I have just had a new experience. I have just read a book about sub-prime and the credit crunch that does not demonise bankers. The book is “Engineering the Financial Crisis: Systemic Risk and the Failures of Regulation” by Jeffrey Friedman and Wladimir Kraus.

The central argument of the book is that the real reason for the deadly concentration of housing market exposure built up in banks assets was that the regulation of banks made holding mortgage backed securities (MBS) disproportionately attractive. As well as the regulators, the authors also criticise the role of the ratings agencies, who provided homogeneously wrong information, with little downside experienced for their mistakes. (They question whether the protected oligarchic structure of the present system would be better replaced by a more diverse, less restricted marketplace of competing agencies). To summarise, they argue that misled incentives from the regulators and ratings agencies together provided an environment where higher tranched MBS required far less capital reserve than investing in other areas such as business and industry. The banks naturally made more profits more easily if they could maximise the volume of their activity in relation to their limited capital base. The authors show that banks disproportionately bought into this MBS market, to a greater proportion than that of non bank investors, allegedly for this lower capital reserve requirement reason. The perverse situation was created where increased investment in MBS, which turned out to be extremely risky, allowed banks at the time to improve the official risk statistics of their businesses, while at the same time borrowing more against their capital base.

The above explanation for part of the sub-prime crisis pushes against the short-term pay incentives and too big to fail risk taking narratives which have pervaded since the crisis. To go further the authors provide evidence that certain bankers did not in fact recklessly maximise their risk exposure and profits in relation to MBS, but clear instances of restraint and risk aversion can be seen. As alluded to in the above paragraph, the banks used some of the benefits of the favourable treatment of MBS by regulators to improve their official risk statistics, rather than pushing potential exposure and profits to the limit.

It is always good to hear the other side of the case, but I am not sure their reasoning is completely water tight in this area. An analogy of their argument could be in the form of bankers as drink drivers: if they really thought they were immune from being penalised for drink driving, they would have gotten totally drunk, but in fact they only had four pints and aimed to drive slowly . . . then crashed! But does people's decision making in relation to risks and fear really work in this min max binary style, or are people affected to degrees? Just because there is good evidence that many bankers did not maximise their negative reaction to the incentives of pay structure and too big to fail, does this mean that there was no effect? Take away these deadly twin incentives for risk taking, and perhaps the downside possibilities - however unlikely and under-appreciated at the time - would have led, wisely, to an even more cautionary stance. Then, when the storm hit, the authors criticise officialdom for putting pressure on banks to use fire sale market prices to value their MBS assets: “price fetishism”^(p149). This dramatically damaged the banks’ balance sheets and, when combined with reserve capital requirement regulations and the belated pessimism of the ratings system, immediately and disproportionately starved them of the ability to continue lending to the wider economy and each other (the credit crunch). The authors argue that in many cases the valuations generated by mark to market accounting in the depths of a crisis were unnecessarily harsh, and that later the confidence of bankers in their distressed assets was borne out.

Bankers may have a point in complaining that mark to market valuation was too harsh a measure of their financial products in the fear bound days of a credit crunch: “The foolishness of crowds enacted into law” ^(p91). But it is useful to ask why the “crowds” had no confidence in these assets. The answer is partially that the mortgage securitisation process or production line had methods of operation and internal incentives that did not inspire confidence in the resulting assets. These are the incentive and accountability issues with the sub-prime gravy train that are now common knowledge (e.g. starting with falsified income statements and home valuations). The complex, clever structures and risk management approaches supporting securitised mortgage investments inspired too much confidence before the crisis, and, as it would be easy to assume from the extract below, arguably inspired too little confidence when the crisis hit:

“Moreover, due diligence on CDO's was virtually impossible under the best of circumstances, since they tranched tranches of private label mortgage backed securities that, in turn, tranched hundreds or thousands of mortgages. Due diligence in the midst of a panic, when quick decision making was needed, was a practical impossibility. These factors - amounting to a classic case of 'uncertainty' - created a vicious cycle of falling mortgage-bond prices” ^(p102).

