In a luxurious chateau in Alsace, France, eight years ago, a top financier made a confession: Some of the complex financial instruments being pumped out by the world's biggest investment banks were potentially "toxic."
Top regulators were left in no doubt of the perils hiding in the financial system after the two-day summit aimed at finding and disarming the "bombs" waiting to explode.
The warning proved to be prescient. About a year ago, one of these bombs exploded. The ensuing credit crunch could lead to a complete redrawing of the financial map and may even herald the end of globalization.
The toxic instruments highlighted by the banker were collateralized debt obligations (CDOs). Little was known of them when this regulatory teach-in was taking place, but since then banks have embraced them as a way of shifting debt off their balance sheets, enabling them to lend more. They have been bought enthusiastically by many investors across the financial system. As they began to blow up last year, there was mayhem at banks and brokers on Wall Street, which, in turn, sent shock waves through the world's financial markets.
CDOs are the villains of the market turmoil. Before they unravelled, however, they fueled easy credit and economic growth in many developed economies.
Britons amassed a record £1.4 trillion (US$2.77 trillion) in debt - more than Britain's GDP - as banks loosened their lending criteria. Millions of Americans with poor credit histories who might not otherwise have bought their homes were granted subprime mortgages.
But as gridlock gripped the markets, the repercussions have been painful. A record number of Americans are having their homes repossessed. Britons are finding it tougher to obtain credit and home loans. The damage is still being quantified, but it is already far-reaching. British bank Northern Rock was nationalized by an embarrassed government. The US Federal Reserve orchestrated the rescue takeover of investment bank Bear Stearns. Rogue traders were found at French bank Societe Generale and Swiss bank Credit Suisse.
`Old-fashioned banking'
Financial regulators now talk of a return to "old-fashioned banking," in which banks grant loans only to clients they know and from resources already available. It is starting to happen.
Last week in Britain, First Direct - part of HSBC - withdrew all mortgages apart from those for existing customers, while other lenders are demanding bigger deposits before handing out home loans. The US is redrawing the regulatory landscape for its financial services industry - as it last did after the Great Depression - and the British Financial Services Authority (FSA) is hiring 100 new regulators. Some bankers concede that fear is stalking the financial system and that markets have become so complicated that it is difficult to work out exactly what is going on.
Terry Smith, who 20 years ago was the City of London's top-rated banks analyst and is now chief executive of the money-broker Tullett Prebon, admits that calculating banks' vulnerabilities is harder now.
"I could tell you Barclays' [bank] sensitivity to a 1 percent move in interest rates," Smith said of the situation 20 years ago.
These days, the straightforward business of taking in deposits and lending the money out to others has become more sophisticated through the use of financial engineering such as CDOs.
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