Double, double, toil and trouble . . .

Fire burn and cauldron bubble (and that’s not all that’s bubbling)

A version of this article appears in Risk & Compliance magazine, January – March 2014

It is 500 years last year since the Florentine diplomat Niccolo Machiavelli first distributed The Prince (as it later became known).  While many (most of whom appear not to have read it) criticise Machiavelli for dubious morality, The Prince is a foundational masterwork of realist observation and prescription.  Machiavelli’s principal point is that we should see the world as it is, not as we might wish it to be; we should respond to the reality, not to the preferred perception.  Instead, as French-American novelist Anaïs Nin pointed out, we see the world as we are.  More problematically, we often see the world as we are conditioned to see it, with little appreciation of our ‘perceptual filters’.  Regulation results in such filters and, thus, plays a material role in  conditioning our perception.  Regulators and regulation are not neutral; they play a material role in how banks and people in them see and make sense of the world in which they operate.  So, getting regulation right matters.  Regulators need to try harder and more realistically.

The global financial crisis which began in early 2007 and then amplified with interbank credit squeeze following the decision by the US Treasury not to support Lehman Brothers in September 2008 has not yet even nearly played out.  The effects of the medicine – central banks’ so-called ‘quantitative easing’ – may end up being almost as bad as the disease it is intended to address.  While banks’ balance sheets are in better shape than they were pre-crisis, European banks, especially, are still blighted by vast swathes of underperforming assets.  Worse, the managerial adjustment that should have followed such a crisis has been attenuated by central bankers’ interventions and further distorted by some frankly nutty legislative responses, especially (again) in the EU.  We are no further ahead at understanding interconnectedness and network propagation of risks or at being able to respond to them to avert crisis.

One of the functions that came in for profound criticism during the early post mortems of the financial crisis was banks’ risk management; many commentators held that banks’ risk management functions had focused on the wrong things – that they missed the real risks in markets and instruments that were building over the course of the decade as economies bounced back from the crash of the dot com boom at the start of the decade.  That is, undoubtedly, partly true.  But, crucially – especially when it comes to thinking about what to do next, partly untrue; it mis-apportions real blame.

Most banks’ risk management functions did exactly what was expected of them.  They calculated risk capital against clearly expressed formulae that permitted firms to mark assets to market (and realise profits on trades at point of trade) and marked to models based on what economists call proxy or shadow prices.  They applied the weights offered by regulators and were invited, if they so wished, to calculate risk-capital requirements more conservatively, which would, of course, reduce their profitability relative to their peers.

Such was the regulatory environment of the omniscient Basel Committee on Banking Supervision.  It relied on weightings of independent credit rating agencies and treated all EU sovereign debt as uniformly low risk.  Within this framework, the growth in complexity of instruments was astonishing.  Ever-more-complex models supported ever-greater financial sophistication.  Of course, such sophistication appeared to improve the precision with which investors could price risk and thus allocate risk, providing for improved “market completion”.  Furthermore, central bank intervention had been shown to be effective in responding to bubbles and crisis as it did when the collapse of Russian debt values led to the bust of Long-Term Capital Management almost exactly nine years before Lehman Brothers collapsed and following the dot-com bust after the NASDAQ had peaked in March 2000, having doubled in twelve months.  Alan Greenspan had blue tights and a cape.  Take away the punch-bowl?  No, just buy a new one.

A few pessimists – a handful of ‘dismal scientists’ – were thinking differently.  Prior to the adoption of Basel 2, academics at the London School of Economics wrote a swingeing and remarkably prescient criticism of the framework and its efficacy in avoiding crisis – their criticism was ignored.  Even within central banks, not all were believers.  In London, in Vienna and in Mexico City, small teams of central bankers were looking differently at how risks propagate across a financial network during a crisis – how systemic risk is different from the sum of individual institutional risks.  In 2007, their work was preliminary and marginal, but it is important to acknowledge that it was underway.

But, elsewhere – and even in those jurisdictions – the regulatory train chugged on up the slope created by the inflating bubble; with boom and bust, in the words of Britain’s then Chancellor, ended, it was a safe train to be on.

In his 2009 critique of the failure of risk management during the financial crisis, American risk consultant Douglas Hubbard states, “the ultimate common mode [node?] failure would be a failure of risk management itself. A weak risk management approach is effectively the biggest risk in the organization.”  This may or may not be wisdom after the fact; I do not recall Mr Hubbard criticising risk management so vociferously before the financial crisis (but that may be a failure only of my memory).  But, it is demonstrably false; the biggest risk to the organisation is following slavishly (as they were required to do) a regulatorily-mandated risk management approach that was flawed.  It turns out that this is exactly what most firms did.  The biggest risk turns out to have been doing exactly what regulators required them to do.

So far, so good; everyone knows this, pretty well.  The difficulty arises in that, despite the optimism of G20 in 2010 and the creation of the Financial Stability Board and passage of the relevant sections of Dodd Frank, little has changed.  Indeed, in Europe, legislative silliness – in the form of unworkable and counter-productive and, arguably, ultra vires provisions around bankers’ pay – is now the order of the day; sitting through regulators’ technical sessions thereon, as I have recently, can only be described as Kafkaesque.

The underlying regulatory approach to risk in the global financial system has barely moved.  The levels of the dikes have been raised: banks have been required to deleverage and regulatory capital tests are more stringent.  However, with the exception of the very sensible concept of banks’ living wills, little has changed.  The progress on system-wide approaches to interconnectedness and to the pathology of crisis in an interconnected global system has been derisory; attention has shifted to creating another bubble to lift us out of the slump of the last one – sorry, that should read “quantitative easing.”

Even more asinine, most notably in the UK but also globally, is the move to regulatory attention to firms’ cultures.  How supervisors without any advanced training therein can be expected to opine on a firm’s culture is beyond imagining.  Without a hint of irony, the Financial Stability Board is advocating supervisors wander in to this area dominated by what Friedrich von Hayek described as “organised complexity.” The potential therein for misdiagnosis and error is astonishing; regulators have learned nothing from the mistakes of the past decade.  Instead, they have assumed the errors were all by firms and rating agencies and have begun doubling their bets.  Central bankers have misread their success in applying a Keynesian responses to the crisis of 2008; they have even misread Keynes.  The continuation of extensive programmes of electronically printing money will have an inevitable effect and more indebted countries will be less able to respond to the next crisis.

It is past time for legislators and regulators to consider how to respond to the crisis of 2008.  Yet the response is, in many ways, going in the wrong direction or, at least, not going in the right direction.  Central bankers, politicians and regulators must accept the lion’s share of the blame for this, if not also for the cavalier build-up to the original crisis.  They must start to deal with the world as it is, rather than as they find it convenient to portray it.  If not, we all risk another crisis and a sustained period of economic underperformance.  ‘Quantitative easing’ has offered central bankers, politicians and regulators somewhere to hide; few have used the time well or thoughtfully.

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