For a brief moment in October it seemed as if the world’s financial systems were about to implode. What was once unthinkable, and if we are to believe many financial models, unimaginable, was actually happening. Rock solid corporations were crumbling, governments that had long espoused free market capitalism were rushing to bail out banks, in many cases through part or complete nationalisation.

As is always the case, along with the woe, there was plenty of finger wagging. A once in a lifetime financial crisis is bound to be accompanied by some serious recrimination. And so it has proved.

In the frame are a number of people and practises associated with the crisis. But perhaps three are mentioned more than most as the principle offenders: banking bonuses; light touch regulation; and financial innovation. All three have been identified as culprits at the heart of the current debacle. But how culpable are they?

Executive compensation and the bonus system
The accusation: The compensation system for many employees in the financial services industry is rigged in a way that encourages and rewards excessive risk taking.
When those risks pay off, profits are privatised in the form of huge salaries and bonuses for senior executives, traders and other employees. Yet when the risks prove a bridge too far, resulting in staggering losses, and, in some cases, destroying companies and billions of dollars in value, the losses are socialised. Banks are recapitalised. Ordinary shareholders and taxpayers lose out.

Plus golden parachute deals, and other aspects of executive compensation, mean that senior executives can still receive significant payoffs when they step down (or are removed), despite presiding over, and presumably approving, the risky, often highly leveraged activities that underpin the slump in the value of many financial stocks.

In defence: If you don’t pay the market rate, the best talent will go elsewhere, whether it is another firm, or another industry. Moreover, financial service firms operate in a global market. So the level of compensation must match the best available globally.

And only a small number of people have the experience and skills required to operate as senior executives, or in various specialist jobs, at firms like commercial or investment banks. Therefore these people can justify what might appear extravagant compensation deals, including golden handcuffs and parachutes. Also, employees need incentives to perform well; the greater the incentive, the better the performance. The prospect of significant profit related bonuses as a major percentage of a compensation plan, drives performance.

The verdict: It is true that in competitive markets, firms must pay attractive rates to attract talent. This needs addressing. If people are rewarded according to performance, then some will be tempted to focus on hitting short-term targets to trigger maximum rewards rather than concentrating on the long-term consequences of the business they are doing.

One suggestion is to introduce some kind of time and performance linked provision with bonuses, such as placing them in escrow, thus allowing claw back in the case of poor performance. As for the global market for talent argument, that is not persuasive. The compensation differential may need to be fairly significant to get people to uproot their lives and relocate to another country. And it should not be assumed that experience gained in one country or market will translate to another.

Light touch regulation
The accusation: That the financial services industry failed to appreciate lessons learnt following US stock market crashes in 1907 and 1929. After the 1907 crash, betting on whether shares went up or down without actually owning those stocks was outlawed. After the 1929 Wall Street Crash, the Glass-Steagall Act passed in 1933 separated the operations of commercial and investment banking.

By the 1970s, however, despite decades of relative financial systemic stability, senior executives grew restless for better growth and shareholder returns. The Glass-Steagall Act was finally repealed in 1999. The Commodity Futures Modernisation Act of 2000 removed derivatives from federal oversight, and rendered the bucket shop laws obsolete.

It is no coincidence that, as the regulations were relaxed, systemic financial crises mounted up.

In defence: External regulation stifles financial innovation, and the ability of firms to provide the best service for their customers, and the maximum value for shareholders. Compliance with external regulation is often very costly, having an adverse competitive impact on business within a particular jurisdiction, with respect to businesses outside that jurisdiction. While oversight is required, it is best provided by the people who have the most appropriate industry specific experience – in this case the financial services sector itself. This is a free market after all, and supply and demand should be left to fend for themselves.

The verdict: The concept of self regulation has been hugely discredited in the wake of the current crisis. Surely if light touch regulation is effective the global financial system wouldn’t be in this mess. However, with the financial services sector playing a significant role in economic growth, particularly in the US and UK, governments are reluctant to interfere when things appear to be going well. And financial institutions are a powerful lobbying force.

Inadequate regulation has played a fundamental role in the credit crisis. But, despite the obvious regulatory shortcomings, and the expected tightening of the regulatory environment through legislation in the short term, history suggests that after an initial rush to regulate, lobbying by powerful corporations, and the lure of significant returns, will once again lead to deregulation over the longer term.

Financial innovation
The accusation: Warren Buffett is right – derivatives are financial weapons of mass destruction. Brilliant engineers at investment banks used their talents to create exotic financial instruments, which in turn were used, among other things, to move loan default risk away from lenders to other investors, and in ways that make it very difficult to understand the level of risk involved in the underlying investment.

Collateral debt obligations (CDOs), as sub-prime mortgages, bundled together, sliced up, repackaged, credit rated and sold on, were used to create a vehicle for speculation on the repayment of mortgages. Then credit default swaps, a $54trn market, invented ostensibly to be able to hedge the risk of default on the CDOs, were used to bet on the future solvency of companies.

In defence: Financial innovation is essential for economic growth. After all, many aspects of finance that we take for granted, such as credit cards, or mortgages, are the product of financial innovation. Nor is there anything intrinsically wrong with derivatives. They are an important and useful device for reducing risk through hedging strategies.

The verdict: One unfortunate outcome from the existing crisis is that financial innovation has a bad reputation. Yet it must be encouraged, not legislated. Alongside that innovation must be transparency. Derivatives are a $500trn market. Credit default swaps a $50trn market. These products need to be regulated and traded in transparent markets. Financial innovation is a good thing, providing it is used responsibly.

Regulators could ensure that originators of loans, and those parties that sell them on, are required to leave some risk on their own books, rather than offloading to a third party, thus leaving the originators of the loans, and those that securitise them, with no incentive to do due diligence.

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