Robert Peston, the BBC’s lead reporter on the banks throughout this crisis and author of: Who Runs Britain?, presented a discussion I attended the other night.
Robert surprisingly used a PowerPoint presentation to talk through this theme. I say surprisingly as we’re so used to seeing him sit and talk for soundbite minutes, that a 45 minutes keynote seemed unusual. And with slides too!
Robert’s presentation was titled “The new capitalism: The cost of men behaving badly” and, just to be clear, he presented under Chatham House rules so the summary below is purely my spin on what he said and not his words.
First, an estimate of the losses to date.
Actually, no, it was $9 trillion.
If a dollar was equivalent to one second, it would take about 11.57 days to get through a million dollars, 31.7 years to get through a billion and back to the birth of mankind 32,000 years ago to get to a trillion dollars.
That's $1 trillion.
$9 trillion of losses.
$4 trillion came from the banking industry.
$4 trillion of bailouts, cash injections, support and relief.
Then a further $5 trillion of corporate losses in lost output through lack of access to liquidity, loans, working capital and trade finance.
About 300,000 years of spending a dollar a second.
That’s 25% of the world’s global output.
A quarter of the world’s output lost due to this silly crisis created by what?
This is best illustrated by the example of Goldman Sachs' Black box event back in August 2007.
This is where David Viniar, Goldman Sachs' CFO, said: "We are seeing things that were 25-standard deviation events, several days in a row. There have been some issues in some of the other quantitative spaces, but nothing like what we saw last week."
A "25-standard deviation event" only happens once every 100,000 years or more according to the models built into the systems, but then they occurred several days in a row and the Goldman Sachs fund lost $1.5 billion.
In other words, banks were organised and managed using bad science.
Now, was that down to too little regulation – ‘light touch’ – or just bad regulation?
To be truthful, it is an indictment of regulation that didn't work combined with a failure of Alan Greenspan’s science.
You see, Greenspan prayed to the lords of securitisation and light touch regulation. He believed markets regulated themselves through competitive forces and securitisation worked because it distributes risks widely across the markets.
But there were two errors in Greenspan’s thinking that went wrong.
The first was the belief that banks only lent money after checking that a borrower had the ability to pay it back; and the other was the belief that banks would lay-off risks to others and spread the risks widely across the markets.
The banks did not do this. In fact, they retained risks because, once this was repackaged and given a AAA rating, it was easier to keep on the banks’ books as assets rather than spreading them around outside the markets.
And in all cases, the regulators missed this trick because they were looking for crooks rather than idiots. This was not criminal activity, just incompetence and the FSA and SEC just thought management of these firms were regulating their staff misbehaviours rather than looking for such malfeasance.
This is why we expect too much from regulation as, to be honest, there was more regulation than you could shake a stick at before this crisis, and much of it was on a statutory footing.
So this was a failure of regulators, regulation, management and markets … but the overall failure was not caused by these factors but more by a failure of theory.
This is because conventional analysis saw the housing and market bubble as harmless, and the theory was that the housing market wouldn’t need to be propped up by bank of England. But that theory was wrong due to the fact that there was far too much lending at far too cheap a price, and the theory that liquidity would remain stable and available was wrong.
The result is that we borrowed more than 100% of GDP and personal sector borrowing today is running at around 170% of GDP.
That’s ridiculous and has increased by around 70% since 2000, and it was unhealthy back in 2000 as a result of eight years of unparalleled growth in the economy.
So here is the horrible paradox: compliance meant that any banker would tell you that regulation was severe and intrusive. The result is that we bred a culture of compliance where, if the boxes were ticked and all ok, then the deal was ok. This meant that no one asked whether the deal was sensible or ethical, in a more fundamental sense.
It was this culture of box ticking that resulted in the biggest regulatory failure any of us will ever witness.
But it was more than this, because the box ticking issue lay with the false comfort provided by experts.
