, wiping out the tidy sum of 2 trillion dollars from tech companies’ market value and leaving 110 billion dollars’ worth of debt in its wake.

Fed chairman Alan Greenspan repeatedly lowered interest rates. In 2008 he said – for good reason, as it turned out: “Most of the time, we got it wrong.” Handing out loans to restart the economy was not enough.

And so it was that banks started to lend money to riskier profiles, hence the term sub-prime (sub: ‘below’, and ‘prime’: interest rates). Households with a riskier profile had to pay a much higher interest rate.

At the time, it all seemed risk-free. Firstly, the loans were hedged by mortgages and house prices were on the rise, and secondly, borrowings were hedged on the financial markets through securitisation.

Prevailing policies did everything to encourage home ownership. But then as now, the main ingredients of a crisis were lurking: large amounts of money in circulation, over-confidence and irrational optimism, and an economy dependent on loans to stay afloat.

In the absence of regulations, the risks taken were increasingly reckless. Many of these were disguised as safe investments and for years, traders enjoyed big profits.

The rate of profit is always highest in the countries which are going fastest to ruin. Adam Smith

“The rate of profit is always highest in the countries which are going fastest to ruin,” wrote Scottish economist Adam Smith in The Wealth of Nations.

Prices continued to rise – suddenly it seemed as if anyone could get rich. Building projects created jobs, which in turn fuelled consumption. Households increasingly fell into debt, believing they could afford a home that in reality was considerably above their means. It's not unlike the Diderot Effect, named after the eminent yet penniless French philosopher Denis Diderot who sold his library to Catherine the Great to pay for his daughter’s dowry. With the money left over, he decided to buy himself a beautiful robe. However, the rest of his possessions seemed so tawdry by comparison that he kept buying more and more until his fortune was depleted. That is how America behaved.

When the first borrowers began to default, no one was concerned. It was only when investors stopped buying stocks that the banks suddenly found themselves with fistfuls of loans that nobody wanted. Still, no one panicked. The banks were convinced that, come what may, they would be saved. The fact that it would be with taxpayers’ money was neither here nor there.

But the death knell sounded when the United States decided not to bail out Lehman Brothers, one of the oldest banking institutions, instead forcing the bank to face its responsibilities. That first failure led to the end of the financial world as we knew it. The entire global economy was now under threat. Governments were forced to inject billions of dollars to guarantee their country’s economic stability. Many of these securities and debts were intermixed – the natural knock-on effect of globalisation. The first substantial government budget deficits occurred during this period. At a time when a 60% ratio was the norm, most governments got to 100%, and in the case of Greece, 170%.

This brings us to the governance rules that banks must now apply to guarantee their financial stability. The efficient markets hypothesis of US economist Eugene Fama, winner of the 2013 Nobel Prize in Economics, revealed its flaws during the financial crisis.

Hyman Minsky, another US economist, had already theorised this, positing that a healthy economy pushed businesses into taking risks and assuming debt. And so arrived the moment – now dubbed a ‘Minsky Moment’ – when businesses realised they’d gone too far and sought ways to reduce their debt, causing not a recession but a full-blown crisis. It was this very crisis that drove governments to introduce stricter regulations to protect investment companies and banks from their own decisions.

Etienne Planchard, Head of Risk Management at Banque de Luxembourg, explains how that period resonates with his management philosophy today:

  • “Banks like ours must draw lessons from events such as the sub-prime crisis and dot-com bubble. You find the same ingredients in both: low interest rates and therefore more loans, and a widespread belief in economic fundamentals that led to a sort of “irrational exuberance’” to use the phrase coined by Alan Greenspan, Chairman of the US Federal Reserve, in 1996. And so the crisis quickly spread to the global economy as high-profile corporations were driven to bankruptcy, either after the dot-com bubble or during the financial crisis, which saw large-scale corporate failures.
  • The most rational solution people found to combat their own irrational behaviour was legislation. As a result, banks found themselves with a raft of regulations to contend with, which we, of course, implemented at Banque de Luxembourg. It required a huge investment, particularly in IT systems, but we made every effort to make it as smooth as possible for our clients. Ultimately, these regulations were exactly in line with the cautious approach we have always taken to our profession. It’s a logical extension of our mission to support our clients over the long term and do the right thing in all circumstances. It's how we ensure our clients have peace of mind as they plan their future. They are far more appreciative of our consistent performance and services than of occasional successes.
  • Such a crisis could clearly happen again since the ingredients of those two crises – very low interest rates and fashionable sectors – have not gone away. The real estate sector, for instance, is currently attracting a lot of interest, especially in the Grand Duchy. We are therefore extremely careful in the support we offer our clients, whether they are individuals or businesses. We take into consideration the feasibility of their projects vis à vis the markets, their financial strength, long-term objectives, and even their personal situation. Our goal is to properly define their ‘risk appetite’ and ensure it is consistent with ours, so that the project will be mutually beneficial over the long term.”

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