How to spot a financial crisis before it spots you

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Look into your crystal ball, oh wise one, and tell me the answer. How can we protect ourselves from the next financial meltdown? 10 years on, have we learned any lessons?

These crises with massive bubbles followed by enormous busts are becoming more, not less common, thanks to more and more debt driving yet more and more credit, making everything more and more unstable. Today, for example, markets have never been higher. Yields have never been lower.

You've heard about the expression risk-free return. Well, welcome to this brave new world, a world of return-free risk. The slightest mistake from here and it means a long, long way to fall.

All over the world lots and lots of allegedly clever people are working with highly complicated risk models trying to figure out what's going to be the trigger-- recession in the US, rocket man in North Korea, the credit bubble in China, or what about a massive monetary mistake made by central banks anxious to end all this money printing? The truth is nobody really knows. So let's get back to basics. To protect ourselves, we need to separate myths from realities and give ourselves a few rules of thumb to help spot a banking crisis before it spots you.

Peek-a-boo.

So forget all these outside threats. One thing we know about banking since the first Phoenicians started lending money on Rialto Bridge is that the easiest way to rob a bank is to run one. The rot starts deep within the organisation.

Hey, where's the money at?

Banks go bad from the inside out. This leads us to myth number one. The first myth of economics is that banking crises are hard to spot, because the world is so complex and so sophisticated. This is not true.

Far from being impossible to forecast, these crises are remarkably easy to spot. And they all follow the same pattern. Here are the early warning signs.

A bank starts to grow like crazy. It does so by issuing crappy loans against nominal yields. It uses extreme leverage to do this and fails to set aside money for possible future losses.

Now the second myth of economics is that the very clever people in the financial market will see all these signs and the share price will plummet. In fact, in the real world, the opposite happens. As the bank takes more and more risk to generate more return, the market gets giddy, and they drive up the share price.

So rather than the share price falling, it goes through the roof. And you know you're really in trouble when, one, the bank records record profits. Two, the chief executive gets very, very rich. Three, he's invited to Davos to address the world on the scourge of global inequality. And finally, he gets a knighthood for his services to banking.

I'm a knight.

The third myth of economics is that we learn from our mistakes. We've got new systems now that can better identify risk. We have super smart regulators, financial Eliot Nesses all over the place, and the system is much more robust.

Again, the truth is sobering. Our free market system actually encourages bad behaviour, and it rewards this reckless carrying on And of course, it's infectious.

If everybody else is doing it and getting rich, why, the CEO asked himself, shouldn't I? The real cause of banking failures and systemic collapse lies with ethics at the top. And human nature tells us that bad ethics drive out good ethics.

Magic mirror on the wall.

And great frauds start by convincing yourself that everything's OK, and then you convince others. To quote from that great Irish book about economics, finance, and corporate strategy, Gulliver's Travels, it seems like Jonathan Swift had all this sussed in the booming Dublin property market of 1725.

"The Lilliputians look upon fraud as a greater crime than theft. For they allege care and vigilance, with a very common understanding, can protect a man's goods from thieves, but honesty hath no fence against superior cunning. Where fraud is permitted or connived at, or hath no law to punish it, the honest dealer is always undone and the knave gets the advantage." Bringing me to the fourth and possibly most expensive myth of them all-- this time, it's different!