The credit-rating agencies priesthood meant that even the Bank of England paid homage to these priests. They gave the best AAA ratings, which were meant to be for the nicest investments, to the stinkiest investments. The AAA rating was given to stinky products because of lousy data and a confusion between solvency and liquidity.
The primary thing they got wrong was using data for defaults and repayment difficulties from the 1990s. This data was created when the market was only worth a few billion dollars and it said the market default rate for mortgage repayments would be the same for a massive market, doubling every year, as it was for this tiny market. In other words, the data was extrapolated from a very small sample to a much bigger one.
In retrospect, it was a classic error.
Another part of the error was the assumption was that an investment could be sold at any time to create solvency. This belief was that money tied up in assets could be turned into cash fast … but you cannot do that when liquidity disappears, which is why the losses and rescues occurred because banks thought solvent were not. The belief they were solvent was based upon a belief in their asset liquidity, which just wasn’t there.
This is due to the alphabet soup of CDOs, CLOs, SIVs, ABS, RMBS, CMBS, CDS.
These instruments all packaged up risk and allowed banks to borrow short and lend long. There’s the rub, because if everyone wants their money back you don’t have it, with all of these Structured Investment Vehicles exacerbating it all.
The capital question is also of huge importance to all of us, even though almost no one took any interest. This is because most people don’t understand how banks work.
Under international rules, banks can lend a part of their capital but must keep some back in case it was to the wrong people.
The issue with this is that no single issue in bank regulation is more important than this one, and yet no-one knows the answer as to what is the right level of capital a bank must retain.
We’ve had Basel and Basel II, and still there was a shortage of capital. That shortage is the reason for this crisis. Have you ever heard a politician discuss bank capital before this crisis?
This failure to debate t
he most basic question in our system has been the core of this crisis. Those basic questions are how much capital should banks hold, and how much capital in total do banks need to retain to cover their total lending?
This is why liquidity was ignored as no-one believed liquidity could just dry up.
And what happens if everyone asks for their money back all at the same time? Especially if your counterparties ask, which are those who have the major exposures to each other?
That’s what the issue was, and this is what caused the biggest run since 1913 on the financial system.
It was because liquidity dried up, all the counterparty banks asked for their money back, and many banks just did not have the capital or access to assets for solvency to cover their exposures.
There were other factors but, generally, the false comfort of statistics and maths was a systematic distribution of common sense. This is why people didn’t ask the stupid questions such as: if we are lending two to three times the buffers of capital we used to, why? Where’s the protection in that?
RBS were leveraged by a factor of 40, and their board thought there was no subprime exposure because they had the illusion of insurance. But their exposure was to insurance, not subprime lenders which is why they thought this. And the insurers didn’t have the resources to make good on subprime loans if the worst happened, so they were taking false comfort too.
The lessons of this crisis are therefore:
Don’t be in awe of experts;
Challenge the science; and
Common sense normally trumps statistics.
Oh yes, and the reference to men behaving badly … interesting note: did anyone notice that not one leader who has been named and shamed in the banking industry has been a woman?
They're all men!
But then, these facts and quotes from a recent article in the Independent explains it all:
- almost half the women in senior positions in investment banking
have no children, according to research from Cranfield University.
- the wage gap in the banking sector is about 40 per cent, almost double the national average of 23 per cent.
- most investment banks now recruit almost equal numbers of men and women
graduates, but at managing director-level, women account for between 5
per cent to 15 per cent of staff.
- almost three-quarters of City
professionals believe the recession will be an opportunity for women to
change careers, while 60 per cent think it will reinforce the glass
"Work by a team from Cambridge University who measured testosterone
levels in a small group of male City of London traders at 11am and 4pm
on a number of days, and matched the results to the same days' levels
of profit or loss. They found that testosterone levels were
significantly higher on days when traders made more than their average
"Financiers are like sportsmen, the study suggested. On
days when they have testosterone coursing through their veins, their
confidence rises and they produce the results expected of them. But the
research pointed to a downside to trading floor frenzy. Too much
testosterone can be addictive, driving over excited males to take more
and more risky decisions.