Wednesday, 17 September 2008

Crash

Take one big investment bank. It employs, amongst other people:

  • traders: who follow market movements and book the deals;
  • salespeople: who manage the relationship with counterparties and talk to them about what sort of business they want to do;
  • research analysts: the economists, who tend to specialise in particular business sectors and analyse developments in the financial world (and also political developments) which are likely to affect commodity prices, equity prices, currencies, and so on;
  • credit risk analysts: who assess the creditworthiness of potential counterparties and factor this risk into the price of a trade (this is partly based on ratings given by credit ratings agencies like Moody's and Standard and Poor, but they also carry out their own research)
  • market risk analysts: the so-called 'rocket scientists', who use sophisticated financial modelling to predict future market movements and factor this risk into the price of a trade (here's an example - the Black-Scholes model for options pricing)
  • lawyers: who document the trades to allow for netting of obligations, which significantly reduces exposure, and ensure compliance with regulatory requirements
  • accountants: who monitor capital adequacy requirements (i.e. that the bank has the required capital set aside in order to meet any likely call on its funds - this figure is reached by looking at the credit rating of counterparties, market risk, existence of netting agreements, diversity of portfolios, etc), and
  • settlements team: who arrange for payment of monies (i.e. settlement of trades), and (usually automatically generated) confirmations of individual trades;
  • senior management: not quite sure what they do, but they get paid a lot for doing it.

And of course there are also the external regulators, like the SEC and the FSA, and bodies involved in monitoring the stability of the financial system, like the Fed, the Bank of England, and the Bank for International Settlements.

So for a top player like Lehmans, there are checks and balances built into the system. (This wasn't the case with Barings, when Nick Leeson was more or less allowed to carry out the entire front and back office operation by himself - but that was then, and this is now, and they were a tiny institution by comparison).

So at what stage of the process did this break down? You can't just blame the traders, as they have to get permission to trade from the back-room boys. I suspect it must have been a combination of the research analysts and the market risk guys both wildly miscalculating what was going to happen in the housing market, and the credit risk guys being over-optimistic about the creditworthiness of the sub-prime mortgage lenders with whom the bank was trading. And then the accountants were presumably happy for all those eggs to be put in the property market basket. And the regulators weren't asking the questions they should have been, or were being fobbed off with the wrong answers.

But the buck stops with senior management, doesn't it? So I look forward to seeing how many of them are called to account when the current situation calms down, and how many simply walk away with huge pay-offs...

7 comments:

thebristolblogger said...

There's also governments unquestioningly buying into free market mythologies of the power and utilty of unregulated financial services markets aren't there Kerry?

Mrs Blogs said...

Yes, bristolblogger, but didn't 'we' the electorate vote for the new paradigm?

Kerry said...

That would be the Government that set up the Financial Services Authority (replacing the previous SROs, and now widely regarded as the best regulatory model in the world); removed banking supervision from the Bank of England and thus removed the 'old boy network' system of cosy chats between supervisors and the supervised; and has a fairly hefty banking reform bill coming forward this autumn. The markets aren't unregulated at all. I could easily occupy the next hour listing all the relevant EU directives, chapter and verse from Banking and Companies Acts, regulatory guidelines... but it's bedtime.

thebristolblogger said...

There's not much point in discussing anything with someone who thinks that the FSA is "the best regulatory model in the world".

Most people would just look at the Northern Rock debacle and think otherwise.

I can introduce you to people with £250k interest only mortgages on an income of less than £40k; or how about someone with buy-to-let mortagages for properties that don't even exist because it's tax efficient for his properties that do exist and I can introduce you to people with 125% mortgages.

You can call that regulation if you like, I call it shameless profiteering

Chris Hutt said...

Markets are bound to experience cycles of boom and bust since they are influenced by sentiment (greed and fear). Even a cold and calculating trader has to take into account the sentiment that will influence others.

The housing market illustrates that in terms that most of us can understand. For many years wise heads have been saying that houses were overpriced in relation to the economic fundamentals (like people's ability to pay), yet people kept on paying over the odds because everybody else was doing the same.

Ultimately the gap between the expected value based on economic fundamentals and the market value based on what someone is willing to pay becomes so great that the whole edifice becomes unstable and collapses.

More frequent cycles of boom and bust would clear out price anomalies based on sentiment before they grew too large. So ironically the Government might be considered to be at fault for having overseen such a long, uninterrupted (uncorrected) period of boom.

Kerry said...

"I can introduce you to people with £250k interest only mortgages on an income of less than £40k; or how about someone with buy-to-let mortagages for properties that don't even exist because it's tax efficient for his properties that do exist and I can introduce you to people with 125% mortgages."

In the first and last of these examples, doesn't personal responsibility come into it too? If someone applies for a mortgage they can't afford, whose fault is it? The bank for lending the money, or the borrower for asking for it in the first place? As for the FSA- of course there are questions to be asked about the effectiveness of their regulatory oversight (and I regularly asked them and the Bank of England about the possible consequences of the level of hedge fund activity and derivatives trading when I was on the Treasury Select Committee). I don't see it as their role to micro-manage banks, however. That was kind of the point I was making in my original post - that there are meant to be checks and balances within banks and lots of people being paid lots of money to make sure the banks are being run on a prudent basis. It's not just a matter for the regulators.

thebristolblogger said...

doesn't personal responsibility come into it too?

Kerry, the whole of the international banking system has just collapsed due, it's widely agreed, to the level of junk debt in the system.

I was simply supplying you with actual everyday examples of this phenomena. Do you really want to suggest that this collapse isn't a complete and utter failure of the current financial system and its regulation but a problem of personal responsibility?

Anyway, now that ordinary people like myself own the banking system, what's wrong with regulating it in our interests rather than in the interests of well-connected greedy fools on 6 figure salaries?

Sneer at it as "micromanagement" if you like but it's perfectly apparent to many people that basing your banking system on the international wholesale money markets is a disaster that hasn't delivered much to a lot of ordinary people.

What's wrong with having a banking system - now that we own it to all intents and purposes - that can only lend money on the basis of actual deposits and real assets on their balance sheets that you don't need to be a Cambridge mathematician to understand?

What's wrong with demanding that banks only extend credit on the basis of a realistic valuation of the price of assets (ie. houses) rather than on what estate agents claim?

And what's wrong with only allowing banks to extend credit to people at a level they can afford (widely believed to 3 - 4 times income)?

Of course, the upshot of these kind of controls is that ordinary households on average incomes, such as ours, could afford to own a 3 bedroom home for our family to live in Bristol, because the price of houses would come down.

The upshot would also be that people in the city wouldn't be able to make huge sums of money for themselves would they?

What price a homeowning democracy? And who has to pay it?