The authors make another conclusion which chimes with Long Finance thinking. This is the Hayek type of observation that a diverse range of financial companies free to approach questions of risk and capital requirements without regulation would generate a healthy heterogeneity. They argue that even if groups of individual regulators hold different opinions, they inherently have to arrive at a single approach, where as in contrast competing companies can simultaneously and automatically diversify their approaches, and hence reduce the systematic risk within the whole financial industry:

“This renders heterogeneous opinions among regulators or voters fundamentally different from heterogeneous opinions among capitalists, for when capitalists disagree, they can (in effect) test their discordant theories against each other by competing with each other. . . . By the same token, economic competition, like biological evolution, need not have some master note-taker standing above it and learning its lessons if the process is to do its work. This is crucial because such a synoptic perceiver, being human (hence ignorant and fallible), could not be relied upon to learn the right lessons from the process being observed. The process of competition 'learns' these lessons as mechanically as evolution does—not by anyone thinking about them, let alone engaging in debate about them, but instead by weeding out—through bankruptcy in the limit case—the erroneous theories embodied in loss-making firms. The participants in this system need not be well informed, prescient or even particularly intelligent. They need only be heterogeneous” ^(p136-137).

Even though I strongly agree with this approach, I would argue that even this point the authors make is dependent on a greater simplicity and the existence of more isolatable units within the financial system. The authors’ ideal of the robust diverse ecology requires the orderly death and extinction of unfit business plans / risk models, and this cannot happen if there is a web of derivatives etc. connecting financial organisations together, lying in wait ready to pull down healthy neighbours through contagion.

The common theme linking the authors’ arguments is that it was ignorance^{(“radical ignorance” p128)} and not perverse incentives that seems to have been in play. Cock-up not conspiracy? Few involved foresaw the sequence of events: bankers, regulators and politicians alike just got it wrong. The most effective parts of their argument are where they reveal or remind us just how much politicians and regulators in the U.S. bought into the illusion of affordable mortgages for all, aided by securitisation. But if the actors within the financial industry in particular are let off with this lesser offence of cock-up, then they must at the same time accept what inherently follows from this verdict. If they have been shown to be on the whole ignorant throughout the forming of this complex world changing crisis, then the greater simplicity of financial instruments and structures must surely be the best defence against the unforeseen problems therefore inevitable in the future. In times of uncertainty, it is simplicity and transparency which instils confidence. When a shock occurs, simple systems are easier to asses, re-design and repair. History shows we should have limited confidence in the players of the game being able to avoid financial crisis, so they should develop a financial system that is more suited to the fevered scrutiny, orderly bankruptcy and surgical redesign required in inevitable future crises.

Strategies for making money, managing risk and circumventing capital regulations / tax liability have exponentially increased in volume and complexity in the last few decades. If ignorance and unintended consequences are now the plea of the financial industry in the face of meltdown and tax funded bailouts, then they also have to forgo our confidence and permission to continue constructing these lofty edifices. Although complexity can be justified in terms of the companies own objectives, often it would be a struggle to justify much of the financial industry's complexity from a wider social benefit standpoint. Strategies and financial products allegedly justified by providing the 'public good' of risk diversification and management, often just improve the particular narrow risk management or leverage objectives of that company at that time, and do not in fact contribute to improving the risk absorption capacity of the whole system. The truth is that the wider system may fare better in crisis if key sources of risk remained in their raw, un-securitised, un-hedged and un-complicated state.

“The history of banking is that risk expands to exhaust available resources. Tail risk is bigger in banking because it is created, not endowed. For that reason, it is possible that no amount of capital or liquidity may ever be quite enough. Profit incentives may place risk one step beyond regulation. That means banking reform may need to look beyond regulation to the underlying structure of finance if we are not to risk another sparrow toppling the dominoes.” ^{(Andrew Haldane, “The $100 Billion Question”, March 2010)}.

In other words, it is useful to look at the issue from the reverse direction. Assume first that the risk which a bank or banker wants to experience, or her appetite for risk, is fixed. Therefore any new financial product or technique which will (on paper?) reduce the risk of her present exposure will merely encourage her to take on new profitable risk, returning therefore to the previous level of overall riskiness. My neighbour's house looks like it is about to fall down onto mine. I help him by building buttresses against his walls. Then he just builds two more floors on top, making it just as unstable as before! Is it not better to force key financial organisations to remain in the remedial state, holding simple raw sources of risk which they cannot massage away through financial sleight of hand?

A banker complaining that her assets were undervalued by the market in a crisis could be compared to a newspaper journalist complaining that his articles were not popular because the target readership did not understand them. It is the journalist's job to ensure his articles are understandable to the reading public. It is the banker’s job to ensure the value of her assets and liabilities are understandable to at least key members of the investing community. After creating financial products which are innovative and profitable, but also opaque and complex and therefore more vulnerable to market sentiment, do they then want to defer to free market signals and sentiment only when it suits them? Banks as businesses are different: they are in the business of providing confidence. And they and their assets should, through more simple and robust modes of behaviour, inspire confidence even in “the foolishness of crowds” during times of crisis.