Complete Blog 5 - Financial Crisis Failings

Prior to watching the documentary ‘Inside Job: Storyville’ I thought I was quite informed about the general factors which contributed towards the financial crisis. Upon watching the documentary, however, I have enhanced my understanding considerably because it was from a US perspective. 

The Growth of Financial Services

Let’s go back three decades, when financial services companies were simpler. Investment banks were small partnerships. It was the partners’ money at risk, so it was in their best interests to make prudent investment decisions. Retail banks were localised, with deposits being loaned out into the communities in which they operated. The segregation of retail and investment bank activities protected consumers from major losses.

Then deregulation came along.

Investment banks listed on the stock market, providing them with an abundance of other people’s money – creating a heads we win, tails you lose situation. The lines became blurred between retail and investment banking through merger and acquisition activity, which consolidated the financial services landscape. Subsequently, with access to new markets and funds, financial services profits skyrocketed and so too did its importance to the US economy. It undoubtedly created financial services conglomerates which were too big and too interconnected to fail.

What I cannot comprehend is the similarity this has to the Wall Street Crash. The blurring of banking activities created a casino industry which blew up in the 1920s. Regulators, and all who were impacted, understood the need for reform at the time and hence the Glass-Steagall act was implemented. Yet, seven decades later the majority of the act was repealed. It is as though there is a collective amnesia among people in power, they seemingly neglect historic reflection to everyone's detriment. While in recent years the Volcker rule has been introduced (and Ring-Fencing in the UK) to remedy the repealing of Glass-Steagall which was instrumental in exacerbating the breadth of the destruction, I would not be surprised if this was repealed in the years to come and another financial crisis ensues (at least David Grundy will have a new list of 'Finance Documentaries' to watch for his cohort of Corporate Finance students).  I will certainly continue reading up on historic financial events to ensure I am informed about these failings should I rise to a position of influence in the future.

The Politicising of Financial Services

On the whole, I view politicians as intrinsically immoral individuals. So, it is of little surprise that the selfish and unscrupulous investment bankers got on so well with them. The two groups remind me of the egotistical Apprentice candidates, you just know they will throw everyone and anyone under the bus to save or enhance their own position.  

My view is that the entangled nature of this relationship was toxic for all external parties. The importance of financial services translated into power over political institutions. There were a number of investment bankers appointed to prominent positions within Government. As a tax payer, I would have no qualms with Government agencies filled by people with business experience who are at the top of their professions and would actually advocate it. However, once they are in this position, their decision making would need to be objective. Having built a career and strong network of friends through investment banking, I have to question in whose interests were these Government appointed investment bankers making decisions; their kin or the general public. I wouldn’t consider it cynical to say that it was indeed their investment banking kin. This created a virtuous cycle for investment banking to become even more powerful and influential in Washington. It makes me lose faith in those who are in charge, they need to try to make the world a better place instead of making their personal world wealthier. That should be the only reason to be in a position of power / public office, and it is clearly not the case. 

One of the most influential actions was to remove the leverage cap on investment banks. As I have discussed in a previous blog, leverage is the debt : equity ratio of a corporation’s capital structure. By increasing debt (the cheaper form of finance), returns could be generated significantly above the cost of debt in the boom years. Investment banks wanted the cap removed so as to maximise their profits. What we know from Corporate Finance 101, however, is that debt magnifies the losses in the downturns, as well as the profits in the good times. Thus, by removing the leverage cap, investment banks losses were exacerbated during the financial crisis. Again, this highlights the importance of learning lessons - the losses this utter short termism and lack of foresight created cannot be forgotten during future cyclical boom years. 

Academia’s Corruption

This was one of my key learnings during the documentary. Before attending University, my impression of higher education was that it was impartial, allowing students to come to their own conclusions about topics.

I believe this previous view, of trusting academics to produce objective analyses in their papers, was and still is widely held among the public and investors alike. In my final year, I am aware that lecturers’ own views come across in their teaching, despite trying to present a balanced picture. However, what I found downright offensive to academics is certain high-profile economics professors taking fees from nation states (Iceland) and Investment Banks to produce papers outlining a significantly more favourable, if not completely fabricated, view on their riskiness. Moreover, the fact that these fees were not disclosed anywhere undermines the papers’ authenticity by having a complete disregard for transparency. The ignorance of any wrongdoing from the academics interviewed dwindled further my faith in humans. Despite not being engaged in the Applied Business Ethics module, this programme gives me reason to believe it has an importance. This is arguably one of the takeaways from this documentary; the teaching of ethics in finance and economics is essential to create an environment for my generation of finance graduates to improve the industry's global reputation.

There was an excellent point raised by the interviewer in which he compared it to doctors. “If a doctor writes a paper saying to treat a disease, one need to take drug X. Would it not be important to disclose that they received 80% of their income from the company that produces drug X?”. Of course it would. Without this transparency, there is a lack of credibility. In this age of fake news, who knows what hidden motives people have for saying the things they say. The politicised financial services industry had, the once credible, higher education profession under its thumb thanks to a few brown envelopes – corruption exemplified in my eyes. This created an environment which prolonged the boom, but intensified the crash and recession.

Financial Engineering

Technological advancements had been assimilated into every industry, so I do not believe that finance should have been exempt. I therefore support the principle of financial innovation and derivatives. I believe they were good intentioned. Having the ability to hedge exposures to provide certainty in a world which craves it, should, on the face of it, have been beneficial. However, where this became somewhat problematic was that somebody would have to take the opposite position – ultimately a bet against. While the idea of certain derivatives were to be much admired in my view, they opened a gateway to provide market participants with more ways to essentially bet on anything related to the markets – which, unsurprisingly, led to abuses.

Despite it sounding like a sensible idea, the regulation of derivatives was banned. With the perfect vision of hindsight, this is arguably one of the great failings and causes of the financial crisis in my opinion. With the political influence and lobbying power financial services had, they were able to pressure the government into ensuring that derivatives weren’t regulated*.

*I see crypto-currencies currently in a similar vein to derivatives in 2007 and prior. There is significant hype around Bitcoin and others. The transaction costs and price volatility make it difficult to be classed as a currency. If it is an asset class in its own right, it needs to be regulated (which defeats much of its purpose of being de-centralised). Without regulation, they will be susceptible to scams and abuses to the detriment of market confidence and consumer trust. 

This lack of regulation and complexity allowed financial innovation to spiral out of control. The securitisation of mortgages meant that lenders were no longer at risk if counterparties defaulted on their loan. While I don’t believe it was right, it was understandable that this ‘no skin in the game’ led to a decline in underwriting standards. This meant that loans were granted on the assumptions that house prices would rise continually into the future. An obviously unrealistic and utopian view from lenders and mortgage derivative traders. Prudent leadership should have thought about the adverse consequences but instead were all too happy raking in their quarterly bonuses, which cascaded down the organisation to create a toxic short term culture.

Light Touch Regulation

During my placement year, I dialled into a conference call for the whole of Lloyds Banking Group’s Risk Division. At the end of the call, one of the questions suggested that regulation was one of the biggest risks to banking in the future. At the time I agreed. During the summer, however, I managed to read a couple of books on the financial crisis and to me, they highlighted the failings by regulators in protecting consumers and the markets. It is only upon reflection now that this comment during the risk conference call makes more sense. I agree to some extent still that regulation is a major risk to banking because of the uncertainty PSD2 / CRDIV / Ring-Fencing and others may cause.

However, the track record of banks is actually quite embarrassing with money laundering, rate rigging and mis-selling scandals happening every year – and this is motivation for me going into the banking industry, to play a role in rebuilding the decimated reputation of British Banking. I really do not buy into what the Chief Lobbyist of the Financial Services Roundtable said in defence of these scandals, “When you’re this large and with this many products, mistakes happen”. My life has taught me that mistakes do indeed happen. But what was emphasised during my placement year was that mistakes can be accepted, but what can’t be accepted is making the same mistakes consistently and not learning and reflecting upon past experiences. And it is for this reason that I believe many people find it hard to sympathise with these Financial Services Corporations – because the same conduct shortcomings and scandals arise repeatedly.

Therefore, while a stringent regulatory regime may be burdensome for financial services corporations, I see regulation as a metaphorical straight-jacket. Yes, it protects other people, which in this case is the customers and investors. But the part financial services corporations neglect is that regulation actually protects them from self-harm and implosion. And while I didn’t think I’d be comparing banks to mentally-ill patients' attire when I started writing this, I feel it is fitting nonetheless. In my view, the light-touch, and often self-policing, regulatory stance is fundamentally flawed. People cannot be trusted to make shrewd forward-looking decisions and look out for other stakeholders’ interests, especially when the culture and financial incentives imply the opposite is right. Thus, I feel regulators should have increased power to protect consumers, despite having the potential to stifle innovation.

Credit Rating Agencies

Similarly to academia, a few years ago I would have expected CRAs to be objective in their work. This confidence has been severely eroded.

The nature of the ratings agencies meant they were essentially competing against each other to rate securities higher. They were paid more the higher securities were rated. In my view, the whole idea of a company paying for their ratings is morally wrong. Much like auditors, I believe there is a clear conflict of interest. By providing a payment, the objectivity of the decision is questionable. The CRA defence was that the ratings were just their opinion of the creditworthiness of securities. They actually stood up in court and said that. Despicable. Even if its not explicit, the market’s implicit assumption is that CRA ratings provide an unbiased view of creditworthiness, based upon a body of evidence. So by saying it was their opinion, I am saying evidence can prove opinions to be factually incorrect. A combination of sub-prime mortgages CANNOT produce a credit rating higher than many sovereign nation states’ debt and equal to the US’s. This whole notion is irrational, so by saying it was their opinion allows me to conclude that they were incredibly incompetent or lying. It is probably a combination of both if I’m honest.

As a sidenote, I actually think there should be a complete overhaul of the CRA system to reduce the corruptibility of credit ratings. Something along the lines of paying the regulator the fee which previously went to a CRA, and the regulator chooses a CRA instead of the company. I of course do not know the exact details of how it would work, otherwise I’d be working for Moody’s as Chief Strategist, but what I do know is the current system is broken and needs fixing.  

Summary

This blog provides just a snapshot of some of the main reasons I believe were influential in causing and exacerbating the financial crisis. Ultimately there were myriad reasons and opinions will vary, so I would advise watching the programme and reading some books to start forming your own views. I believe each of these factors facilitated one another and this created a perfect storm of problems for the global economy. The fact that regulators and key investment bank leaders did not want to be filmed for the documentary provides sufficient evidence for me to conclude they have guilt on their conscience. The overarching theme of the documentary was ethics. History has told that finance and ethical practice are seemingly incompatible, however they are not. As I have mentioned in previous blogs, it is the shareholders who are often responsible for demanding short term returns. However, it is finance leadership who should stay true to their values and pursue a strategy which is underpinned by ethics. It is only through transparency, accountability and a genuine attempt to do the right thing in which trust will be rebuilt in financial services. 

So, has the Wall Street Culture changed?

I am unconvinced it has, and dubious about whether it actually can. Ethics teaching in business schools will go some way to remedying that but organisations needs to take responsibility for creating an environment in which ethical practices are encouraged and rewarded.